Adam at Wealth of Geeks has written this excellent beginner’s post on penny stocks. I’ve got permission to republish it here, I hope you enjoy it.
Investing in penny stocks can be lucrative, but it can also be risky, which is why many traders avoid penny stocks when looking for cheap stocks to buy. To find success trading penny stocks, you need to reframe your investment mentality and recognize that the penny stocks trade market is not like a traditional major stock exchange.
There are different rules to penny stock trading and dramatically different approaches. While traditional stock trading methods will not work, you can learn how to successfully trade penny stocks and make a reasonable amount of profit in the process.
Tim’s note: There is a higher degree of risk with penny stocks. With bigger stocks, it’s easier for investors to protect themselves against price falls through swing trading but that’s not the case with penny stocks. While my swing trading course might be of interest, if you’re keen to look at penny stocks, understand the risks involved and do your research.
This article covers what penny stocks are, how they trade, and ways you can maximize your chances of success in pursuit of these volatile investments.
What Is a Penny Stock?
Once upon a time, penny stocks traded for pennies on the dollar. Today, some die-hard investors still maintain they are stocks that trade for less than $1 per share.
However, the U.S. Securities and Exchange Commission (SEC) has since revised the definition to include any stock priced under $5 per share.
The vast majority of penny stocks originate from untested small companies that don’t have any past performance to accurately judge their performance on the market.
As a result, most penny stocks are traded over-the-counter (OTC) on either the OTC Markets Group or OTC Bulletin Board.
Still, it’s possible to see stocks listed on a major exchange such as NASDAQ or the NYSE if they have enough shareholder equity, a certain number of public float shares, and high enough total assets, among other requirements.
Penny stock trades can bring large gains or significant falls in the blink of an eye. Some investors are drawn in by these risky stock trades while others turn away.
In any case, stocks at this share price are considered volatile and can see significant swings in short order.
It’s not uncommon for penny stocks to represent small companies that trade infrequently. In these situations, trading penny stocks can be difficult because of low liquidity or a lack of interest.
How Penny Stocks Work
Trading penny stocks is very different from buying and selling on major exchanges. Most trading strategies on Wall Street are based on playing the long game or looking for small companies poised to take off.
However, penny stock trading works best when you focus on a short-term investment that allows you to get in and out quickly.
Ideally, penny stocks trading works best when you identify a positive market trend, purchase shares quickly, and then sell penny stocks before the value dumps again.
This is one reason why penny stocks are considered risky investments, as trading strategies are almost always short-term.
One primary concern surrounding penny stocks on the OTC is fraud since these markets are not tightly regulated. Although infrequent, penny stock companies can result from clever marketing campaigns designed to supplement clever pump and dump schemes.
Others are small startups with little to no value that may have just opened their doors for the first time. These businesses have no history and few stock trades to glean insights from. Sadly, most of these enterprises never make it big and ultimately fail.
Shares at less than $5 per trade seem like a great launching point for beginner traders. However, the factors above make the penny stock market dangerous for those new to the game.
Still, active traders who can track market conditions hourly can benefit from investing in certain penny stocks identified for short-term profits.
One benefit of investing in penny stocks is that they require a meager upfront investment. It is possible to play the market and learn the nuances of penny stocks and how they trade before investing a substantial amount of money.
OTC vs. NYSE/NASDAQ Penny Stocks
It is essential to recognize that penny stocks traded over the counter do not have the same federal regulations or restrictions attached to them.
In fact, many penny stocks exist on OTC markets instead of the major stock exchanges because they cannot meet the minimum standard requirements to be listed there.
In other cases, some companies cannot meet the performance requirements necessary to stay on the New York Stock Exchange and are forced to move elsewhere.
Both NASDAQ and NYSE have rigorous reporting requirements that protect stock traders, but shares that trade over the counter have much fewer rules.
Consequently, the OTC is not an exchange but a market where some 10,000 to 12,000 securities trade between parties. When listed for a specific price, buyers and sellers can negotiate amounts before completing a sale. Depending on supply and demand, shares can be purchased for more or less than the listed value.
Most trades on Wall Street involve studying historical trends and acting accordingly, but penny stock traders don’t have history to rely on. Instead, these investors only have by-the-minute data analysis alongside quick and decisive instincts.
While market research is still required to invest in penny stocks, it is much more a day-by-day investment strategy that requires constant monitoring and readjustment.
This is why penny stock trades are more suitable for active traders and not those who are more interested in reliably building a long-term investment portfolio filled with publicly traded companies.
What Is the Risk in Trading Penny Stocks?
In terms of personal finance, penny stocks are not likely to make you millions. That being said, they can help experienced traders comfortably supplement their stock market portfolios.
The following are some of the most prominent risks that traders need to recognize before diving into the penny stock market.
Large businesses tend to be very liquid, with many shares being bought and sold all the time.
Penny stock companies usually fall on the other side of this spectrum, with few shares and little movement. This limited liquidity can make it a challenge to buy or sell shares quickly without impacting the stock price.
The result is stocks that may not sell quickly or have to be sold at a discounted value to move them out of your portfolio.
Companies Are Unknown
Alongside having few shares, several penny stocks come from companies with little to no track record. Even if they look good on paper, these ventures have yet to prove themselves in the real world. There’s simply no way to know for sure if they have what it takes to stand the test of time.
While penny stocks can be excellent short-term plays, many do not survive in the end.
Although fraud on NASDAQ or the NYSE is relatively rare due to stringent regulations that a stock must follow, scams are much more prevalent on the OTC.
In these cases, creators aim to drive up the stock price until it reaches a desirable level before selling their shares. This allows the share majority holder to get out with a profit, but all other investors promptly lose money.
Worst of all, these tickers can appear to be doing well at first glance, leading unsuspecting traders to invest. Situations like these show why research is crucial before making any investment, no matter how big or small.
Small Market Capitalization
OTC stocks tend to have a very low market capitalization, with most small companies on OTC trading platforms valued at under $300 million.
This is why their share price is so low and accessible, but it also means that the company can crumble very easily.
The number of shares you hold will determine how much money you lose when that happens.
Penny Stocks Are Volatile
At such low price points, penny stocks enjoy being extremely volatile. This volatility can work for or against you. Share prices can drop dramatically in a short period, but the opposite is also true.
If timed correctly, these swings in price per share can bring in significant gains. Missing the mark could lead to disaster.
Lack of Standards
Most investors find themselves day trading penny stocks on OTC markets where companies are not held to as high a reporting standard.
Even legitimate companies can lie about numbers without facing retribution from a higher power. Bloated numbers can lead to investments that don’t pan out when these businesses cannot deliver.
Bid vs. Ask Spread
Thanks to supply and demand, securities on OTC markets may be subject to significant differences between bid and ask price. Finding a bid set lower than the trade price and an ask set higher is possible with a small number of shares.
These swings can lead to money loss even if the share price stays the same.
Should I Buy OTC Penny Stocks?
Buying penny stocks is not for everyone, but savvy investors can make money from only penny stocks. Remember that the over-the-counter market requires constant attention and a keen eye for detail.
While many penny stocks represent legitimate companies, there is an inherent danger of pump and dump schemes or market manipulation.
Should you wish to trade OTC stocks, look for a commission-free trading platform with a low minimum deposit. This way, you can trade penny stocks with minimum risk until you accumulate valuable investment advice and become more familiar with the trading platforms.
Many investors are not looking for the next Amazon in a penny stock company. Instead, they are looking for stock trades that can jump in value.
The upside of OTC stocks is that there are potential profits to be made if you avoid the wrong stocks and find those with the potential for quick sharp price raises.
If you feel equipped to trade on the OTC market, there’s no issue with taking it slow. Simply because stock prices are low doesn’t mean you have to invest in a bunch right upfront. When you trade penny stocks, be prepared for the hills and valleys that inherently come along with them.
Suggestions for Investing in Penny Stocks
Whether new to the stock scene or a long-time trader, consider the following suggestions for buying and trading penny stocks.
Don’t Hesitate to Paper Trade
If you have the means, paper trading can be a great way to introduce yourself to this volatile market. You can compare your judgments against the real thing to see if your predictions were correct. Best of all, you’re not out anything your entire investment tanks.
Have a Budget in Mind
Once you’re ready to try the real thing, it’s ideal to have an amount of money set aside that you’re okay losing in the event things go sour. You don’t want to be out a life-changing amount of money if things don’t go as planned.
Choose a Good Trading Platform
When dealing with small amounts of money on the stock market, you don’t want to lose a chunk of it to commissions per trade. Finding a platform with a low minimum deposit also allows you to keep investments down until you’re ready to go big.
Stick to the Big Exchanges
Pursuing penny stocks that trade on exchanges such as NASDAQ and the NYSE is possible. While there’s still the potential for volatility, there’s less risk of shady dealings from manipulative offshore brokers trying to take advantage of limited information or pump and dump scams.
Do Your Research
Penny stocks may rise and fall quickly, but that’s not an excuse for skipping research on the ticker you’re investing in. Remember that companies on the OTC market don’t have to be as transparent with reporting, so you shouldn’t rely on company information alone.
If you can’t find any credible information to back up your pick, you may be walking into something fraudulent. Instead, find penny stocks that are also backed up by third-party sources.
How To Find the Best Penny Stocks
Penny stocks that have made their way onto a major exchange will always offer more security than those listed over the counter. With that in mind, keep these other tidbits in mind as you search.
It would be best if you looked beyond research and audience insights alone to find the best cheap stocks to buy when it comes to penny stocks. An equally crucial maneuver is to look at how penny stocks are trending and analyze their likelihood to rise or fall.
Stocks that are already carrying upward momentum have the potential to continue down that path. Since you’ve taken the time to do your research, you can feel confident that this rise is genuine and not part of a pump and dump.
Similarly, tickers kissing new highs can be great picks as well. A stock that’s staying up from those early morning gains may be ripe for a short squeeze or follow a similar pattern in the future.
If a company is legitimate, keeping an eye on its news can yield success. An upcoming earnings report, corporate filing, or acquisition announcement can create a buzz and a share price increase at the same time.
With several penny stocks in the technology or biotech space, information on an upcoming patent or FDA approval can also send shares soaring.
Several platforms exist for trading penny stocks on the NYSE or NASDAQ. To trade stocks on the OTC, you will need to work with online brokers outside the traditional stock market. Be sure to locate a reputable broker that won’t charge a commission per share.
Can You Get Rich Off Penny Stocks?
Everyone wants to strike it rich on the stock market, and a penny stock’s low price point can seem like a great way to do so. After all, if a $0.01 stock jumps to ten cents per share, you’ve increased your investment tenfold, right?
While the math behind this thinking adds up, the reality of such a situation is lacking. It’s doubtful the company you’re investing in will turn into the next Amazon, let alone grow significantly at all. Penny stocks are cheap for a reason, and a jump like the one above is all but unheard of.
That being said, there’s plenty of potential for profit with penny stocks. Exponential gains won’t come overnight, but anyone who trades intelligently can rack up significant income over a more extended time.
Investing in Penny Stocks: Final Thoughts
Penny stock trading is a high-risk investment that should be approached carefully by traders of any experience level. While the entry point is low, the ability to lose money is high, and the over-the-counter market is easily manipulated.
It is worth noting that penny stock trading is not a long-term investment strategy but instead utilized by a series of quick but well-planned out trades. Savvy penny stock investors with the available time to day trade can make consistent profits that will allow their investment portfolio to grow.
Disclosure: The author is not a licensed or registered investment adviser or broker/dealer. They are not providing you with individual investment advice. Please consult with a licensed investment professional before you invest your money.
Learn how to diversify and hedge your long-only stock portfolio. Sign up for a free insight into the Swing Trading 101 program developed over thousands of hours of trading over hundreds of thousands of dollars across stock, commodities, options, and cryptocurrencies. It’s designed to empower you to take a unique but strategic approach to the markets. Learn More.
Tim Thomas has no positions in the stocks, ETFs, mutual funds, forex, or commodities mentioned.
This post originally appeared on Wealth of Geeks and has been syndicated by Tim Thomas / Timothy Thomas Limited.
Featured image credit: Unsplash.