What are Penny Stocks?
Penny stocks (also called micro-cap stocks) are stocks with extraordinarily low stock prices. There isn’t a firm, SEC-approved definition of a price limit for penny stocks, but typically anything from $5 and less is looked at as a penny stock.
The companies are very risky propositions. There are really two types of penny stocks: real companies and scams.
Remember, stock price is tied to the market’s expectation of future performance. If the stock price has fallen very low the market is not expecting the company to be around much longer. Yet if the company is a real company with real revenues, expenses, and earnings there is a chance it can return to its former glory.
A good example of this is Citigroup during the financial crisis. The stock had been cruising around $50 per share and crashed down as low as $0.97 per share. The market thought Citigroup was going to disappear, but if you had taken the risk you would have been rewarded handsomely. Shares are currently at $47.
Citigroup is an example of a real company facing serious headwinds. Risky, but a real company.
The other type of penny stock are scams tied to pump and dump schemes. These stocks often don’t trade on the major exchanges and are either traded on the over-the-counter bulletin board (OTCBB) or via pink sheets. Pink sheets are compiled in a daily publication by the National Quotation Bureau and the shares used to be physically traded over pink pieces of paper. Pink sheets are not on a stock exchange and do not need to meet minimum requirements or file with the Securities and Exchange Commission (SEC).
Editor’s Resource: Best Penny Stock Newsletters
As you might expect this type of penny stock is at significant risk to price manipulation and pump-and-dump schemes. Pump-and-dump schemes are where someone buys a bunch of shares in a penny stock then encourages others to invest so the price goes up; that’s the pumping part.
Once the shares have risen enough to make a tidy profit the pumper then dumps the shares and sells everything he has at the higher price to all those other investors that were drawn in by the encouragement of the pumper.
That having been said there is definitely money to be made with penny stocks. I just want to provide fair warning: this isn’t your normal day trading of stocks. This is a risky operation that is fraught with hidden agendas. Coming into the situation with this knowledge allows you to prepare how to defend yourself from the risks while still working your way to a profit.
How to Invest in Penny Stocks
First, you need a broker that has inexpensive trading fees and extremely fast execution. You will be trading a lot so high fees can ruin your profits. Slow trading execution times can result in massive losses due to the fluctuations in the stock price while you wait. You put in an order to buy or sell and it takes a while to go through, meanwhile the stock moves in the opposite direction you want it to and you end up losing a ton of money.
Next, you start doing research on companies to potentially invest in. This requires in-depth analysis so you can avoid the pump-and-dump schemes and focus on real companies. You’ll need to come up with your own criteria as to what makes a stock attractive, but you can’t do a simple search for low stock prices and just start flinging money at random penny stocks.
Once you invest in shares you have to watch them like a hawk. This is not a buy-and-hold philosophy. Penny stock traders often hold shares for less than a day — or even trading in and out of the shares multiple times per day. You have to be able to dedicate the time to being aware of the fluctuations in the price so you can exit at a profitable moment.
4 Ways to Find Top Penny Stocks
Here are four ways you can narrow down your search for the right penny stock:
1. Subscribing to Free Penny Stock Newsletters
There are a multitude of penny stock newsletters available. They have various criteria and many of them are plying shares in order to pump up the price so you must be cautious. The SEC requires the newsletters to have a disclaimer at the bottom of the email as to why the company is being promoted.
More often than not it is because of the firm’s investors we can to drum up support for the stock price. There’s nothing inherently wrong with that — the good companies are trying to ‘graduate’ off of the OTCBB and pink sheets to a more reputable exchange like the NYSE or Nasdaq, but you must know the motivations behind the newsletter.
2. Paid Penny Stock Services
Another option is to pay for a membership to a penny stock alert website. These websites charge you and provide the analysis and alerts of potential investment options. Again, there’s nothing wrong with outsourcing the work but you must know the reputation of the firm and the motivations behind the alert.
3. Penny Stock Experts like Timothy Sykes or Jason Bond
Timothy Sykes turned $12,000 of bar mitzvah money into $4 million over several years.
Just trading penny stocks.
He has a website and newsletter that promises to train you in the methods he used so you can replicate his success.
Likewise, Jason Bond Picks is another website that focuses on training you on how to profit from swing picks of stocks valued at $10 or less.
These aren’t the only two gurus with newsletters and services, but they are two of the most prominent ones available to learn from.
4. Learning the Fundamentals and Technical Analysis
Alternatively you can learn all of the fundamentals, technical analysis, and other strategies that are the foundation behind all of the experts’ success. This is by far the hardest route — no one is doing the work for you, no one is providing you a list of stocks to pick from — but can be the most rewarding as you come up with your own unique strategy.
How to Trade Penny Stocks
There are two methods to trading penny stocks just as there are with any other stock. The only difference is the small changes in stock price can be huge profits or losses. Things move faster at the penny stock level than they do with shares at $50 each.
Buy and Sell
You buy at a lower price and sell at a higher price. Buying shares at $1 and selling them at $1.25 in a few hours or days is a 25% profit. Buy 1,000 shares you would profit $250 before taking brokerage trade commissions into account. This method is hoping for the stock price to go up.
Short and Buy Back
The opposite of buy and sell: you want the stock price to go down. When you short a stock you borrow shares from your brokerage firm at the current price. In the future at hopefully a lower price you buy shares and return the shares you had to the broker. A stock starting at $1.25 that you short down to $1 would result in $0.25 profit per share.
There is more risk on shorting stocks because the downside is unlimited. If you short 1,000 shares at $1.25 and they skyrocket to $10 per share you’ve just lost $8,750. On the other hand if you had bought shares in hopes of them going up and they plummet to $0 you would only lose $1.25 per share (for a total loss of $1,250).
Penny stock trading is definitely not for everyone. Those who are okay with riskier investments and don’t mind losing your shirt a few times before making any money, then you should give penny stock trading a try. Make sure you tip toe into it and invest small amounts of money before scaling up your investments. There is a service that you should check out that is a great way for beginners to learn penny stocks. Click here