Penny stocks are one of the most exciting types of stocks you can invest in. Many penny stocks are little known, high-growth companies, so investing in this asset class can be something like a treasure hunt for traders.
Investing in penny stocks can be risky, since the companies behind these assets aren’t regulated in the same way that companies on major stock exchanges are. Of course, that risk is balanced by penny stocks’ enormous upside potential, which makes them attractive to investors willing to take on risk. Wondering exactly how to invest in penny stocks? Read on to learn more.
What Are Penny Stocks?
There is no strict definition for what constitutes a penny stock, but most traders consider any stock that trades for less than $5 per share a penny stock. While some companies on the major exchanges are valued at less than this cutoff, the penny stocks that most investors think of are for companies that trade on over-the-counter markets.
Penny stocks are typically issued by small companies that want to raise public capital, but don’t meet or don’t want to meet the requirements for listing on a major exchange. Many of these companies are legitimate businesses that simply have small market capitalizations or a less-than-global reach.
Why Invest in Penny Stocks?
There are several important reasons why an investor might want to trade in penny stocks.
Just because a company’s stock is worth less than $5 doesn’t mean the company is bad. There are tons of promising startups and established companies that are trading as penny stocks. Many of these companies are flying under the radar because the penny stock market just doesn’t get that much attention.
For savvy investors, that means there are bargains to be had in the penny stock world. High-growth companies might be trading at extremely low prices. While there are few companies on major exchanges that you can get into before they take off, the penny stock market offers the chance to invest in companies at ground level.
The ratio of penny stock traders to penny stocks is much lower than the ratio of traders on New York Stock Exchange to stocks on the exchange. In addition, there is typically a lot less money moving through penny stocks on any given day than there is moving through a major exchange.
That means that liquidity is typically low when you’re trading penny stocks. On top of that, penny stock shares are inexpensive and there are few institutional investors trading penny stocks. So, any individual trader can buy enough of a single penny stock that they’re able to move the market for that stock. All of this can be attractive for risk-tolerant traders, since it means that small moves can force big changes in the price of a stock.
Of course, the promises of investing early in a high-growth company and seeing huge windfalls from small changes in demand don’t come without risk. Penny stocks are in fact much riskier than stocks trading on major exchanges.
To start, low liquidity cuts both ways. A small drop in demand can tank a penny stock’s price in the same way that a small increase in demand can cause it to skyrocket. There is a real chance that you can get stuck with a penny stock when selling pressure is high, since there simply aren’t many buyers for that stock even in the best of times.
Low liquidity also means that pump-and-dump schemes are possible in the world of penny stocks. A single investor or group can inflate the price of a stock through rumors or large purchases, and then dump the stock for a profit and collapse the share price in the process. When trading penny stocks, you need to be extremely careful to avoid scams.
Even the allure of high-growth companies comes with quite a bit of risk. Many of the companies behind penny stocks don’t report financial data since they’re not required to by the SEC. It’s entirely up to you to evaluate whether a company is not only legitimate, but whether it is making money or actually delivering the growth the executive board is promising.
That said, these risks can be managed – which is why many investors still see profits from trading penny stocks.
How To Invest In Penny Stocks
Investing in penny stocks is a lot like investing in any other type of stock. Let’s cover the elements you need to consider.
Set A Strategy And Goals
Before you even consider placing your first trade, you need to know why you’re trading. That means carefully considering what your goals for investing in penny stocks are in the first place. Do you want to invest in companies that you can hold onto for the long term and grow your wealth over time? Or do you want to generate income by buying and selling stocks on daily or weekly timescales? Your investment goals should determine how you approach penny stocks.
Once you’ve decided on your trading goals, you’ll need to develop a trading strategy that will help you achieve them. Your strategy should align with the timespan and risk tolerance of your trading goals, while offering a specific plan for what you’ll invest in, when, and why. There is an infinite number of number of trading strategies, so you need to do your research to figure out which one works best for you.
Open A Brokerage Account
In order to trade penny stocks, you’ll need a brokerage account. A brokerage buys stocks on your behalf and holds them for you, as well as finds a buyer for your shares when you decide to sell them.
There are numerous brokers you can use for trading penny stocks. E*TRADE and Webull are two of the most popular options. Just make sure you choose a broker that offers trading on the over-the-counter markets where penny stocks are listed.
How Do You Choose Which Penny Stocks To Buy?
After you have a brokerage account ready to go, you’re ready to start investing. So, it’s time to figure out which penny stocks are worth buying.
Match Your Strategy
The best place to start is to think about your strategy. Narrow your strategy into a series of questions or parameters that you can use to filter through stocks. You may be able to home in on a specific market sector, say, or exclude all penny stocks that have a downward price trend.
In addition, you should be specifically looking for stocks that fit your investing style. Some penny stocks are more volatile than others, for example. If you’re looking for short-term profit, that volatility can be attractive. If you’re looking for companies you can buy to save for retirement, that volatility is a red flag.
There are several different ways to generate trade ideas. First, rely on what you know. If you have a background in a specific market sector, like technology, a good place to start is to look at companies in that sector. You’ll have a leg up on other traders since you know more about the potential market for a company’s products and how they work.
Another good place to turn is to market news and analysis sources. Sites like Benzinga, MarketWatch, and others are frequently highlighting news about penny stocks and emerging companies. Reading through these reports is a good way to find out more about promising companies you may never have heard of before.
Industry trend reports are also helpful. If you can find a specific sector that’s taking off, you can then do a search to identify any companies trading as penny stocks within that sector. Further evaluation of these prospects may lead you to find a gem or two.
Do Your Research
It’s not enough to find a promising penny stock and buy it. Companies trading on over-the-counter markets are often opaque and scams abound. It’s essential that you do your due diligence to make sure that a company is legitimate and that it’s in good financial health before you buy shares.
Of course, research goes beyond just making sure you’re not investing in a scam. You should always compare a company against its competitors and fully evaluate whether the stock price is appropriately valued. If you can’t find reliable information about a company – which sometimes happens when researching penny stocks – don’t assume that it’s a worthwhile investment. Move on to another opportunity instead.
Conclusion: How To Invest In Penny Stocks
There are many investment options when it comes to the stock market. You could invest in private companies, index funds, municipal bonds, stocks, and of course – penny stocks. Investing in penny stocks can be a good way to profit from companies that many traders simply ignore.
There are plenty of strong companies that trade as penny stocks and represent better investments than some stocks on the major exchanges. That said, penny stocks do come with some added risks that you need to be aware of before investing. Be sure to carefully research any company before you commit to buying shares and always keep your broader trading strategy and goals in mind.