The old saying about the need to speculate to accumulate certainly applies when you are talking about investing in penny stocks, but despite the perceived dangers and volatility attached to this arena of stock market investment, there are ways to control the risks.
When you read about penny stocks today or pretty much any other day, you will often be able to find stories of huge gains and big falls in the price of certain stocks, so you need a strategy that helps you manage and even potentially lower the risks, so that you might be able to reap higher rewards on the winning plays.
How real is the risk?
By most investor’s definitions, penny stocks are considered to be high risk investments, and there are plenty of traders who might have found themselves in a position where they have lost money on a stock or only managed to scrape a small profit.
If you fail to take the right approach to investing in penny stocks and end up putting your money down based on inadequate or inaccurate information, or both, you are probably setting yourself up for a fall at some point.
The risk attached to penny stocks is defined by what you do in order to identify a penny stock to trade, rather than just the concept of penny stocks on their own.
There is no question that if the stock is trading under $5 and is either an embryonic or small business, there are greater risks in comparison to putting your money into a blue chip stock, but if you do your research and have a disciplined approach, you can manage that risk.
Cutting through the noise
A fundamental point to raise about penny stocks straight away is that there are sometimes scams and misinformation around, that could lead you to make an investment based on news and data that is not all it should be.
The reason why this can happen sometimes with penny stocks, is that there is not the same level of regulation attached to these type of stocks. Most of these stocks don’t trade on the major market exchanges and are subject to more limited listing requirements.
Therefore, if you find a penny stock being talked up on a bulletin board or get an email suggesting you get in quick while the price is still low, everything may not always be as it might seem on the face of it.
What you need to do to become a successful penny stock investor, is base your investment decisions on solid facts and figures and information that you know comes from a reliable and verifiable source.
Process of elimination
There are some basic clues that you can look for when researching every company, which will help reduce the risk by eliminating stocks that don’t meet your chosen criteria.
It is all very well someone talking up a certain penny stock, but if they don’t enjoy a positive cash-share ratio, that raises a question about their staying power to build the business and even keep trading beyond a certain period.
If you find a business that can boast a strong gross margin, that is a positive attribute, as it means that they have already been able to demonstrate that their business model works.
Also look for a business that enjoys a strong profit margin, as this is a fair indication that the company is well placed to withstand and follow their expansion plans, which is crucial to the stock adding value.
Another pointer when looking at penny stocks, is to avoid company’s offering dividends. That may well surprise you, as that is considered an attractive feature amongst the blue chips. However, down in the world of penny stocks, you really want to to see that a business is putting their money into financing expansion and infrastructure, rather than giving stockholders some of that cash, which can come later when the business has grown.
These simple rules are an example of how you can apply a process of elimination to reduce your risk and find a short list of stocks that tick these important boxes, making them potentially ripe for investment.
Penny stocks are truly unique in a number of ways. They can soar in value and dive in a matter of days, or even hours. So you need to be prepared to take a short-term view if it is required, to make your profit and move on to the next opportunity.
Whatever you decide to do, remember that penny stocks can actually only be as risky as you make them.
Edward Briggs likes to share his tips and insights on penny stock trading with those just starting out or looking to gain more knowledge. He writes for a variety of personal finance and investment/trading blogs.