People gravitate towards penny stocks because they often offer a high potential for bigger profits than other equity investments at a low purchase cost; this type of investment is exciting because it's all about "finding the next big winner." But before anyone can reap the rewards of these types of investments, they must conduct research, be patient, and have a well-developed plan when investing in penny stocks.
In this guide, we'll define what penny stocks are, show you how to find them, and discuss the proper ways to invest in them while minimizing unnecessary risks. Whether you're just starting out as a new investor or a seasoned investor interested in high-growth investments, this guide will provide you with clarity and confidence to get started with penny stocks.
Investors considering a penny stock purchase should first understand what 'penny stock' means and why it can offer an excellent opportunity for growth.
A penny stock is a share issued by a very small company that is generally quoted at less than $5 per share (by the U.S. Securities and Exchange Commission), and typically trades on an over-the-counter (OTC) market, as opposed to an established exchange such as the NYSE or NASDAQ, where trading occurs.
Because many of the companies (which issue penny stocks) are in their early stages of development, they often (1) don't have a long operating history; (2) have smaller market capitalization; (3) provide less publicly available information.
There are several reasons investors consider to be drawn to penny stocks.
1) Relatively low capital requirement
2) Higher opportunity for growth (compared to other established companies)
3) Opportunity to diversify their portfolios with speculative investments.
However, the SEC and FINRA warn that investing in penny stocks is highly speculative (i.e., high volatility, low liquidity, and difficulty obtaining accurate information) and that an individual needs to understand these risks before making an informed investment decision.
Quality penny stocks can be found through research of reputable sources and not from random tips. Traders who know how to find penny stocks are disciplined investors, not gamblers.
To begin, use reputable market screeners (such as those used by brokerage firms) to identify penny stocks based on price, volume, and market capitalization. Look for penny stocks that have consistently traded volumes, are financially compliant with regulations (have financial statements), and have established business models.
FINRA states that one should avoid investing in stocks that are forwarded via unsolicited emails or social media hype, as they are also strong indicators that the stock is being pumped and dumped.
Small businesses can have their company fundamentals readily available; you can confirm this by examining (for example):
The lack of available information is ranked among the largest risks related to penny stocks by the SEC’s investor education website.
You will find that many penny stocks are invested in growing industries, e.g., clean energy, biotech, or technology innovation. By reviewing macroeconomic and industry data, you can research businesses poised to grow without speculation.
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When you’ve researched the potential opportunities and have identified exactly what they entail, the next step is to execute. Knowing how to invest in penny stocks will minimize your risks and provide the opportunity for maximum returns.
Not every brokerage will allow you to trade penny stocks (especially over-the-counter securities). You will want to select a regulated brokerage that can execute your orders efficiently, transparently, and legally. Some features of good brokerages include:
FINRA suggests you verify that your broker has the necessary licenses; that he/she is properly registered before you proceed with an order, and that you fully understand the fees associated with executing your order.
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Many of the shares traded on the Pink Sheets tend to have liquidity issues, so a sudden spike in the share price could result in you not being able to execute at your desired price. By placing limit orders (instead of market orders), you can avoid paying more than you'd like to pay or receiving less than you'd like to receive, due to volatility in the stock market.
Don’t overinvest a large part of your portfolio into cheap (or “penny”) stocks if you’re an experienced investor; keep your exposure relatively small (e.g., less than 10% of total capital). This way, if you do lose money, the losses are manageable. One of the things that the government financial services constantly say is that “diversification” is a fundamental principle of responsible investing.
Take the time to monitor and strategically exit your penny stock investments. Don’t just buy and hold penny stocks because you bought them; you need to regularly check:
Set specific price targets for both gains and losses before investing in penny stocks; this will help remove emotion from your decision-making process.
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Investing in penny stocks offers distinct and diverse possibilities for the disciplined, realistic investor. Penny stocks are speculative instruments that can subject investors to very high risks or losses, so they should not be viewed as shortcuts to wealth. Rather, penny stocks should be considered and included as part of an overall diversified investment strategy.
Investors can learn about penny stocks, use proven techniques to find them, and follow the recommended guidelines for investing in them—thus increasing their chances of making intelligent investments, avoiding unnecessary pitfalls, and becoming informed participants in the stock market.
Investment professionals (SEC and FINRA) strongly encourage informed investors to become empowered investors. To become a successful investor, you must rely on knowledge, patience, and strategy as your primary assets.
Penny stocks provide large potential returns for high-risk, high-volatility speculation. Penny stocks are considered ‘peripheral’ investments, as per SEC recommendations on how much of a total portfolio to use.
Beginners interested in purchasing penny stock should use established, regulated brokers for small investments, place limit orders, and conduct thorough research on the company via SEC filings and FINRA educational materials to prevent fraud and reduce the risk of loss.
Though there are many public and private resources with good information about penny stocks, finding issues requires taking care to avoid promotional hype and making decisions based on sound research and data.
Penny stock companies exist within the SEC and are regulated by the SEC (Securities and Exchange Commission) and FINRA (Financial Regulatory Authority) regulations. However, the lack of information about many penny stocks means one should conduct independent research before investing in them (to avoid fraud, misinformation, or highly speculative companies).
The safest way to invest in penny stocks is to diversify across them, set strict position sizes, place limit orders, and rely only on verified financial promotions, not rumors or social media-driven stock tips.
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