The term penny stock does not actually have a strict definition. One of the more common definitions of a penny stock is one which is literally priced in pennies or more specifically with a share price under a dollar. A more common definition however is that a penny stock is any stock which is priced under $5.
Another way that people define whether a company is a penny stock is according to how it is traded. This definition describes penny stocks as being those companies which trade on the over the counter market or the pink sheets. In other words, these are alternates to the traditional stock exchanges such as the NASDAQ or NYSE.
Why Trade Penny Stocks?
While the risks are higher than those you may encounter on the conventional stock exchanges, it is return on investment (ROI) figure that keeps people addicted to penny stocks. There is a lot of money to be made in these explosive investments–but only if you know what to buy, and when.
In the penny stock market you will of course have losing trades. But, you make money in penny stock trading by cutting your losses short, and taking profits when the market gives them to you.
How Much Money Should You Invest in Penny Stocks?
Penny stocks must be viewed as a purely speculative investment. The exact amount of money that you want to devote to penny stocks will depend on your own appetite for risk. A conservative investor may only want to invest 5% of their portfolio or less in penny stocks where as an aggressive investor may wish to invest more than this. Generally though it is recommended that penny stocks make up no more than 10% of your portfolio.
Trading Penny Stocks
When trading penny stocks two of the most important things to look at are liquidity and size of the spreads. What follows are some of the basic strategies you can use when trading penny stocks.
With momentum trading you aim to profit by following the existing trend for the stock. For example if a penny stock is trending strongly upwards you would buy in until a reversal was signaled at which point you would sell out. Momentum traders will often trade on the release of news pertinent to the company which will push the stock of the company one way or another.
With fading you are shorting the stock when a stock that has surged up shows signs of falling back. The idea here is that a stock which has a lot of momentum will eventually become overbought. Traders will start to take profits and this will push the stock back down again. The key here is timing as you need to make sure that you don’t short the stock to early and that you cover the short before buying action forces it back up again.
Scalping is where you make multiple small trades throughout the day to pick up on the difference between the bid and ask price. With penny stocks the bid-ask spread can be quite wide which makes it perfect for scalping. This strategy allows you to make money even if the stock is moving sideways.
Here you are taking advantage of the daily volatility of a particular penny stock. The idea is to buy at the lowest point of the day and sell out at the highest point of the day. You are not so much concerned with the long term price direction for the stock as identifying these two points.
How to make your penny stock trading profitable?
Simply put, the correct penny stock pick can make you a fortune, and set you up for a life time of casual day trading. But sadly, making an incorrect penny stock pick seems to come easier than choosing the next Microsoft or Google.
These are the stocks that I would never touch:
• Stocks with a track record of diluting their share structure
• Stocks with no physical address or apparent presence in the market
• Stocks with a business model I cannot understand or identify
• Stocks with no apparent revenue, or prospects of ever making money
Most of the penny stock companies that can fit in any one of the above categories are either scams or operate in such a way to scare potential investors away from their stock. The one exception may be the companies that lack cash flow, but I don’t have the patience to wait around until they figure out how to make money. After all, who wants to invest in a losing company?
Some risks that come with penny stick trading
Lack of Liquidity
Penny stocks tend to be slightly illiquid to very illiquid. This means that there is not always an active market for the stocks that you own. This can mean situations where it is difficult to sell out at the price that you would like and if you do want to sell the price can be much lower than you would normally expect.
Lack of Accurate Financial Information
Stocks which are listed on the major stock exchanges have to follow strict regulations about providing accurate and timely information about their companies.
Penny stocks listed on the over the counter market is under no such requirements. This means that the information that is provided maybe inaccurate or there may be no public information provided at all. Doing analysis on these stocks can therefore be much more difficult.
Greater Levels of Manipulation
While stock manipulation exists at all levels of the stock market it is far more prevalent in the penny stock market. Penny stock promoters artificially inflate the price of the stock of the companies they have invested in so that they can sell out at a profit.
One thing you will learn in the penny stock market business is that you will never stop learning. Everyday is a new day in this business, and what worked yesterday, may no longer be valid tomorrow. You simply must keep up with news relevant to the stock market in general and your trade positions in particular.