The Advantages and Disadvantages of Penny Stocks

2010-12-15T15:03:00.000-08:00

          Penny stocks are very much like regular stocks except they are not traded on the major stock exchanges. Penny stocks are, by definition, stocks that are trading at or below five dollars a share. The object of trading penny stocks is the same as regular stocks: Try to buy low and then sell higher.

          Penny stocks are far more volatile than regular stocks and herein lays their major advantage AND their major disadvantage. Penny stocks can and do double their value in a single day whereas it could take weeks, months or even years for a regular stock to do the same. For some reason, it is a lot easier for a stock worth 1 cent per share to increase its value to 2 cents a share than it is for a stock worth $30 a share to double its value to $60 a share.

          What all of this means to the penny stock investor is a good news / bad news kind of thing. Bad news first: Penny stocks can be so volatile that you can lose your entire investment in less than a day. It’s nothing for a stock worth 1 cent a share to go to zero quickly. Regular stocks can also go to zero but they will take a much longer time doing it, giving the investor a chance to cut his or her losses and preserve some of their investment. You can be easily blind-sided by penny stocks if you are not watching closely with your finger ready on the sell trigger. Penny stocks do not always perform as you might expect after studying up on the fundamentals of a company. In the world of penny stocks, one often sees good companies going down and bad companies going up.

          The good news? You can make a big percentage increase quickly with only a small amount of money at risk. And, while you can lose most or all of your investment quickly, you won’t be hurt that much if you have only invested a small part of your total net worth. Admittedly, investing a penny and having two pennies tomorrow is not going to change your life that much and so you may be tempted to try to double a much larger initial investment. Because of the volatility of penny stocks, you should never invest more than you can afford to lose.

          How then, can you put the odds in your favor? It’s all about picking the right penny stock and you may need some help there. Use professional stock picks from a reliable stock-picking service as a starting place. Make a list of the 10 best penny stocks from the stock picker and then do your own due diligence. List these ten stocks on a spreadsheet and make columns for company earnings, revenues and the like. As stated above, penny stocks don’t always perform as you might expect from the fundamentals but a lot of the time they do so going through the above exercise is not a waste of time. Listing the ten stocks on a spreadsheet helps you see readily which one of the ten is most likely to succeed. After making your buy, keep a journal of the actual performance of all ten stocks, including the ones you did not buy. This will be a great learning tool for you.

          Learn from your past mistakes. Try to see what went wrong and why. Don’t make the same mistakes again. Watch what other traders are doing and learn from their successes and failures. If the price of a stock is low, try to find out if it is because it hasn’t yet been discovered or if, instead, the company is in financial trouble. Buy the former, never the latter.

          When you have a big win of 100% or more, it’s time to sell all or part of your holding in that penny stock. There are several ways to do this. You could sell half of your shares and let the other half ride or, as an alternative, you could leave 1/3 in, sell 1/3 for cash in your pocket and sell then invest the proceeds of
the final third in another, different penny stock. Don't get greedy and hang onto a stock past its time. What goes up must come down and penny stocks usually do that suddenly. If the stock keeps going up after you have sold it, don't worry about it. There will be another train leaving the station in five minutes. The whole idea is to buy under-valued issues and then sell them before they become over-valued. Never buy or sell for emotional reasons. Always go by the numbers and follow your plan.

          Finally beware of hot penny stock tips from promoters. Promoters buy a penny stock and then try to get everyone else in the world to buy the same penny stock, thus driving the price up. Since they made their buy before you, they will make a 100 percent gain or more before you do and will then dump the stock like a hot potato causing a sudden and unexpected drop in share price at your expense.