The Securities and Exchange Commission (SEC) defines penny stocks as securities issued by small companies that trade for under $5 per share.
The bulk of these low-priced securities trade on the OTC Bulletin Board. However, penny stocks can also trade on the New York Stock Exchange, Nasdaq, and foreign exchanges.
Because of their speculative nature, the SEC has rules in place to protect investors. As outlined on the SEC's website, these rules include the following:
- A broker-dealer must approve a customer for a specific penny stock transaction. It must also receive a written agreement from the customer for the transaction.
- A customer must receive a disclosure document describing the risks of investing in penny stocks.
- The broker-dealer must provide the customer with the current market quote for the penny stock.
- A customer must be advised of the commission amount the firm and the broker will receive for executing the trade.
- After completing a sale, the broker-dealer must send the customer a monthly account statement with the market value of each penny stock held in the customer's account.
Among penny stocks' appeal is that they don't cost much money, and rewards can be substantial for those willing to take on additional risks.
Yet thanks to scams and manipulators, penny stocks have gotten a bad rap. There are, however, plenty of legitimate microcap companies offering lucrative opportunities. The key is finding them.
Knowing how to trade shares is also imperative.
Indeed, 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. 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. Never invest more than you are comfortable losing.
Disregard Hype: Approach penny stocks with caution, and be suspect. Ignore puffed-up press releases touting explosive gains. Paid promoters are typically behind 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, quickly move on.
Hang Up the Phone: If you get calls plugging a low-priced stock, hang up. This is a common high-pressure tactic. Before you hang up, insist your name be added to the "do not call" list.
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.
Listing: Look for low-priced stocks that trade on the NYSE or Nasdaq. Avoid those listed on the OTC Bulletin Board or Pink Sheets. Companies that trade their stocks on major exchanges like the NYSE or Nasdaq must meet listing standards. These include minimum net asset amounts and minimum numbers of shareholders. Plus, companies are held accountable for such data. In contrast, OTCBB- and Pink Sheet-listed stocks aren't held to the same high standards.
Volume and Price: Find stocks that trade at least 100,000 shares a day. Trading stocks with low volume may make it difficult to unwind a position. Also, stick with stocks priced at least $0.50 a share or more. These are generally the most liquid.
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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, a limited-size trade makes it easier and quicker to exit a position.
Never Sell Short: Shorting inflated penny stocks might be alluring, but it's best avoided. Penny stocks are notoriously volatile. It's easy to get caught in a short squeeze that could cost 50% or more of your investment.
Price Targets: Always use limits on buy and sell orders since penny stock spreads can be as much as 10%. That's also why it's important to maintain mental stops (that should be adhered to) instead of placing stop orders. If a 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. Remember, until you sell, all you have is a paper profit.
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- Securities and Exchange Commission: Penny Stock Rules