Penny Stocks 101: What Are They About?

Penny Stocks 101: What Are They About?

A penny stock trades outside of the major market exchanges at a low price and has a small market capitalization. These stocks are generally considered highly hypothetical and high risk because they lack liquidity, large bid-ask spreads, small capitalization and limited following and disclosure. They often trade over-the-counter through the OTC Bulletin Board (OTCBB) and pink sheets.

Penny Stocks

The term penny stock has grown in the market. In the past, penny stocks were traded for less than a dollar per share.

Most penny stocks don’t trade on the major market exchanges. However, there are some large companies, based on market capitalization, that trade below $5 per share on the main exchanges.

Thus, the typical penny stock is a small company with highly illiquid and hypothetical shares. The company generally goes through limited listing requirements along with fewer filing and regulatory standards.

Creation of Penny Stocks

A penny stock, like any other publicly traded stock, is created through a process called IPO or initial public offering.

First, a company must file a registration statement with the Securities and Exchange Commission or file stating the offering qualifies for an exemption from registration. It must also check state securities laws in the locations it plans to sell the stock.

Then, upon approval, the company may start the process of soliciting orders from investors. Finally, the company can apply to have the stock listed on an exchange, or it can trade on the over-the-counter market, or OTC.

Small companies and startups usually issue stock as a means of raising capital to grow the business. The process is lengthy, involves mountains of paperwork and can be quite costly, though. Nevertheless, issuing stock is often one of the most efficient ways for a start-up company to get necessary capital. Penny stocks are often the result of such ventures and can make for profitable but risky plays for investors.

What Makes Penny Stocks So Risky?

Lack of Information Available to the Public

The key to any successful investment strategy is getting enough tangible information to make informed decisions. For micro-cap stocks, information is much more difficult to find. Companies listed on the pink sheets are not required to file to SEC. Thus, they are not as publicly scrutinized or regulated as the stocks represented on New York Stock Exchange and Nasdaq. Furthermore, much of the information available about micro-cap stocks is not from reliable sources.

No Minimum Standards

Stocks on the OTCBB and pink sheets don’t have to fulfill minimum standard requirements to remain on the exchange. Occasionally, this is why the stock is on one of these exchanges. Once a company can’t keep its position on one of the major exchanges anymore, the company moves to one of these smaller exchanges.

While the OTCBB requires companies to file well-timed documents with the SEC, the pink sheets have no such requirement. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.

Lack of History

Many companies considered as micro-cap stocks are either newly formed or approaching bankruptcy. These companies will generally have poor track records or none at all. As you can imagine, this lack of historical information makes it harder to find out a stock’s potential.

Liquidity

When stocks don’t have much liquidity, there comes 2 certain problems. Firstly, there is that you won’t possibly be able to sell the stock. If there is a low level of liquidity, it may be hard to find a buyer for a particular stock. Also, you may be required to lower your price until it is considered attractive to another buyer.

Secondly, low liquidity levels provide opportunities for some traders to use stock prices, which is done in many different ways. The easiest is to buy large amounts of stock, hype up and then sell after other investors find it attractive (also known as pump and dump).

A penny coin that indicates penny stock trading

Guides for Trading Penny Stocks

When it comes to penny stocks, there’s a right way and a wrong way to do things. The beauty is that the risks and mistakes can be easily avoided, while you step in with the right types of companies at the right trading prices.

Decide If Penny Stocks Are Right for You

Penny stocks and low-priced shares are not right for everyone, despite that they have a lot of great attributes. They truly can turn a small investment into a large sum of money pretty quickly. But they can also just as quickly wipe those dollars out.

For many people, the potential for big rewards doesn’t offset the risks. Be honest with yourself, and do not feel bad about walking away from the entire concept. In general, this is often the best choice, because MOST situations involving penny stocks result in many investors taking losses.

The good news: the reason most are wasting their investment dollars is they are buying the wrong stocks, at the wrong prices, and usually for the wrong reasons. These investment risks can be easily avoided, mainly by learning a little bit about the reality of trading penny stocks.

Risk Money and Honest Guides

You should invest in penny stocks only with risk money or those funds that you can afford to lose.

Also, you should only get yourself involved with low-priced shares once you have gained significant knowledge, and have a strong stomach for the potential volatility, which can sometimes be found in the investments trading at the lowest prices.

Moreover, follow someone who knows the industry very well. An expert can help you avoid mistakes, and you can learn from his or her experiences. These are true and honest, whether talking about penny stocks, home renovation, cooking, yoga, or otherwise. The caliber of your results will be directly equal to the caliber of your guide.

Heavy Metal Lottery Tickets

People want to turn a few hundred dollars into total financial happiness and freedom. Therefore, they let their guard down, and believe the promises.

This is what explains the success of the “robot that picks stocks” scam, the popularity of the Iraqi Dinar, binary options, marijuana penny stocks, and every other “close your eyes and hope” stampede, from the Dutch Tulip Bulb mania to the California Gold Rush.

If you want more recent and relevant examples, just think back to $1,300 Bitcoin, or the Dot Com Bubble. Whatever happened to Darkcoin, Peercoin, Gridcoin Namecoin, Primecoin, and so on, don’t fall through the lottery ticket promises. Investing well in penny stocks involves some work, some knowledge, and some guts.

Start By Paper Trading

You can avoid big mistakes by learning how to trade with risk-free, no-money-required method of buying and selling low-priced shares. They are called “Paper Trading”. All you need is a pen and a piece of paper to keep track of imaginary trades in real stocks.

This will probably be the best thing you will ever do in terms of penny stocks. By tracking imaginary profits on your imaginary Paper Trading, you can make a more knowledgeable jump into real money. This will also help you learn all the relevant penny stock lingo, learn from your mistakes, and appreciate all the things to look for when you try to find the next penny stock winners.

Decide Which Types of Companies You Will Focus On

Most investors make the mistake of investing their money in whatever is the latest “hot industry.” By the time you hear about which industry gets hot, it typically means that it is on everyone else’s radar. That’s the problem because the trade is already crowded, matured, and heavily overpriced.

In other words, the next move for the latest hot industry is almost always down. When it comes to penny stocks, the change from current to former trends usually results in the shares of all the penny stocks in that hot industry collapsing significantly.

Your Passion

Not sure which types of businesses allow you the greatest advantage? Just take a look at what industry publications you have a subscription to, or what your passion involves. Mountain biking? Deep sea diving? Gold mining? Fashion?

Typically, people overlook their own industry, and instead focus on what they think will make the largest difference for them. In so doing, they give up a major pre-established advantage that they didn’t even know they have already.

Our Human Nature

This is just human nature. Especially, since the last thing you want to do when you’re done working for the day is to focus on other things related to that exact same work. Not always, but often, chefs don’t cook their dinner, painters don’t paint their den, internet entrepreneurs don’t surf the web.

You may be happy by reversing this psychology. Focus on those industries and corporations which you understand the best. When it comes to trading penny stocks, you want to bring every advantage to tolerate.

Conclusion

When it comes to penny stocks, there is a right way to do it and a wrong way. By expanding your knowledge about trading penny stocks and following guides, you will be able to avoid the risks. In doing so, you open yourself up to finding the really high-quality companies, which operate in industries which you understand and are passionate about.

 

See Also: Cyclical vs. Non-Cyclical Stocks: What Sets Them Apart

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