As you get your feet wet in the world of investing, a dramatic run in the value of a penny stock is going to catch your attention at some point. It happens all the time. But as a beginner, you’re told to stay away.
In fact, the United States Securities and Exchange Commission (SEC) defines penny stocks as highly speculative investments in small companies. The regulatory authority says that these stocks trade with little liquidity, meaning that once you own shares, it may be hard to get rid of them.
Outlining the dangers further, the SEC goes on to outline a long list of risks associated with these stocks.
Regardless of the risks, many beginners get involved anyway. A little reading online will outline personal stories from some that went from fast food workers to market millionaires. The allure of the high end life with big boats, fast cars, and beautiful people is too much for many to ignore.
The truth of the matter is that not all of us have to. There’s a subset of the investing community that can really make it big trading penny stocks. Do you fall within that category?
What Are Penny Stocks
Penny stocks earned their name decades ago when pennies were actually worth something. At this time, penny stocks were defined as companies that traded at values of $1 per share or less. Today, they have incredibly little value. As such, smaller companies, generally trading under $5 per share are considered to be penny stocks.
Most penny stocks are traded on Over-the-Counter (OTC) exchanges and come with an elevated level of risk. Some of the most important risks to consider when considering penny stocks include:
- Pre-Revenue – There is a large number of stocks that trade in the penny range that don’t generate revenue at all. These companies are in the research and development (R&D) stages. For example, a biotechnology stock that trades in the penny range likely has no approved drugs on the books. Instead, these companies are hemorrhaging money in an effort to develop new therapies. At the end of the day, pre-revenue companies will need to get their hands on funding. Unfortunately, this leads many to raise funds at the cost of investors, sell off what little assets they do have, or enter bankruptcy.
- Liquidity – As the SEC outlines, liquidity is a major concern for penny stocks. Oftentimes, these stocks trade very few shares per day. If you purchase a penny stock that doesn’t trade and realize that you’ve made a mistake, it will be hard to sell your shares to anyone to get out of your position. This leads you to being stuck in a losing streak.
- Quotes – In many cases, it can be difficult or even impossible to find an accurate price quote for penny stocks.
- Speculation – The bottom line is that penny stocks have not proven themselves to the investing public. If they had, they would be trading at much higher values. As such, investment in penny stocks is fuelled by speculation. Investors speculate that a new product that hasn’t been sold yet will take its market by storm. They speculate that a biotech company may cure cancer or a tech company may be onto the latest and greatest piece of technology. The reality is that the chances of these blockbuster events are minimal, and wrong decisions with regard to penny stock investments can lead to a substantial loss of value.
It’s Possible To Make Big Money Flipping Pennies
The truth of the matter is that while penny stocks tend to come with elevated risk, there’s a reason that they’ve become so popular. Making the right investment decisions when investing in large, household names, or blue chip stocks, can yield 10% or more per year. However, making the right decision when it comes to a penny stock investment can yield gains of 10%, 20%, or even over 100% in a single day.
Of course, doing so takes quite a bit of work. After all, blindly throwing money into any stock is a dangerous move, but blindly throwing money into penny stocks is just downright stupid.
Who Should Invest In Or Trade Penny Stocks?
There’s no questioning the fact that penny stocks are risky plays. So, investing in and trading them is not for the faint of heart. Here are some qualities of those that should consider trying their hand at investing or trading in this risky arena:
Who Should Invest In Penny Stocks?
Investing is a long game. It’s the process of buying and holding shares through the good and bad, looking for long-run gains. Due to the highly speculative nature of penny stocks, there are far more short-term traders in them than there are long-term investors. Nonetheless, there are plenty of investors that put a percentage of their portfolio into pennies, hoping to predict the next big winner.
Here are the qualities of those who should consider investing in penny stocks:
- A Healthy Appetite For Risk – Risk has been a big topic within this article. If you’re going to invest in penny stocks, you have to have a healthy appetite for risk. If you’re a risk averse investor, penny stocks simply aren’t for you.
- A Diversified Portfolio – No matter how strong your belief that a penny stock is going to run through the roof, this is not the place to have all of your eggs. If you’re going to invest in penny stocks, it’s important that they are a small part of a properly diversified portfolio. This way, if, and when, the value of your penny stock pick or picks start to fall, your entire portfolio doesn’t take a hit.
- A Keen Fundamental Analysis Ability – Fundamental analysis is a very important of any long-term investing strategy, even if you are investing in penny stocks. In fact, moreso. It’s important to have the ability to go through financial reports and understand what you’re seeing, the patience to read through SEC filings, press releases, presentations, and more. Then, you have to know how to put it all together to get an understanding if the company has enough money to get through the next few years while their ideas come to life.
- Time To Recover – There’s a strong argument among financial professionals that risky plays, like investments in penny stocks, should only be part of a younger investor’s portfolio. This way, if the result of a penny stock investment is a loss, the investor has plenty of time to recover.
Who Should Trade Penny Stocks?
By its nature, trading is a far more risky process than investing. That’s because trading is a fast paced endeavor. Of course, making moves in the stock market is all about predicting price movement. While no one can tell the future, the longer you have for a prediction to come true, the more likely the case that it will. Trading flips that general concept on its head.
Instead of focusing on the long-term viability of a company, traders look for trends that create an opportunity to generate compelling gains in a short period of time. This makes the fast-paced, volatile nature of penny stocks a perfect stomping ground for many in the space.
Nonetheless, penny stocks aren’t for all traders. Those that should consider trading them possess the following qualities:
- A Healthy Appetite For Risk – In general traders have a pretty healthy appetite for risk to start with. However, when trading penny stocks, there are a few added risks to the trade. So, you have to have a strong stomach.
- A Keen Technical Analysis Ability – Trading in penny stock is all about technical analysis. The idea is that by studying patterns on a trading chart, you’re able to map out strong points at which to buy and sell a stock. Successful traders have a knack for finding and exploiting these patterns.
- The Ability To Set Emotion Aside – Emotion is the downfall of most beginner investors and traders. When fear and greed take hold, informed strategic decisions tend to go out the window. Traders begin chasing runs rather than cutting losses. As the great Kenny Rogers once said, “You’ve gotta know when to hold’em…” and you’ve gotta “know when to fold’em.” If you let your emotions get in the way, you won’t know until it’s too late.
- The Willingness To Use Paid Tools – The best penny stock traders take advantage of the best tools on the market. Oftentimes, these tools can come with some pretty hefty price tags. However, when used properly, many of them pay for themselves and offer plenty of gains on top.
- Money To Lose – Never trade using money that you’re not OK with losing.
Choosing Penny Stocks To Invest In
If you’re going to invest in penny stocks, picking the right kinds of stocks will improve your odds of making the big bucks. Follow these general rules to improve your odds:
Invest In What You Know
If you’re a nurse, you have a better understanding of medical innovation than the average patient. Investing in the medical space would make sense because you work in the space.
The more you know about the industry in which you invest, the better suited you are to make practical long-term predictions as to which companies will outpace others.
Dive Into Dollars
The truth of the matter is that most penny stocks operate without generating a profit. That means that they are dependent on money they have in the bank, grants, and funding from the investing community.
Before making an investment, dive into the financial reports from the company over the past year to get a good understanding of how much cash they have in the bank, how much they’re burning through, and how long current cash needs to last before the company reaches the next catalyst.
Check Out The Product
Never invest in a company without a product. Whether that product is under development, or already available, it needs to at least exist.
For example, you don’t want to invest in a biotech company that says I’m working on developing a drug candidate for ovarian cancer, but you may want to invest in one that says I’m studying and ovarian cancer treatment candidate that I’ve already made, sent through preclinical trials, and believe will be successful.
Do your research on the product and make an educated decision as to whether or not it will be successful. Also, take a look at the size of the market the company is attempting to get into with the product and how much competition the company will need to contend with.
Look Into Intellectual Property
One of the biggest lessons that we can learn from Warren Buffett is that it’s best to invest in companies that have an economic moat. This essentially means that the company makes something that no other company can make.
How does that happen?
Through intellectual property! Patent, trademarks, and other forms of intellectual property provide companies with protection from sub-par, lower cost, competition. If you’re considering investing in a penny stock, make sure that the company represented by the stock has the intellectual property it needs in order to keep competitors at bay.
The Bottom Line
The bottom line here is simple. Investing in penny stocks can be a very lucrative endeavor. However, it can also prove to be a very risky one. The reality is that these stocks are often at the beginning stages of business.
Those who are not in the beginning stages that are still trading in the penny range, generally have something fundamentally wrong with them or they are in the biotechnology sector developing therapies that may take years to come to fruition. Either way, they are very speculative plays.
Nonetheless, if you’re comfortable with risk, willing to do the research it takes to make sound investment decisions, and believe that you have what it takes to pick the next big winner, it may be a good idea to set a small percentage of your investing funds aside to try your hand investing in penny stocks.