You see these ads all the time: “This stock could go up 1,000 percent in the next week!” or “I made millions trading currencies and you can too!”
If you get sucked in, your heart starts racing and you start to imagine the thrill of a quick win — doubling or quintupling your money with a single investment.
These two investments — penny stocks and foreign currencies (a.k.a forex or FX) — are a sucker’s game and should be thought of as pure gambling. You might as well play blackjack as an investment; your odds of success are probably higher.
So what’s the catch? Why are other people making money and you’re getting warned away from these areas?
It’s all a matter of scale.
Foreign currencies (forex)
Let’s start with forex, the market for trading currencies. The size of foreign-currency trading is massive – around $4 trillion is traded every single day. It’s easy to open an account as a retail investor. Initial funding requirements can be as low as just $1, but it takes more than that to actually execute a trade.
So what’s attracting thousands of would-be millionaires to the volatile world of currency trading?
Leverage. In many cases leverage of 50:1 up to 200:1 is used which allows the average everyday Joe to control vast sums of money with a relatively small amount on margin.
Here’s how it works:
Let’s say you want to buy the US Dollar against the Japanese Yen and plunk down $5,000 to control a trade worth $250,000. By the end of the day, the dollar rises 1 percent against the Yen giving you a profit of $2,500 – a 50 percent gain in just one day.
Sound too good to be true? It is. Here’s the catch: if the value fell by just 1 percent, you lose $2,500…half of your investment. Unlike stocks, you can’t hold on indefinitely and hope that it will recover. A type of accounting known as “mark to market” means that all positions are closed out at the end of the day. Fortunes are won or lost in an instant.
Retail traders are at a huge disadvantage when it comes to foreign currency trading. Investment Banks and hedge funds typically make trades in this market, sometimes for speculation, but in most cases it’s simply to hedge their risk against the loss of capital from foreign currencies in international investments.
Such hedges mean that money is switching hands and influencing daily prices that may not correlate to macroeconomic trends. Over the long-term, trends will follow economic reasons, but on a day-to-day basis, one hedge fund’s decision to sell the US Dollar could cause you to lose everything in one day only to witness a jump in value like you predicted the day after. In other words, it’s nearly impossible to intelligently predict the short-term rise or fall of currencies in the forex market; it’s unpredictable and therefore akin to gambling.
When it comes to trading the Pink Sheets, or “penny stocks,” the risks are even harder to gauge than foreign currencies. A penny stock is the stock of a small company that trades at less than $5 per share and is not held to the same regulatory standards as larger companies.
Penny stocks do not legally have to reveal the same detailed financial information as larger companies, and this is what makes them so risky. Reliable information about these companies is virtually non-existent.
The other flaw in investing in penny stocks is the lack of liquidity. Stocks that don’t trade very often can mean that potential buyers are harder to find leaving you with no choice but to discount shares until someone finds them attractive. A common scheme known as a “pump and dump” takes advantage of this inherent lack of liquidity by hyping up the value of a stock until it’s sold at an inflated price that doesn’t match the stock’s actual value.
Penny stocks are mostly sold via paid subscription newsletters that claim to have the information you need. The only one making a profit in these situations is the person selling the newsletter. Don’t be fooled into thinking that a stock is cheap because it literally costs just pennies to own. If you invest $5,000 to buy 10,000 shares of a stock that costs $0.50, you will lose real money if the stock falls just a few pennies per share.
The simple rule is to avoid penny stocks, period. Some people are going to get sucked in anyway — so if you ever decide to gamble on them you can read more about minimizing your risks here.