When you hear the term “penny stocks”, something along the lines of small investment with a large return probably comes to mind. While it’s possible to turn a profit without breaking the bank to buy shares, you can also end up on the shorter end of the stick as these investments are quite risky.
Keep reading to learn more about penny stocks and how to get started with trading:
Table of Contents
What are penny stocks?
Penny stocks are defined by the Securities and Exchange Commission (SEC) as shares issued by small or micro-cap companies for any amount below $5 per share.
They typically trade on the over-the-counter (OTC) or dark market. But you may find some on U.S. securities exchanges, foreign exchanges, and in rare cases, on major exchanges.
They are designed for investors who can withstand a high level of risk as the low price point is a tell-tale sign of bigger issues going on within the company. It could be anything from cash-flow issues to impending bankruptcy or fraud. You could also be dealing with a startup with little to no track record or a company with management woes.
How to get started with trading penny stocks?
Step 1: Do Your Homework
Since you are aware that the low price per share has an underlying connection to something that’s going on into the company, it’s your job to pull back the curtain. Once you’ve done your due diligence and are ok with the riskiness of the shares, you can move on to the fun part; actually buying or selling shares.
Not sure where to start? Consider reaching out to a seasoned penny stock trader for guidance. They can serve as your mentor and help you avoid some of the same mistakes they made early on.
You can also try your hand at “paper trading” to get acclimated with buying and selling shares. It won’t cost you a dime and will give you a bit more time to decide if you want to move forward with investing in that particular company or penny stocks altogether.
Step 2: Decide How Much You Want to Invest
There’s no golden rule for the exact amount you should or shouldn’t invest in penny stocks. But one thing’s for certain: you should only put an amount on the table that won’t tear apart your finances if you lose your investment.
Why so? Penny stocks are volatile and “investors in penny stock should be prepared for the possibility that they may lose their whole investment,” according to the SEC.
When deciding on an amount, also consider the volatility of the industry the company is in. it may be tempting to dump all your hard earned cash into a company within an industry on the up and up. But be mindful that this could be the result of a short-lived fad and will put your investment at even more risk.
Step 3: Start Trading
Still sold on penny stocks? If you’ve done your due diligence and made the decision to invest on the merits of your own research, and not a “hot commodity” someone else is selling you, it’s time to start trading.
Even if you’ve done some paper trading, it’s best to start off slow with a small amount and buy and sell more shares once you’re comfortable.
Some Important Considerations
Before you dive into the world of penny stock trading, there are some risks you should be aware of.
Trade Volume and Fees
It’s no secret. The trading volume for penny stocks is relatively low because of their risky nature, so you may find it difficult to buy and sell at the most optimal times. You also want to pay attention to the fees that brokers sometimes tack on to penny stock trades.
If you find that they are substantially higher than what you’d pay to trade regular shares, move on to brokers that don’t employ this practice.
If the shares aren’t listed on a major exchange, like the NYSE or Nasdaq, proceed with caution as the regulations are little to non-existent. In turn, you have much more to lose as there’s no way to gauge how the company will perform in the short or long-term with little information to go on.
Return on investment
When trading penny stocks, there’s no guarantee that you’ll turn a profit. In fact, the odds definitely aren’t in your favor if the company the shares are tied to is in the midst of a financial storm or rough patch.
While this isn’t a definitive nail in the coffin, you have to think about the time between the purchase of shares and when the stock price appreciates and if it’s worth the wait. This could take months, if not years.
Be on the lookout for scam artists that promise to make you wealthy from penny stocks overnight. They do this through promoting a particular stock heavily or issuing warnings that a particular stock should be avoided at all costs. Either way, these deceptive marketing tactics can drive prices up or down in a jiffy and wreck your earning potential.
Investors that are ok with taking on risky investments and waiting it out may find that penny stocks are a suitable way to turn a profit. Otherwise, you could be better off buying stock from an established company that is traded on a major exchange to help minimize the risk of loss.