Stories of beginner traders who have managed to turn a few thousand dollars into a million with penny stocks make it sound easy to rake in the profits. So let’s take a deeper look at what penny stocks are and if they are a good trading option for beginners.
Common fallacies about penny stocks include that all stocks start as penny stocks, and the second is that they have more room for appreciation than others. Both are untrue!
Understanding Penny Stocks
The definition for penny stocks provided by the Securities Exchange Commission (SEC) says they are any security trading for under $5 for a share. These low prices make these shares alluring to investors, especially those with small amounts of investment capital.
However, one concern about these stocks is their high volatility, making it possible to make or lose money fast. In addition, some penny stocks may list on major stock exchanges, but mainly, they trade as over-the-counter (OTC) transactions or on a system known as the electronic OTC Bulletin Board.
Still, these are typically shares from small companies with a low market capitalization that may have poor products or services. Their increased risks include their lack of liquidity and that they trade at low volumes.
Penny Stocks Fraud and Risks
It is not unknown for fraudsters to use tactics to exploit people unfamiliar with the stock market by pressuring them into buying penny stocks. As people purchase these stocks based on misinformation, the price rises, and scammers then “dump” their shares, collapsing the price of the worthless stock.
There is also the danger of buying from dishonest offshore brokers who persuade people to buy stocks by providing attractive information.
Of course, not all penny stocks are scams, but their value tends to remain low. There are some exceptions, where company shares begin trading as penny stocks and then end up trading on the NYSE.
Because of the low price, even a tiny move can mean huge gains or losses in percentage. For most investors can’t afford the immense volatility.
Companies With No Proven track Record
The companies issuing penny stocks are often unproven and may have lower reporting requirements, making it difficult for investors to research their financial data. Therefore, they are essentially investing their money blindly.
Trading Volumes Remain Low
The stocks on the NYSE, Nasdaq, and other large stock exchanges have plenty of buyers waiting to buy into them. So even when demand is low, brokerages buy the stocks because they know the market is there.
On the other hand, the trading volume for penny stocks is low because there are few buyers, meaning that you might struggle to sell them even if you have made gains on them and want to cash in the profits.
How Should Beginners Buy Penny Stocks?
Before buying any penny stocks, you should look for as much information as possible about the company. For example, look at its balance sheet, management, previous performance, share price, etc. Look for filings on the SEC or ask your broker for information.
The next step is to get comfortable trading these stocks by doing simulation accounts, also known as paper trading. Paper trading allows you to learn the patterns and practice how to handle the dramatic price fluctuations.
Once you have mastered the art on paper, do the following:
- Set aside the amount you want to risk.
- Prefer to trade penny stocks on major exchanges.
- Research any company’s stocks you are interested in and look for companies that recently fell to below $5,00 liked by other professional traders. These are sometimes good companies that might experience temporary setbacks.
- Fees and commissions can make penny stocks expensive, so carefully pick an exchange with no fees or low fees.
Finding the Best Penny Stocks
Penny stocks may be riskier than other stocks, but that does not mean you should avoid them as a beginner because they can prove profitable. Here are some points to consider:
Research remains your most critical tool. The most important thing to look into is the company statements to ensure it is a sound investment. You can also check up on their auditing company. So do your due diligence, making sure to buy shares that fit your investment strategy. Avoid recommendations because they are often biased, preferring to go with your gut feeling.
Thanks to their minimal capital requirement, penny stocks offer beginners an exciting investment opportunity. However, due to the minimum standards, short history, and liquidity issues, these stocks also have inevitable volatility that makes them risky for inexperienced investors. Nevertheless, research and practice can help you choose the right penny stocks if you want to try and invest a small amount of capital.