What are Penny Stocks and How to Trade Penny Stocks

How to Trade In Penny StockWhen you first hear someone talking about penny stocks, what comes to mind? Is it the unsolicited e-mail you got tipping you off on the next hot penny stock? Or the lowly whispered stock tip you thought you were lucky to hear about around the water cooler at work?

Most people dismiss penny stocks outright when it comes to an investing strategy. They often have low trading volume, which means it’s easy to buy a penny stock but hard to sell it. Because penny stocks are more often than not associated with smaller companies, many believe it’s hard to both find reliable information and accurately price the stocks.

When it comes right down to it, most people think penny stocks are a speculative investment that ought to simply be ignored. More traditional, conservative investors think it’s better to fortify your investing portfolio with solid large-cap stocks.

The Securities and Exchange Commission (SEC) even warns that investors in penny stocks should be prepared for the possibility that they may lose their whole investment. It’s as if investing in penny stocks is akin to gambling in Las Vegas.

Nothing could be further from the truth. When it comes to gambling at a casino, you play with low odds; and in the end, the house always wins. When it comes to penny stocks, investors can look at a company’s fundamental and technical indicators for predictable patterns, just like you would with any publicly traded stocks.

Related Article: Top 9 Oil and Gas Penny Stocks for 2015

The fact of the matter is that the SEC should warn investors they could lose their whole investment in any kind of stock, not just penny stocks. Case in point: a lot of too-big-to-fail companies went under around the time of the Great Recession in 2009.

Who would have thought that Enron, Bear Stearns, Washington Mutual, Lehman Brothers, or even Nortel would be risky investments? After all, they were big companies with lots of analyst coverage. The point is it’s not just penny stocks that are risky. The stock market is inherently risky, and if you don’t do your due diligence and pay close attention to what’s going on in the world and in the broader markets, you could lose everything.

Now granted, the vast majority of penny stocks are not worth the paper the stock certificate is printed on. But there are a small number of revenue-generating, profitable penny stocks out there with legitimate operations and excellent long-term growth potential, the kind of penny stocks that give investors the kind of returns that mid- and large-cap stocks could never realize.

What exactly is a penny stock?

A penny stock used to be defined as an equity trading for less than $1.00. But thanks to inflation, a penny stock can now be defined as any stock trading for less than $5.00. Some even think stocks trading under $10.00 per share are penny stocks.

Again, investing in penny stocks is not for those who are passive investors. To invest in penny stocks, you have to be actively engaged in the stocks you’re adding to your investing portfolio.

Why? Penny stocks do not need to be riskier than large-cap stocks. Remember: size doesn’t matter. Large-cap stocks and penny stocks can both cut corners to appease investors and manipulate their share price; there is no investing safe haven. Consider those investors who sunk their money into blue chip behemoths like Lehman Brothers, Nortel, and Enron.

Why do some investors and Wall Street shy away from penny stocks?

Wall Street tends to pass over penny stocks because they are too small for them to take a big position in. They could find a penny stock with excellent fundamentals but have to ignore it because a solid investment could actually buy too large a portion of the company.

Some investors dislike penny stocks because they think they are beneath them. More often than not, though, these investors probably don’t want to take the time to do their due diligence. They would rather follow the herd and make safe, single-digit gains.

For the most part though, investors shy away from penny stocks because they don’t know what they are investing in. It’s a lot riskier to go out on your own and research a stock than listen to a talking head on TV and buy what they recommend.

Most investors on Wall Street follow a herd mentality, buying when the market is buying and running when the market sells. Few investors actually do their own research and invest on the path less travelled. While large-cap investors sneer down on penny stock investors, the truth of the matter is that they are no more sophisticated in their trading than their penny stock peers.

Want proof? Look back at the stock market crash that began in 2008. It didn’t matter what stock individual investors were holding or what their fundamentals were—they were selling. Profitable large-cap companies were sold off at the same alarming rate as some penny stocks that deserved to be sold off.

The markets sold off not because the fundamentals of the companies were bad, but because the outlook and fear sent everyone running for the exits. After the massive sell-off, investors who would normally never consider a stock trading for less than $10.00 all of a sudden did. And they were richly rewarded. When the markets rebounded in March 2009, penny stocks were some of the biggest winners.

Now, how do you find the best-performing penny stocks?

You have to look for them. It’s not an easy task, but it is a necessity that’s worth the extra effort. The payoffs from solid penny stocks will beat out the winners on Wall Street every day.

Regardless of where the stock market is heading, it’s important to find strong penny stocks with great long-term growth potential. When it comes to predicting the future direction of any stock or commodity, investors follow two schools: fundamental analysis and technical analysis.

A fundamental analysis looks at a company’s financial statements in an effort to predict a trend. Investors here focus on the forward-looking picture and consider data that could impact the price of a penny stock—that includes quarterly results, cash flow, and debt levels.

Performing a fundamental analysis is a lot of work. A fundamental analysis entails looking a penny stock over from top to bottom. But by digging deep into the company’s financial statements, investors can access the stock’s future prospects and figure out whether it is undervalued, overvalued, or fairly priced. A lot of long-term investors take a fundamental approach to penny stock investing.

Penny stock investors who use technical analysis believe that chart patterns and past price performance can predict what the future prices will be. Examples of technical indicators include the relative strength index (RSI), money flow index, MACD (moving average convergence/divergence), price data (open, low, high, close), moving averages, and Bollinger bands. Many day-traders use technical analysis because it alerts them to short-term price action.

There are a lot of great companies trading under $10.00. Why? It could be choice. It could also be that the company’s stock price slipped into penny stock territory because of poor corporate earnings, tough economic conditions, or any number of other factors. Regardless, you need to look into the company’s history and fundamentals to find out whether you think they’re due for a turnaround or deserve to die as an overlooked penny stock.

Most companies that trade for less than $10.00 are smaller companies. Again, that doesn’t mean they should be avoided. There are a number of excellent penny stocks with the same kinds of metrics as their mid- and large-cap peers. Unlike blue chip stocks, however, it’s not uncommon for a penny stock investor to see triple-digit returns.

What do you look for in a good penny stock?

The same things you would look for in any other stock. Look for a penny stock that offers unique products or has a strong position in a niche market. Look for penny stocks with strong cash positions, little or no long-term debt, growing revenues, and ongoing profitability.

Where do you turn to find excellent penny stocks?

There are two major exchanges in the U.S: the New York Stock Exchange (NYSE) and the NASDAQ. You can find excellent penny stocks trading on either exchange.

There are two other stock market exchanges where penny stocks reign supreme: the Over-the-Counter Bulletin Board (OTCBB) and the Pink Sheets. Companies that trade on the OTCBB do so either because they were delisted from the NYSE or NASDAQ, or because they cannot meet the initial listing requirements for either exchange. It may also be that the company is testing the waters before attempting a run at the larger exchanges. Penny stocks that trade on the OTCBB must comply with SEC reporting requirements.

Companies on the Pink Sheets however do not need to meet any minimum requirements nor do they need to file with the SEC—so it’s pretty difficult to find accurate information and analyze their fundamentals.

A large number of resource companies are penny stocks. The best exchange in the world for resource penny stocks is the Toronto Stock Exchange (TSX) in Canada. Almost 60% of the world’s public mining companies are listed on the TSX, while 35% of the world’s public oil and gas companies and 21% of the world’s public energy services companies are listed on the TSX.

While Wall Street may be content with annual double-digit gains, most penny stock investors are not. Depending on the news, penny stocks have the ability to soar or fizzle. Strong double-digit gains are not uncommon. Neither are triple-digit gains.

Keep in mind, however, that some penny stocks can go down just as quickly as they go up, so it’s important to watch your penny stock portfolio and take profits. But that can go for all the markets; many large-cap investors have seen their profits evaporate because of greed.

Wall Street might ignore penny stocks, but it’s important to remember that many of today’s biggest American companies started out as penny stocks. For many investors, it’s more fun to get involved in tomorrow’s big winners today.