How To Invest In Penny Stocks

Infographic courtesy of Timothy Sykes.

Successful penny stock traders, such as Tim Grittani, often make headlines. On September 20, 2015, CNN Money did a story on Grittani, a star pupil of Tim Sykes, famed penny stocks day-trader turned penny stocks investing instructor. Over a period of three years, Grittani turned $1500 into an investment portfolio worth more than $1 million. Success of this magnitude is the exception, not the rule, in this market. Volatile, with the potential for high returns or high losses, penny stocks success requires knowledge, skill and, for the average person, moderate expectations.

Penny Stocks Defined

The Security Exchange Commission (SEC) defines a penny stock as a common company share priced below $5. In common usage, however, the term is used to describe shares with a trading price of less than a dollar or two. These shares are not typically found on national exchanges, though some notable exceptions could be pointed out, such as when Ford was trading at a mere $1.87 during the first week of March in 2009.

Penny stocks, also referred to as microcap stocks, are usually traded via the Over The Counter Bulletin Board (OTCBB), an exchange run by the National Association of Securities Dealers (NASD), or in over the counter markets, including the OTCQB and the OTCQX. Information on these stocks, including bid and ask prices, is published daily in what are called pink sheets. The requirements for OTC listing are less stringent than for stocks listed on the New York Stock Exchange or NASDAQ. There is far less SEC involvement in penny stocks than in stocks trading on national exchanges on par with the New York Stock Exchange.

That difference in degree of stringency is an important distinction to bear in mind when assessing the viability of companies offering penny stocks, whether those shares are offered via exchange or market. In general, penny stocks offered via an exchange tend to be a bit – and that can be a very little bit – safer than those offered in over the counter markets. That doesn't mean that there are not good buys to be found in the OTC markets. What it does mean is that, when dealing in penny stocks, due diligence is always required.

Due Diligence Is A Must

Low share prices alone are not indicative of high risk or volatility. After all, there are many healthy, thriving small businesses. In fact, small businesses collectively employ more people in the United States than large ones do. Share price must be placed in context to arrive at a company or stock assessment that is as accurate as possible. Due diligence is all about assembling the pieces of information necessary to create that context.

Because penny stocks traded in the over the counter markets are obligated to provide less information than stocks traded via exchanges, you'll have to do some serious research to properly perform your due diligence. You're going to want to know about the history of the company, as well as its trade history. There's a big difference between a small company on the way up, one that is gradually growing and a company that is on a downward trajectory, perhaps delisted or fighting to avoid bankruptcy. A suddenly hot stock from a company with no real history or with a history that simply doesn't logically merit such sudden interest should be viewed with caution.

Beware Of The Classic Pump And Dump

That sudden, almost viral buzz around a little known company can be a sign indicating that a schemer is trying to make a killing using the classic pump and dump ploy. In this scenario, the schemer sets a whole lot of buzz in motion, hyping a particular company and its stock, shares that the schemer bought at a very low price. As interest grows, demand for the stock increases, right along with price and trade action. The higher the rise in share price, the more money the schemer will make when he or she sells that stock. Once the stock is sold and the profit made, the buzz dissipates and disappears, as does share value.

Study Trade Theories

Take the time to develop a real understanding of trade theories. That way, you enter the market with a plan of action. For the beginner, one of the safest strategies is to not hold on to penny stocks for too long. If you see a reasonable gain, or return on investment (ROI), be satisfied with that. Sell the shares and make that moderate ROI, instead of holding it in hopes of the price shooting up, garnering a return of two, five or ten times what you paid for the shares.

Once you gain a bit more experience, learning the signs of a company that is in a growth mode and recognizing the sorts of signals that may indicate a stock price is going to spiral seriously upwards, then you can move beyond the safety zone into those higher risk trades. There is a difference between educated risk and blind risk. Educated risk is part and parcel of successful stock trading, but wait until you have the knowledge and experience to take your trading to the next level.

Practice On Paper

One way to feel out penny stock trade theories and to get some real time trade experience without risking the loss of your hard-earned money is to practice on paper. Use a notebook to open up your practice trade account. Decide how much pretend cash you are going to fund your notebook trading account with. Research real trade rules, fees and limits and abide by them, treating your notebook trading account like it is the real thing while you buy and sell penny stocks according to the various trade theories you are learning.

As you learn trade theories, open a notebook account for each one and compare the results of your trades. Try developing your own method from the various theories, taking what you think works from each of the theories you are testing. Open a notebook trading account based on your assimilation of trade theory information and gut instinct. Once you find that you are consistently making good trades and understanding the how and why of those trades, you are ready to take your newly developed trading skills into the real world penny stock markets.

Setting Up For The Real Deal

The first step is to find a broker willing to work with what your budget allows for your penny stock trading adventure. You can find online brokers associated with well established brokerages with a proven track record of quality customer care willing to open a trading account for as little as $500. Before making a final decision on your broker, compare transaction fees and trade restrictions between at least three different brokerages.

Once you've created and funded your trading account, you can automate certain account functions for buying and selling. Not everybody can invest full-time hours into being in front of the computer screen watching trade action and performing manual buying and selling actions as trade ebbs and flows throughout the day. With a limit order, you can set the highest price you are willing to pay for a stock that you're interested in. When it comes to selling, you can place an order to sell if stock price hits a certain point.

While it certainly is possible to be wildly successful in the penny stock market, building the sort of investment portfolios that Grittani and Sykes have, that sort of success is rare. You may be better off with more moderate goals and expectations, using investment strategies that feature moderation, caution and smart risk-taking. When you profit, take some to add to your capital and leave some in the account to increase your investment fund. And, remember the tortoise – slow and steady often wins the race. You may very well find that over time, using that approach, you exceed your expectations.

Only Invest What You Can Afford To Lose

While experience and knowledge can protect you from many trade errors and losses, it cannot protect you from them all. Even the well-experienced trader can experience huge losses in the penny stocks market. The fact is penny stocks are and will always be a volatile market. Start-ups come and go. A company has a lifespan. Sometimes that lifespan can be generations long, but all too often it isn't. Sometimes, the market throws a curve ball that is impossible to predict. Your smartest strategy is to invest only the amount of money that you are willing and able to lose.