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No doubt you've heard about penny stocks. But if you're confused about what they are exactly and why so many people invest in them, we're here to help.
First, let's define "penny stock." Simply put, penny stocks are stocks priced under $5 a share.
Beyond that basic definition, penny stocks also have a very low market cap (the total value of all shares outstanding) – typically under $300 million. To put that in perspective, the market cap of Apple Inc. (NASDAQ: AAPL) is 3,100 times more than that limit, at roughly $930 billion as of early July 2019.
These aren't necessarily hard and fast rules of what is considered a penny stock. Some people only look at penny stocks that are under $2 a share. Some adjust the market cap limit upward to $500,000. These are just general guidelines that you can tweak as it suits you once you learn more.
And that penny stock definition doesn't begin to tell us what's unique about this asset class. It doesn't tell us why you would want to invest in penny stocks, how to do it, what risks to watch out for, or the profits you could potentially score.
So let's dive into it…
Penny Stocks vs. Stocks: More Risk, More Reward
The difference between penny stocks and the rest of the stock market is more than just price. Or rather, the low price tag of penny stocks has some big implications.
Penny stocks are priced to move. Don't get us wrong, a stock like Amazon.com Inc. (NASDAQ: AMZN) is great to own. But at nearly $1,900 per share right now, it's probably not going to double or triple in a day or even a month.
But a stock that's priced at $1 can easily jump to $2 or $3 in short order. In fact, it happens all the time.
For example, Foresight Autonomous Holdings Ltd. (NASDAQ: FRSX) rose 109%, from $0.94 to $1.96 in 10 days at the end of June.
And Moneygram International Inc. (NASDAQ: MGI) rose 167%, from $1.45 to $3.88 in one day on June 18.
This isn't uncommon. There are probably a few penny stocks today making giant leaps like this.
Now, you might be thinking "Sure, those are impressive percentage jumps. But if the price is only going up a dollar or two, who cares?"
But the beauty of penny stocks is that even investors without a lot of resources can buy in large quantities. So if you had owned Moneygram on June 18, you could have turned $100 into $267, or $1,000 into $2,670 in just a day.
And because finding the right stock can double or triple your money (or more), you don't have to pick a winner every time. One "rocket stock" can more than make up for several others that don't perform as well.
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Of course, the flip side of these big returns is that penny stocks do come with very real risks – certainly more so than stocks that are part of the S&P 500.
So risk management is key. And there are a few simple principles that will greatly reduce your risk of getting burned.
Risk Management for Penny Stock Investors
Because penny stocks are small companies and not always subject to the strictest financial regulations, some of them can be risky investments. Some are barely even companies at all, but shell companies designed to separate investors like you from their hard-earned money.
But it's not that difficult to separate the potential big gainers from the non-starters. These tips and strategies will keep you from falling into the pitfalls that can ensnare novice investors…
Allocation: You can't lose what you don't put on the table. So a simple step to lower the risk of your penny stock investments is not to put too much of your capital into them. Penny stocks are high-risk, high-reward investments. So they go into that section of your portfolio, which should be a relatively small percentage of the total.
That way, you still reap big benefits when one of your rocket stocks take off. But you'll still be okay if you end up with a dud or two.
It's up to you to decide how to allocate your portfolio, based on your individual risk tolerance. But a good place to start is the 50-40-10 model, in which 10% of the portfolio goes to risk capital. You can learn more about that right here.
Pay attention to the exchanges: Stocks that are listed on the NYSE or Nasdaq exchanges are subject to strict regulations and reporting requirements. That doesn't mean they won't lose money. But you can rest assured that the company is a legitimate business, and you'll be able to find extensive information about its financial health to aid your decision.
You can find plenty of penny stocks on those major exchanges. But the reporting requirements make it less friendly to young companies, leading many promising startups to choose other exchanges.
It's okay to invest in stocks on the various over-the-counter (OTC) exchanges, but you'll have to exercise more judgment.
OTCQX is an exchange with similar requirements to the major exchanges. OTCQB still has some restrictions, but it is more amenable to new companies.
You can do very well investing in stocks on these exchanges. What you'll probably want to avoid is the "Pink Sheets," OTC exchanges which have very little regulation and therefore can be a breeding ground for predatory shell companies.
Watch out for scams: Spotting penny stock scams doesn't take much more than watching for them. If you get a random call or an email pressuring you to invest in a stock you've never heard of, it's probably a scam. If the stock doesn't have a track record of success that you can find, it's probably a scam.
Scammers prey on your emotions and don't want you to look too deeply into what they're selling. Which gets us to the next tip…
Do your research: This is true for any investment you make, of course. You might not hold penny stocks to the same standards as a blue-chip company. But the same basic principles apply. You want a company that is consistently growing its revenue. You want a company that doesn't have an absurd amount of debt compared to its overall value. You want a company with a relatively high trading volume, to make sure you can sell it quickly and at a fair price when the time comes.
We'll give you some hard numbers you can use for your research in a bit. And let's also add that you definitely want a company that is tapped into a solid growth trend.
The key here is that, when picking penny stocks or any other kind of stock, you use your brain… not your gut.
Set your exit point (and stick with it): Another way to take your emotions out of the equation is by setting your exit point: the price at which you will sell no matter what.
You can do this whether the price is going up or down. One of the most basic exit points we recommend is a trailing stop, which executes a sell order whenever the stock drops a certain percentage below its peak.
The trailing stop protects you from losing too much if a stock starts to tank. But it also protects your profits on your successful picks. Every time the stock hits a new peak, the trailing stop trigger price rises along with it. That way you're locking in profits as you go.
A trailing stop of 25% is a good starting point. You can tweak it depending on your preference.
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You may also want to set a stop limit to cash out your winnings at a specified price. This keeps you from holding on to a winner too long and watching it lose momentum.
You can set stop limit orders in phases, too. For example, you might want to cash out 50% of your shares after the stock doubles. Then sell the rest after it (hopefully) triples.
Again, you can experiment to figure out what strategy works best for you. The key point here is that whatever price you set, stick to it. When you let emotion get the best of you, that's when you're most likely to get burned by holding on to a stock past its spoil date.
With those caveats out of the way, you're ready to start enjoying the big gains penny stocks can deliver…
How to Invest in Penny Stocks
By now, you hopefully know the answer to the question, "What are penny stocks?" You should also understand how to distinguish between promising investments and the ones you want to stay far, far away from.
Now the question is how to actually begin investing in penny stocks.
As it turns out, the process of buying and selling penny stocks is pretty much exactly the same as it is for any other kind of stock. The same brokerage account you use to by Apple or Amazon stock is also where to buy penny stocks online.
When you know which stock you want to trade, you can enter a ticker symbol into your online broker's trade portal, indicate how many shares you want to buy or sell, and execute the trade with a click of a button.
But since penny stocks aren't as well-known as big-name stocks and not as well-covered in the financial press, you'll have to put a little more effort into finding which penny stocks you want to buy.
That's where a stock screener comes in.
A stock screener lets you filter the whole universe of stocks down to a list of only those that fit a set of parameters selected by you. That way you can find just the penny stocks you might want to invest in and filter out the ones that don't meet your standards.
Your online broker very likely has a stock screener you can use. But you can also search the Internet and find a wide variety of options – many of which offer both free and premium tiers.
Once you find the screener you want, you can dive right in, setting the parameters according to your preferences. But here are some settings you can use to get you started:
- Share price: A penny stock trades for $5 or less. But if you want to be stricter, you can set this to show stocks under $3, or even under $2. The lower the stock price, the easier it is for the price to double or triple quickly.
- Market cap: Typically, a penny stock has a market cap below $300 million. But again, you might want to tweak this. Even going as high as $500 million means you're dealing with a stock with a lot of room for growth.
- Average daily volume: This number indicates how many shares are trading hands per day, and it's extremely important. It doesn't matter what a stock's share price is if you can't find anyone to buy your shares. A minimum daily volume of 200,000 should be enough to protect you from getting stuck with an investment you can't unload down the road.
- Sales growth: You don't want to hold penny stocks to the same standards you would hold other investments to. You might end up missing out on a huge opportunity. But at the very least, you do want to know that any company you're investing in is increasing its sales. So setting the "sales growth" parameter to ">0" (i.e., more than zero growth) will limit your search to growing companies.
- Debt-to-equity: The penny stocks you own will probably have more debt than your growth-oriented investments. But you don't want a company whose debt is out of control. So sticking with penny stocks that have a debt-to-equity ratio under 5 is a good starting point. If you have stricter standards, you could go as low as 1.5. But that's going to limit your choices a lot.
Just how much you want to tweak these settings depends on how many stocks you want to choose from. Once you get your screener list – which could include just a handful of stocks or over a hundred – then it's time to ask some more specific questions…
What industry is the company in? Is there room for growth? Is there a clear path to profitability? Is its management solid?
In other words, at this point, you're asking many of the same questions you would ask about any other stock. Because, after all, penny stocks are stocks. Once you've set your strategy and found the picks you're interested in, you don't have to treat them any differently.
Just remember to use your head, and don't let emotion take over.
Also, keep checking back with Money Morning. We'll be offering tips along the way to help you get the most out of your penny stock investing.
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