Penny Stocks: should you play with them?

The world is full of stories of windfalls – fortunes made overnight and get-lucky guys who happened to be in the right place at the right time. And among them will be a number of investment gamblers who will swear by penny stocks. Truly, there are some people who have learnt to develop a quick eye and a fast hand, and have benefited sometimes quite handsomely from penny stock dabbling. What they might not mention is how much money they may have lost along the way.

What exactly are penny stocks?

  • Penny stocks are a high-risk alternative to traditional stock and bond trading.
  •  They are generally investments in small companies whose shares are somewhat liquid and very speculative.
  • Generally, they present high risk of loss but also opportunity for good returns if there is enough underlying business value to succeed.
  • Penny stock companies are often not confined to the expected regulatory standards and rarely trade above $5 a share. More often they will be trading under $1 per share.
  • Some penny stock companies are not even legitimate and will ultimately fail – however around 1% can surprise and grow in the long-run. Picking and running with that 1% is a tricky business. Even if you have an astute eye, your returns may be small. Doubling your money is rare – although there are always the ‘kings of penny stocks’ who claim to have grasped the formula and made themselves millionaires.

Could playing penny stocks be for you?

You may choose to supplement your investments with penny stocks, but they should never be your primary investment because of their high risk. Penny stocks invariably belong to companies that are in financial trouble. But if you’re thinking of investigating this option, you’ll need real insight and agility to meet the challenges.

  • Keep your trades small. Knowing when to buy and sell at the right time may protect you from losses. But that kind of expertise may take years of practice and experience and just think how much you may have to lose along the way.
  • Don’t dream of big wins in penny stocks. If you do, you could force trades at the wrong time – and make mistakes that will wipe you out before you’ve even begun.
  • Respect the risk. Understand it. Play with the caution of a mouse trying to steal from the cat’s bowl. Penny stocks can be very volatile. A stock that you think is on its way up can reverse in a matter of minutes. You need to be alert and quick.

Make sure you know what you’re getting into

Most penny stock companies don’t meet SEC filing requirements and those people who trade them can therefore manipulate stocks. This means you don’t always know what you’re dealing with. Everything you’re told or read could be legitimate or a pack of lies. Well, you can always sell, you might tell yourself – but the tricky part is finding a willing buyer for the price. The value of a stock depends firstly on what someone is willing to pay for it. And secondly on the value of the business behind it. Some pointers to keep in mind:

  • Make sure you don’t commit too much of your portfolio to a single play.
  •  Make sure that the position you take isn’t large enough to affect the stock’s price action.
  • Watch for good liquidity – a reasonable trading volume would be a few hundred thousand shares traded daily – that way you will be fairly sure you can get in and out as you need to.
  • Set up a journal to record moves and positions, profit and loss. That way you will grow your knowledge about trading and ultimately become more adept and successful at the process.
  • Keep reading what you need to know. The Securities and Exchange Commission (SEC) has released multiple warnings to investors about investing in penny stocks.
  • Always check a company’s level of disclosure – how much information they provide to investors. The OTC Bulletin Board has a Delinquency/Eligibility list showing companies that have and have not met its standards.
  • It’s difficult to properly judge the value of a business in financial trouble, therefore difficult to know whether you are paying a fair price or not. In addition you’re competing with a lot of people trying to outsmart each other.
  • At the very least, you should see whether the company has released any financial statements. Read as many financial reports as you can – these can give you good guidance as to where you might want to risk your money.
  • If the company is in deep financial trouble there may be little chance it will be able to pay off debts. In this situation it will possibly be broken up and assets sold off to creditors. And you will have lost your money.
  • Turning around a troubled company takes time – and you may have to wait a long time before you see any returns on your investment. Good returns on penny stocks are rare – and when they do happen, they’re often less than expected.
  •  ‘Hot penny stock tips’ are usually somebody trying to trick you into buying stocks that he or she can’t sell. Don’t fall for it. No ‘hot’ cheap stock will make fabulous returns in a matter of weeks.

Let the experts advise you

At Foster Wealth we know that the real value in investment is a matter of time and patience, careful analysis and buying good businesses. No decent broker will try to persuade you to get wealthy with cheap stocks. We work with successful investors everyday – and they aren’t trading penny stocks. But the investment field is wide open to your choice – and by all means experiment. Our advice will be as sound and informative as on any investment. The final decision is always yours.

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