Trading Penny Stocks: 5 Things You Should Know

Trading Penny StocksThe Lowdown on Trading Penny Stocks

Investors are turning their attention back to trading penny stocks.

Why? Because they’re looking to make money and bigger stocks aren’t providing them that.

The long-in-the-tooth bull market recently celebrated its seventh birthday and continues to limp along, rewarding investors with nothing.

The S&P 500 is up a measly 0.08% year-to-date, while the Dow Jones Industrial Average is up a “princely” 1.5%. That’s not much to celebrate.

To get into the black in 2016, investors have had to stomach the worst start to a year. It’s worse for the tech-heavy NASDAQ that’s down three percent in 2016 and the Russell 2000 Small Cap Index, which is down 2.1% since the beginning of January.

All of this is to say that it’s no surprise investors are looking where they might not normally look for solid gains. And the allure of penny stocks is not without merit. (Penny stocks, for the sake of this article, are any stocks that trade for $5.00 or less, with the potential to reward savvy investors with massive returns.)

A $0.50 pop on a $2.00-a-share stock represents a 20% return, which isn’t uncommon when trading penny stocks. It’s pretty tough for a $100.00 stock to do that. Keep in mind, too, that with penny stocks, there is a risk/reward payoff. You can see your gains or even your initial investment disappear just as quickly.

To invest in penny stocks, you need to have a high tolerance for risk. But that also holds true for the broader market. As is evidenced by the major swings the S&P 500, Dow Jones, and NASDAQ have been experiencing.

I understand that most people think penny stocks are riskier than the average stock and speculative in nature, but they really aren’t. That is, unless you toss your money at a penny stock you don’t have a comprehensive understanding of.

But that can be said of any stock. Lest we forget those investors who sunk money into so-called safe bets like Lehman Brothers, Nortel, and Enron.  There is no sure thing with penny stocks, just like there’s no sure thing when it comes to investing in small-cap, mid-cap, large-cap, or mega-cap stocks.

That’s why you need to do your due diligence—there’s no easy way around it. Doing so will help you find some excellent penny stocks with growing earnings and revenue, alongside excellent short- and long-term growth potential. After all, part of the joy of trading penny stocks is making quick money. Not everyone wants to hang on for the long term.

Still, listening to the “experts” and avoiding penny stocks just because you don’t like the entry level will mean missing out on some pretty spectacular gains.

5 Top Tips for Trading Penny Stocks

The following are five of my top tips to consider when trading penny stocks to ensure you’re making the best investment:

Tip #1: Disregard Hot Tips

It’s amazing how many unsolicited e-mails I get telling me about the next big ten-bagger—poorly written e-mails touting an obscure penny stock operating on the periphery of a great industry. But correlation is not causation. Just because Facebook is a social media company making lots of money doesn’t mean the same will happen for the $0.25 social media penny stock you’re being asked to buy.

I research, for fun, most unsolicited penny stock e-mails I get. To date, 100% of them have been garbage: no volume, no earnings, no cash, lots of debt, and no potential. Few seem to do the five minutes of research it takes to see these penny stocks are garbage. How else can you explain average daily volume spiking from 1,000 to 2.5 million the day the e-mail lands in your inbox?

Why would I send you an e-mail telling you about a great penny stock that I think is going to make me returns in excess of 1,000%? I wouldn’t. Neither would the people putting out the e-mail.

It’s one of the most blatant examples of conflict of interest. If you read the disclaimer at the bottom of the newsletter (which is required by the Securities and Exchange Commission) you’ll see that the senders of the e-mail were paid a solid fee or ungodly amount of shares to pump the stock, which they might sell at any given time. And that generally means the day the mass-market, unsolicited e-mail goes out.

Ignore unsolicited e-mails. Along the same vein, ignore hot tips at the water cooler.

Tip #2: Understand the Penny Stock

Penny stocks are generally not great for technical analysis. That’s because they can be thinly traded and volatile. The same technical indicators that point to an entry point or exit point are most often moot when it comes to penny stocks. That’s why with most penny stocks, you need to do a thorough fundamental analysis.

A fundamental analysis looks at a company’s financial statements to predict a trend and takes a lot of work. BUT, having a comprehensive understanding of a company and its finances will tell you about its financial health, products and services, and outlook. It will also help you determine whether the penny stock is undervalued, overvalued, or priced fairly.

The more you learn about a company, the more confident you’ll be having it in your portfolio.

What kind of fundamentals should you look for in a penny stock? The same kind you’d look for in a big-cap stock.

Look for a penny stock that offers unique products or has a foothold in a niche market. Does the penny stock have a solid cash position? What does its debt load look like? Is its revenue growing and is the company profitable? What is its long-term outlook? Does it provide a dividend (yes, some penny stocks do)? Does it have a share buyback program (yes, some penny stocks do)?

Some fundamentals will be more important than others. You might not disregard a penny stock simply because it doesn’t offer a dividend, but you may if it’s bleeding cash.

Tip #3: Buy the Best Penny Stocks

Ninety-five percent of penny stocks should be avoided at any cost. That doesn’t mean it’s hard to find the best penny stocks. Again, look for penny stocks with solid operations that are profitable and are reporting growing revenue.

If you find a penny stock that has been trading in a tight range for a long period of time then starts to soar, find out why. If there’s no news to report, it’s a newsletter pump-and-dump. Stay away!

But if it jumped because it announced amazing earnings or a new corporate direction, stay intrigued and run your fundamental analysis!

Tip #4: Buy Low, Sell High—Fast (Sometimes)

Investors tend to get greedy when it comes to penny stocks. A 35% return on Facebook might sound decent, but when it comes to a penny stock…investors are holding out for massive returns.

That could be a big mistake.

Even solid, well-run penny stocks can see their share prices rise and fall on any given day…for whatever reason. Penny stocks can rise and fall depending on earnings, the share price can fluctuate on investor sentiment, or broader economic conditions can cause peaks and dips. If it’s thinly traded, a penny stock can plummet because someone wants out—at any cost.

Before you buy a penny stock, determine your profit goal and sell. Or, take profits and leave some on the table if you think the company’s story remains compelling. After all, some penny stocks are more interesting than others.

For example, in late 2008 and early 2009, when the markets were crashing and investors were running for the exits, Ford Motor Company (NYSE:F) was a penny stock and, for a little while, traded under $1.00.

During the mayhem, Ford revamped its operations, had a great cash position, and offered a fabulous growth strategy. That would have been a good penny stock to hold onto. At the same time, it wasn’t a stock to ignore just because it was trading for less than $5.00.

Even today, there are a lot of penny stocks out there with market caps of more than $1.0 billion, $2.0 billion, even $5.0 billion trading for less than $5.00 per share.

Tip #5: Don’t Fall in Love with Your Penny Stock

Don’t do it. A lot of small penny stock companies will hook you in with their story. They have a technology that will revolutionize the world…maybe. Stay objective and keep the company on your radar. Take a loss and sell if you need to.

There’s no reason to hold onto a penny stock just because it has an interesting story. Investors need to be results-oriented. If it’s not making you money or doesn’t look like it’s going to for the foreseeable future, dump it, free up some cash, and invest your money elsewhere.

The Bottom Line on Trading Penny Stocks

The bottom line: Investors love trading penny stocks because of the potential to make a lot of money. However, if you’re not careful and conduct proper due diligence, you could end up losing your entire investment—and not just because the stock isn’t performing well. There are still a lot of penny stock scammers out there who are more than happy to dupe you into giving them all your hard-earned money.

Be diligent. Stay alert. Trust no one. If you keep these principles in mind, you might be able to earn huge profits trading penny stocks.