At its best, investing in penny stocks can be an exciting, lucrative endeavor. In most cases, a good strategy is to maximize the leverage of the invested capital by buying as many shares as possible. A move of only a few pennies when multiplied by a large position can equal a substantial gain in a relatively short period of time. Additionally, penny stocks can have lower trading volume than many listed options, a lack of liquidity which might present additional trading difficulties.
As investors become more sophisticated they turn to products such as options as a method for increasing the amount of leverage in a position. Given the lure of penny stocks and options it's natural for an investor to try and combine the two. Unfortunately, in the case of penny stocks, trading associated options is not possible.
Key Takeaways
- Penny stocks are low-priced shares of companies that often come with a greater degree of risk and volatility.
- Because they have low share prices, investors and traders can acquire a sizable position, especially if employing leverage or options contracts.
- Leverage however, can magnify the risk and volatility associated with penny stocks, so beware!
Options on Small-Cap ETFs
While it may not be possible to trade options in specific penny stocks, it's still possible to use options to leverage the potential of the small-cap or micro-cap universe. One popular product for trading small-cap stocks is the iShares Russell 2000 ETF (IWM). For those unfamiliar with this product, IWM seeks to track the investment results of an index composed of small-cap U.S. equities.
Let's look at a historical example: Over the twelve months ending Sept. 23, 2014, IWM returned 17.62%. While it isn’t possible to trade options in many of the components, it's possible to trade options on the ETF itself. Small moves in the underlying ETF generally translate to significant movements in the options. One of the biggest benefits of trading options in small-cap ETFs rather than the stocks themselves is that it removes much of the company-specific risk.
Margin Accounts
Another method for increasing leverage to penny stocks is to set up a margin account. This type of investment account gives investors access to additional capital based on leveraging capital and securities existing within the account. Essentially this is the equivalent to borrowing money from your broker, using existing cash and securities as collateral, and then paying interest on the borrowed money for the right to use capital for buying and selling shares.
While trading on margin provides investors with additional leverage, it can be extremely risky. Using money that you don’t have for the purpose of buying any kind of stock is frowned upon by many, and if not used correctly, can lead to financial ruin. A good rule is to tread lightly whenever using margin or leverage of any kind to buy financial assets.
The Bottom Line
Buying penny stocks with cash can be a risky maneuver. That said, there are some traders out there that would like to increase their leverage to penny stocks even more by using products such as options. Unfortunately, in the majority of cases, options are not available for trading penny stocks. However, some risk-tolerant traders can turn to options on exchange-traded funds as a workaround. Some traders may even use the benefits of their margin accounts when trading penny stocks, but this should be considered a last resort and used with extreme caution.
FAQs
Some experienced traders with well-diversified portfolios who are risk hedgers and use options as part of their overall trading strategy choose to use portfolio margin because it can translate to more buying power in their account.
Are penny stocks good for options? ›
Penny stocks are low-priced shares of companies that often come with a greater degree of risk and volatility. Because they have low share prices, investors and traders can acquire a sizable position, especially if employing leverage or options contracts.
Why should trading on margin be avoided? ›
While margin loans can be useful and convenient, they are by no means risk free. Margin borrowing comes with all the hazards that accompany any type of debt — including interest payments and reduced flexibility for future income. The primary dangers of trading on margin are leverage risk and margin call risk.
How much margin is required for option trading? ›
Margin requirements (applies to stock & index options) Greater of these 3 values: 100% of the option proceeds + (20% of the underlying market value) – (OTM value)
Can you make a living trading penny stocks? ›
Yes, you can make money with penny stocks, but you can also make money playing the lottery, though you probably won't. To make money in penny stocks, you have to be able to separate the good companies from the bad, and that means you have to be able to analyze companies.
What percentage of penny stocks succeed? ›
Smart money doesn't only go to large companies like Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN). Many investors look for smaller companies poised for a breakout that have reasonable valuations. Still, penny stocks have their risks — over 90% fail.
What Cannot be traded on margin? ›
Non-marginable securities include recent IPOs, penny stocks, and over-the-counter bulletin board stocks. The downside of marginable securities is that they can lead to margin calls, which in turn cause the liquidation of securities and financial loss.
Can you lose more than you invest in margin trading? ›
On its website, it says that margin accounts "can be very risky and they are not suitable for everyone." Before opening a margin account, the SEC suggested that investors should fully understand that "you can lose more money than you have invested," and they may be forced to sell some or all of their securities when ...
How to safely trade on margin? ›
If you're thinking about margin trading anyway, you need to make sure you have enough cash on hand to cover any potential losses if your investments fall in value. Otherwise, your investments could be liquidated, and you could lose a significant amount of money.
Has anyone got rich off penny stocks? ›
People do get rich by using penny stocks primarily due to its volatility and fluctuation of price. There is no process to become wealthy by only investing in penny stocks.
Even so, the gains posted by Ambrx Biopharma (AMAM) in Friday's session are unusual and particularly eye-catching. The stock soared to the tune of a hardly believable 1007% after the company announced pleasing results from the mid-stage testing of its breast cancer drug ARX788.
Is it smart to trade on margin? ›
The bottom line. Buying stock on margin is only profitable if your stocks go up enough to pay back the loan with interest. But you could lose your principal and then some if your stocks go down too much. However, used wisely and prudently, a margin loan can be a valuable tool in the right circ*mstances.
Is it better to trade on margin or cash? ›
Cash accounts provide stability and simplicity, while margin accounts offer the allure of increased opportunities and flexibility. You should approach margin trading with caution, fully understanding the mechanics and risks involved.
Should I trade futures or margin? ›
While margin trading offers higher potential for profits but also exposes you to higher potential for losses, futures trading is more stable in results. The difference between margin trading and futures trading lies in the ownership of assets, risk and leverage, timeframe, and price determination.
Is it better to buy on margin or margin call? ›
A margin call occurs when the percentage of an investor's equity in a margin account falls below the broker's required amount. An investor's margin account contains securities bought with a combination of the investor's own money and money that was borrowed from the investor's broker.
