Penny Stocks 101 – Everything You Need to Know Before Investing in Penny Stocks

Penny stock investing is all over the internet. There are thousands of pages of information being thrown at you and me – young investors – about how to make the best penny stock choices. You know the images of ads with that slimy looking salesman giving you a thumbs up, promising 1000% returns on penny stock investments. The truth is far different.

What are Penny Stocks?

Penny stocks are not just the stocks that trade for one cent a share or even those that are less than a dollar. Many on Wall Street consider penny stocks to be those priced under $5 a share and some even consider them to be the stocks trading at under $10 a share.

Although penny stocks are still trading on respectable listings such as the New York Stock Exchange and the NASDAQ most penny stocks that we are pressured into buying are not available on these exchanges. Instead they are listed as Over the Counter OTC; Bulletin Board (BB) or Pink Sheet Stocks.

Why are penny stocks Dangerous to Buy?

Penny stocks are often thinly traded, meaning that there are not enough buyers and sellers on a daily basis to have the most accurate representation of the value of the stock. Thus they are subject to price manipulation. This happens when a person or firm buys several thousand or even million shares of a penny stock, often less than $1 a share. Then they build up hype for it online through penny stock newsletter or message boards. When enough hype has been built to bring more investors there are not enough shares to go around, driving the price up. It is at this point that the spammer sells their holdings of the stock and makes a huge return. This is known as price manipulation. The company of the stock could have negative earnings or could actually be a nonexistent company when the trading is taking place.

As a result of being thinly traded, penny stocks often lack the amount of research more frequently traded stocks, like those in the S&P 500 would receive. Analysts are also practically non-existent. This can be troublesome because of a couple of people who may not be qualified, reporting on the success of a penny stock. Is there anyone to back up their analysis or recommendation? Often not.

Why do Penny Stocks trade so Low?

Penny stocks trade so often less than a dollar and very often for just penny’s because of inherent problems in these companies. Let’s be honest, penny stock newsletters and investing services do not have faith in the company based on an calculate or fundamental analysis. Penny stocks trade so low because the company is either falling apart, not making any money or is a scam. The most frequent scam for penny stocks is bio medical companies. The classic pitch is, “When the FDA approves this surgery or this device, this stock is going through the roof.” Perhaps you have heard this language before on the classic stock brokerage film Boiler Room.

This type of thinking can get quite dangerous as that film has illustrated and many lives are ruined from a penny stock investing scam or even addiction. Why does this happen? The barrier to entry is so low, especially for us young investors. Being able to acquire several thousand shares for just a couple hundred bucks is incredible. We feel like we are part of something big, the pie in the sky dreams start to come out. We then to put misguided and emotional faith in the penny stock. Emotional investing has ruined many portfolio’s and is not an exclusive problem to penny stocks. However with penny stocks we stop paying attention to clear signals that tell us of a scam or a dead company.

How Can I Invest in Penny Stocks the Right Way?

There are plenty of resources to use, especially technical analysis and charts to invest in penny stocks. I am not necessarily an advocate for this style of investing, as I prefer the fundamental it is nonetheless proven very beneficial for those who have mastered this difficult art.

Simple fundamentals though can go a long way for a beginning penny stock investor. Using simple tools such as income, expenses, debt/equity, price/earnings, etc. will produce a lot of useful information. The main problem is that this information is often not available for the penny stocks trading under $1 a share. Even when it is pink sheet penny stocks are not watched as rigorously by the SEC and their accounting practices are often questionable.

Remember though, this all assumes we are owning the company and that this is a long term investment. Investing in penny stocks can be a minute to minute affair. You can definitely buy the stock of a company that is losing money, failing, unpopular, etc. and still make money. What do you look for? Trends. Penny stocks like any other stocks can go up on days when the company reports poorly and down on days of positive news. There are many other elements at play in the powerful financial markets.