Penny stocks have acquired a reputation for being risky investments, probably rightly so, and if you are going to trade them you should be aware of at least a few factors to watch for that might help minimize the risks related to such issues.
Penny stocks, as their name implies, are really cheap stock issues that sell for less than a dollar and in some cases, less than a penny. However, in the stock market, they are not limited to stocks that trade for less than one dollar. By general agreement, stocks that sell for just a few dollars are also considered to be in the penny stock category. There is no firm upper dollar limit but commonly, stocks that trade for $5 and less fall into that classification.
Attractive but higher risk
An attraction of low priced stocks for some speculators is that less capital is needed to participate in trading them, making it even more appealing for those speculators who are short of cash, working with reduced capital, their attention may be drawn to penny stocks even though they have a reputation carrying higher elements of high risk.
There is also a belief that the percentage gains achievable with penny stocks are likely to be greater than those achieved by high priced stocks. In other words it is easier to gain 50 or 100% on a one-dollar stock than on stock that trades at fifty or one hundred-dollars.
The risks, thinly traded and manipulation
Among the main risks in low-priced stock issues are that they are often thinly traded. The definition of being thinly traded varies, but effectively it means that the average daily trading volumes are so low that it makes it difficult for a shareholder to sell shares, or sell shares at an acceptable price. This is because there are not enough buyers available who are interested in the stock.
Also, in some cases when stocks are low priced and thinly traded, it makes it easier for unscrupulous operators, who have purchased a large amount of the low priced stock, to more easily manipulate the price by circulating false promotion rumours and reports that hype the future prospects and urge naïve and gullible buyers to get in on the next big thing. When sufficient numbers of buyers are enticed into buying, creating increased demand, it causes the stock to rise in price, tending to confirm the false rumours and lure even more into buying the stock.
But that cannot be sustained for very long, and at some point, while prices are higher, the fraudsters will dispose of their stock to the unsuspecting buyers and walk away. The result being that the price will then fall back to its prior lower level that reflects the real worth of the company and the recent buyers are out of pocket and with nobody to sell to.
1. Always beware of slick promotions and try to verify any promotion claims. Even if there really is something good in the future, it may be a long time until it happens. If it seems worthwhile, watch the stock for a while, it could still be a winner and worth buying at a somewhat higher price later on when more facts are available and the prospects of the company are improving as forecast.
2. Don’t buy stocks that trade in low volume, say less than a couple of hundred thousand shares daily on average for more than the last three months -- and look for increasing volume taking place when the current price is going up, often a positive sign.
3. Try to buy stocks that are listed on the major stock exchanges, they may be a safer choice because they are listed. Many cheap stocks are unlisted and trade with the aid of participating stockbrokers on the Over-the-Counter market and Pink Sheet trading systems, which are regulated but not to the same degree as those listed on the major exchanges.
4. Don’t buy stocks when they are in a downward trend and don’t average down in price by buying more stock as the stock is declining in price.
5. Know when to exit a losing position, when a stock is bought, fix a maximum amount of loss that you can tolerate and be sure to sell at that price if a loss occurs. Not doing so is one of the most common errors that speculators make.
6. Learn to read stock charts at a simple level. Doing so will enable to examine a chart of the stock ( they are available free from web sources such as StockCharts.com), and if the stock is in an upward trend, make sure it has broken through an overhead resistance, such as an earlier and recent stock trading price-high. It is also a positive sign if they are making a series of higher price-highs and higher low trading price highs.
More on stock chart interpretation
There are many patterns of stock price movement that, if recognized on a stock chart, can provide an indication of where the stock might move in price. Such “signals” are not guaranteed to be correct and they are not scientific but they can be helpful in making decisions when taken into consideration together with other factors. Price movement and developing patterns in price can be a guide on when to enter or exit a position or whether to just stick with it for the time being, until further development of the stock trend can be seen.
In most instances, a penny stock is worth only that, a few pennies (cents), perhaps close to zero and that is why expert traders and investors will usually recommend avoiding them and they will usually refer to the high risk and other dangers cited above.
But if you are going to trade them, learn and take heed of the guidelines offered above and emphasized in the title of this article, Guidelines For When You Buy Penny Stocks.