Penny stocks in popular industries such as cryptocurrency, legal marijuana, and biotech are seeing a rise in public interest and trading volume. This won't be news to many of my readers, but investors in penny stocks do very badly. However, when digging into the SEC data, even I was surprised at just how poorly investors do in penny stocks. With the surge in volume of penny stocks trading on the over-the-counter market, investors need a reminder of just how rigged the penny stock game is. The SEC recently warned that cryptocurrency and marijuana stocks have particularly been targets of pump-and-dump scams.
The SEC extensively studied penny stock (OTC) returns in a mostly ignored 2016 white paper. Here were some of their findings:
1. The trading volume of penny stocks is rising.
Penny stocks don't trade on the NASDAQ or NYSE. Instead, stocks trading for less than 1 dollar per share are relegated to trade on the over-the-counter market (also known as the pink sheets) run by OTC Markets Group (OTCQX:OTCM). In 2011, total OTC volume was roughly 136 billion. Now it's over 250 billion, and the overwhelming majority of the volume is penny stocks.
Investors are clearly not learning their lesson. Fraudulent stocks with buzzwords like "cannabis," "crypto," "blockchain," "biopharma," and "gold" are getting bought and sold as you read this article. The demographics of OTC-traded stocks are somewhat surprising. The researchers stated that buyers are wealthier and better educated than the typical American. It appears that the majority of the SEC's sample of penny stock investors had a bachelor's degree or higher.
2. The returns are even worse than you think.
Even if you don't trade penny stocks, knowing just how bad the returns are can teach you a little about the mechanisms (or lack thereof) behind stock returns on larger companies.
Here's what they found:
- The median penny stock returns -37 percent per year.
- The average penny stock returns -27 percent per year.
- Penny stock returns experience positive skew, but the mean is strongly negative. This means that a few penny stocks are big winners, but the gains from the winners are not nearly enough to cover the losses of the losers.
- Liquidity is weak for OTC stocks, with zero transactions occurring on roughly 50 percent of overall trading days.
- The typical investor loses a few hundred bucks per year playing the OTC market, but a few lose much more. In the aggregate, investors lose roughly 18 billion per year in penny stocks, which is about the revenue of the US music industry. The SEC report hypothesizes that many of the big winners from penny stocks are likely to be pump-and-dump scammers and promoters.
Here's what the SEC had to say about why penny stock volume is growing in spite of dismal investor returns:
The first hypothesis is that OTC investors are simply gambling since OTC stocks have a lottery-like distribution of returns. The second hypothesis is that investors are poor at estimating return probabilities of OTC stocks because these companies tend to provide fewer disclosures. Most academic studies provide empirical evidence more consistent with the second hypothesis...
I find this interesting because it makes me question the conventional wisdom around the market-wide relationship between risk and return. OTC stocks have loads of volatility and negative returns. But otherwise sophisticated investors still buy penny stocks, in spite of their abysmal returns. In fact, there are a lot of people with college degrees and good jobs losing money in penny stocks.
3. Holding for short periods of time won't protect you.
There are a lot of people online who push the idea of day trading penny stocks. Traders are also under the impression that they can hold penny stocks for a few days and get out before the drop. However, based on their returns, I believe that investors are fundamentally underestimating how bad short-term penny stock returns are. The median investor buys $2293 worth of stock, holds their penny stock purchases for 16 days, and realizes a return of -13.4 percent.
This is important. A notion that a lot of otherwise sophisticated retail traders have is that they can effectively ride an OTC short squeeze for a few days and sell their shares for a profit. The SEC data throws some cold water on this theory. It's not impossible to make money trading penny stocks short-term, but the data shows doing so is swimming against the tide.
Options provide a better alternative to penny stocks.
If you insist on making risky trades for small-dollar amounts, it would seem logical to try to get a better risk-adjusted return. As such, call options have expected returns (and risk) greater than common stock. While I tend to question the mentality of trying to hit it rich by investing a couple of thousand dollars, academic research shows that at-the-money call options have expected returns in excess of 9 percent per month. While I wouldn't recommend betting the farm, risk-seeking investors are likely to do better risking their money in call options in popular names like Apple (AAPL) or the Nasdaq (QQQ) than wasting it by trying to trade penny stocks.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.