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Penny stocks for beginners: a complete guide

By Valerie Medleva

12:46, 3 May 2019

Penny stocks guide

Penny stocks can bring great opportunities if chosen wisely. We are here to explain the phenomenon and get you up and running with some tips and tricks on how to trade penny stocks.

What is a penny stock?

If you are new to trading, you might ask yourself, “what are penny stocks?” A penny stock refers to any publicly traded security with a very low stock price and a small market capitalisation. These securities are issued by relatively new, small companies that haven’t established a proven track record as successful businesses.

In the US, it can be any stock valued at less than $5 per share. There is no formal definition in the UK, but a penny stock is generally considered to have a share price under £1. Although some penny stocks do trade on large exchanges such as the New York Stock Exchange (NYSE), most of them still trade via over-the-counter (OTC) means, as they are too small to meet regular exchange listing requirements.

Keep in mind that sometimes a stock valued up to $10 might still be considered a penny stock if its market capitalisation is low enough. Penny stocks are also referred to as small-cap stocks, cent stocks and OTC stocks.

Penny stocks trade infrequently, lacking liquidity. Consequently, traders might find it difficult to sell stock as there may not be interested buyers at that time. Little trading activity also results in larger bid-ask spreads, so it can also be difficult to find a price that accurately represents the market. Additionally, a penny stock may also indicate a company approaching bankruptcy. This high risk of uncertainty makes investing in penny stocks extremely risky and considered to be among the most speculative investments one can make.

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The history of penny stocks

In fact, penny stocks have been traded in some form or another for as long as the stock market has existed. Companies have offered large numbers of their shares for a relatively low price since the late 19th century.

Given their uncertainty, the US federal government blamed penny stocks for the 1929 stock market crash. In 1934, the Securities Exchange Act was created. It brought a definition of penny stocks as all equity securities that were trading for less than $5 and unlisted on any national stock exchange.

The penny stock market remained relatively quiet throughout most of the 20th century. Prior to the invention of the internet, the only real way to trade penny stocks was over the phone.

With the spread of the World Wide Web in the mid-1990s, penny stock trading exploded: penny stock brokers emerged, offering online platforms to trade penny stocks at discounted rates. New investors entered the stock market. Some made a fortune. Some, however, did not.

After the Great Recession, its definition would change again. The SEC added that some penny stocks could be traded on US and foreign securities exchanges.

How is a penny stock created?

Sometimes, you might hear that Apple or Microsoft were once penny stocks. However, that’s not true. Actually, the vast majority of penny stocks are from companies you've probably never even heard of.

Like any other publicly traded stock, a penny stock is created through the process of an initial public offering (IPO). Startups and small companies typically issue stock in order to generate much-needed capital to fund and grow their businesses. Even though the process is quite lengthy, issuing stock is usually one of the easiest and most effective ways for a small company to gain capital.

To be listed on the Over-The-Counter Bulletin Board (OTCBB), the company must first prepare a registration statement or file that states the offering qualifies for an exemption from registration. Once approved, the company is allowed to begin the process of seeking orders from investors. Then, the company can finally apply to have its penny stock traded on the OTC market or, in exceptional cases, listed on a larger exchange. Some companies make an additional secondary market offering, which dilutes the existing shares but gives the business access to more investors and higher capital.

Why do people trade penny stocks?

Today, penny stocks have been associated by many with scam tactics and pump-and-dump schemes. So, with all of the potential risks involved, you might wonder why someone would even consider trading penny stocks. As some say, “the higher the risk, the higher the potential returns.”

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The desire to make some quick earnings draws traders to work with penny stocks. Even though they can be hard to find, some penny stocks are those of profitable companies with high potential for growth, leading to enormous gains for early investors. Additionally, unlike regular stocks, penny stocks generally move on the momentum of price action.

When investing in penny stocks, you should be aware of the pros and cons and be prepared with the possibility of losing some of your money. It is always a good idea to carefully research each company and diversify your holdings to manage risks.

Why do people trade penny stocks?

How to trade penny stocks

You can buy and sell penny stock through online brokers. Once you buy it – be ready to sell, as penny stocks typically aren’t long-term bankers. The goal of this trading is to sell right before its price hits the top of the curve.

Since penny stocks are often without regulation, they are sometimes the target of manipulators and scammers. Don't fall through the lottery ticket promises you get from the bad brokers: investing in penny stocks involves some knowledge, work and guts.

When considering penny stock trading, you have to first decide which types of companies you are going to focus on. Many make the mistake of investing their money in whatever is the current ‘hot industry’ – the one that is talked about in the news and even suggested by your taxi driver. The problem is, when you hear about which industry is hot, it typically means that it is on everyone else's radar by that time. The trade is already crowded, matured and probably overpriced. Often, the next move for the latest hot industry is downward. When it comes to penny stocks, the sudden change in trend usually results in the shares of all these stocks in that hot industry collapsing significantly.

In this case, we recommend you to stick to what you know and understand. For example, if you are an IT specialist, you can have an advantage when penny trading various tech companies. If you are an engineer, consider picking some industrial firms. This will help you to better navigate in the multitude of given options.

One of the biggest pros of penny stocks is that they can be traded after hours. With significant market movements that tend to happen after exchanges close, penny stock prices can fluctuate after hours. Investors who execute trades during this time may be able to buy shares for very low prices or sell shares for very high prices. However, in this situation, an investor selling the stock might have a hard time finding a buyer.

When investing in penny stocks, search for the more serious and regulated exchanges. If you plan to actively engage in penny stocks trading, keep in mind that some brokerages might charge more for the transactions. Take time to find the best broker for your trading goals.

Another important thing to remember: you should only invest in penny stocks with the money you can afford to lose in case if everything goes against your initial plan.

Well-managed penny stocks can play a good role in your portfolio. Just like any stock you buy, whether it is a blue chip or penny stock, remember to do your research before making an investment decision. This can be checking the balance sheet to compare the company’s assets against its debts; reading cash flow and income statements to see how profitable the company is; and, last but not least, watching corporate presentations to get a better feel for the chosen company. This will serve you well when spotting legitimate companies and weeding away scams.

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