How to Invest in Penny Stocks? Beginner’s Guide

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by Adedamola Bada · 8 min read
How to Invest in Penny Stocks? Beginner’s Guide
Photo: QuoteInspector

Many who are still finding their way around the world of investment have found penny stocks to be a good starting point. Find everything you need to know about investing in penny stocks in this guide.

As implied by its name “penny stocks”, these are the companies trading at $1 or even less per share. This unique format of investment makes room for investors to buy a significant amount of shares with only a little capital. Thereby they may cash out substantial percentage returns even when the realized profit is as little as a few cents per share.

However, it is vital to know that penny stocks have downsides as well. One of them is its reputation for being a high-risk investment. Others include miniature market capitalization, liquidity shortage, and large bid-ask spreads.

Key Points

  • Penny stocks trade at $1 or less.
  • They encounter a problem of liquidity.
  • The majority of penny stock trades happen in top market exchanges.

What Are Penny Stocks?

The definition provided by the Securities and Exchange Commission (SEC) regarding penny stocks says it is security originating from companies with either small or micro capitalization, which trade at or below $1 per share. The companies in this category usually have one of two things in common, like a non-existent financial history or a very poor one. Sometimes, the company may be on the verge of bankruptcy.

Due to the nature of penny stocks, they aren’t welcomed in the big boys’ stock exchanges like NASDAQ or NYSE. Though this looks like segregation, it isn’t. These stock exchange giants have requirements that must be met if any company wants to trade on them. One of them is that primary equities must have a minimum bid price of $1 per share, which penny stocks cannot satisfy. As an alternative, penny stock investors make use of the over-the-counter market (OTC) for trades.

How to Find a Penny Stock

There are some penny stocks with share prices of below $1 and others that go for $5 per share or less. However, all of them have the same trading station and that is the over-the-counter bulletin board (OTCBB) and the Pink Sheets. The OTCBB differs from the Pink Sheets in terms of legitimacy as it demands certain requirements for listing. On the other hand, Pink Sheets are just a quotation publisher with no relationship with the SEC which makes them highly risky.

How to Invest in Penny Stocks

To get the best out of your investment in penny stocks, there are key things you must take to heart.

Begin With Little:

The best advice is to start with a small capital and progress slowly. Let your investment in penny stock be only a little portion of your portfolio, say 10% or less, or you might fall victim to scammers.

Look Out For Scams:

Bear in mind that penny stocks are not traded on established stock exchanges. Instead, they trade on the over-the-counter exchanges, which means that they are prone to manipulations from scammers and there is little or nothing anyone can do about it because they answer to no authority.

Be Mindful of the Volume:

Profits are only realized when you have successfully closed your position. If a penny stock you are holding suddenly experiences a spike in price, the increase won’t benefit you if you cannot sell your holdings. Therefore, obtain information about the average daily trading volume of stock before purchasing it.

Diversify:

Ensure that a good amount of your capital is in more reliable investments like a S&P 500 index fund. This will bring a level of normalcy to your portfolio.

Put In The Work To Research:

Carry out proper research before buying any penny stock. Obtain the company’s financial filings and read through it. If there is no clear financial statement, it means the penny stock is shady and should be discarded.

How to Select a Broker

The trading business cannot do without the professionals known as stockbrokers, as they make available the needed trading infrastructure, as well as influence the trading choices of investors. However, not all stockbrokers are ideal for every investor. A crucial aspect that must not be overlooked is their fee structure. Investors have to ensure that they are comfortable with the commission of the stockbroker and can afford it.

Below are some US-based penny stock brokers that are regulated:

ChoiceTrade:

This is an SEC-registered broker that provides access to penny stocks on the Over the Counter Bulletin Board (OTCBB) and Pink Sheet markets. It is also a member of the Securities Investor Protection Corporation, NYSE Arca and the BATS Exchange.

Charles Schwab Corp: 

With its brokerage charges set at $4.95 for every trade, Schwab offers Over the Counter Bulletin Board (OTCBB) and Pink Sheet securities trading via its website and mobile app.

Interactive Brokers (IB):

This broker uses its standard equity trading account to offer selected stocks for penny stock trading on the Pink Sheet and OTCBB.

TD Ameritrade: 

Through its equity trading accounts, TD Ameritrade offers penny stocks on the OTC Bulletin Board and Pink Sheet securities. It charges $6.95 for each trade.

Associated Risks

Knowing the risks involved with penny stocks is one way to reduce the chances of losses during trades. Here are some risks that are associated with penny stocks.

Lack of Vital Information:

Trading without a good information source can be very dangerous. Investors should join trading communities where they can obtain data and information to support their trades. However, all information must be scrutinized for accuracy before use.

Investing With No Minimum Standards:

A common sign of a company in financial trouble is when it drops out from the major stock exchanges to find succor in the Pink Sheets. If there is no information to state otherwise about the company, then it will be wise to flee from its stock.

Insufficient History:

When there is no trading history to bank on, it can be a sign of impending bankruptcy, unless it is a new company.

The problem of Liquidity:

The lack of liquidity is a popular risk with penny stocks. It is quite easy to purchase penny stocks but selling them in the future is not that simple.

Types of Charges

Penny stock trading has its transaction charges and below are some of them.

Transaction Charges: 

This appears on the websites of brokers as either “3% per trade order” or “Brokerage starting from $x per trade.” It is the general amount charged by brokers for their services.

Minimum Brokerage per Order Charges:

This is the minimum amount charged by brokers for each trade, say an $8 minimum per trade, as opposed to the “3% per trade order” advertised by the broker.

Large Order Surcharges:

Some brokers add more charges to large quantity orders, like in the purchase of over 100,000 shares.

Brokerage Account Maintenance Cost:

A maintenance fee is required annually for every penny stock trading account. More charges may be deducted for services like money transfers, depository accounts, etc.

Withdrawal Charges:

For every withdrawal, the broker may deduct charges for them. Money transfers from your trading account usually attract withdrawal charges.

FAQ About Penny Stocks

Here are some frequently asked questions about penny stocks that will help you make up your mind whether to invest in it or not.

Where Can Penny Stocks Be Purchased?

Penny Stocks are very cheap to buy, however, purchasing them via a live broker is not always profitable. The alternative is to go through an online broker which will let you control the trades by yourself.

Are Special Techniques Required For Success?

Penny stocks require calculated techniques to make money but what works for someone else may not work for you, hence the reason you need to come up with your strategy. For some, technical analysis is better than fundamental analysis. You just have to trust your instincts and know what works for you.

Are There Successful Investors In Penny Stocks?

Absolutely! That’s why the market still exists. Though it is a high-risk investment, the capital involved is way smaller compared to other investments. If you can trade every day and diversify your portfolio, you should make profits constantly.

Is There Money To Be Made In Penny Stocks?

The answer is yes. But it isn’t a fast cash scheme. For some people, it could take some years before making headway in penny stock trading while some will breakthrough within a maximum of six months.

Conclusion

The need to exercise caution in penny stock investing cannot be overemphasized. Most of the time, the companies involved are prone to massive volatility. This market should only be ventured into once you have a sufficient understanding of it. If you are convinced that you’re ready to take the step into penny stocks, then you have to first find a broker, fund an account before locating a trading candidate that will be suitable for you.

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