How to Trade Penny Stocks

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Stocks are expected to end this year only modestly higher after last year's 30% gains, prompting investors to hunt for growth. One way to find it is by learning how to trade penny stocks.

Defined as stocks that trade under $5 a share, penny stocks have gotten a bad rap thanks to scams and manipulators. However, there are plenty of legitimate microcap companies offering lucrative opportunities. How to Trade Penny Stocks

The appeal of trading penny stocks is that they don't cost much money, yet the rewards can be substantial for those willing to take on additional risks.

The key is finding those with healthy prospects and knowing how to trade shares.

Trading low-priced stocks calls for a strategy. With that in mind, here's how to trade penny stocks.

How to Trade Penny Stocks: What to Do Before You Buy

Respect Risks: First and foremost, remember that trading penny stocks involves risks. Prices are volatile and, if traded on the Pink Sheets, companies aren't required to disclose as much information as if they were listed on an exchange. Be prudent with any penny stock investment, and never invest more than you are comfortable losing.

Disregard Hype: Approach penny stocks with caution, and be suspect. Ignore puffed-up press releases that tout explosive gains. Paid promoters are typically behind those unsolicited junk faxes and high-end glossy mailers pushing a microcap company. Do your homework. Information is your best tool. If you can't find any data, move on - quickly.

Hang Up the Phone: If you get any calls plugging a low-priced stock, hang up - after you insist your name be added to the "do not call" list. This high-pressure tactic is common.

How to Trade Penny Stocks: Deciding What to Buy

Buy the Cream of the Crop: Investors have thousands of penny stocks to choose from, but really good ones are rare. Keep an eye out for companies that post solid earnings, have secured new contracts, have heavy insider buying, and/or are breaking out to 52-week highs on volume of at least a quarter million shares a day. Take a look at the top 10 penny stocks for January 2014 for examples of what a stock fulfilling these criteria looks like.

Listing: Look for low-priced stocks that trade on the New York Stock Exchange or Nasdaq, and avoid those listed on the OTC Bulletin Board or Pink Sheet. Companies that trade their stocks on major exchanges like the NYSE and Nasdaq must meet listing standards such as minimum amounts of net assets and minimum numbers of shareholders, and they are held accountable for such data. In contrast, companies on the OTCBB and Pink Sheets aren't held to those same high standards.

Volume and Price: Find stocks that trade at least 100,000 shares a day. Trading stocks with low volume could make it difficult to unwind a position. Also, stick with stocks priced at $0.50 a share or more. These are generally the most liquid.

How to Trade Penny Stocks: Profiting After You Buy

Don't Trade Large Positions: Never trade more than 10% of a penny stock's daily volume. Large penny stock orders typically "move the market." Additionally, when you trade a limited share size it's easier and quicker to exit a position.

Never Sell Short: Shorting inflated penny stocks might be alluring, but don't do it. Penny stocks are notoriously volatile. It's easy to get caught in a short squeeze that could cost you 50% or more of your investment.

Price Targets: Always use limits on buy and sell orders since spreads on penny stocks can be as much as 10%. That's also why you want to use, and adhere to, mental stops instead of placing stop orders. If your stop order is triggered, the next sale price (yours) could be much lower and cost you plenty.

Take Profits Quickly and Often: A big draw to penny stocks is the ability to pocket gains of 20%, 30%, or more in mere days. Take gains when you have them. You haven't booked a profit until you've sold.

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