Penny Stocks Trading & Investing Pros And Cons
The benefits of trading in penny stocks
It is well known and accepted that penny stocks carry high risk. However, they are still attractive to some speculators because their low price enables people with limited finances to participate in the stock market trading.
Secondly, profits on a winning position in top penny stocks are often far more significant as a percentage of the original investment than when trading high priced stocks.
The theory is that it is easier to go from a low price to a higher price with a common priced stock than with a stock that starts at a high price. For example, it’s easier to go from 10 cents to ten times that amount at $1 than from $10 to ten times that amount at $100 — which is a big attraction, even if it is riskier!
Many of the best penny stocks are not listed on the major exchanges but trade Over-the-Counter and are listed on the “Pink Sheets”. That doesn’t make them good or bad. They are just less regulated because they do not come under the jurisdiction of the Securities and Exchange Commission.
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Not limited to pennies
In the stock market, it is understood that the penny stocks category is not limited to stocks selling for pennies (cents) or up to a dollar. They also include higher-priced stocks that sell for a few dollars, perhaps up to $5, typical of many micro-cap companies and start-ups or beaten down issues, some even of previous great fame.
So what are the risks?
1. Thinly traded
Many of the stocks in the penny category are described as volatile and “thinly traded”, meaning they trade in low volume and with only a relatively small number of buyers and sellers. In that case, it leads to wider spreads in the bid and asks prices. This is especially important when a shareholder wishes to exit their position quickly and must accept a lower price because there are so few interested buyers.
The number of shares traded daily that can be categorized as low or high volume is a matter of opinion. A few tens of thousands are low volume, and some stocks don’t even show any trading on some days.
As a trader who wants to move quickly in or out of a stock position, several hundred thousand shares trading daily are needed for safety. That should be the minimum required to warrant taking a position in the stock of any company. To maintain a listing on the NYSE (New York Stock Exchange), companies must trade a minimum of 100,000 shares on average daily. Stocks on the NYSE typically trade in millions every day.
Another factor with very low priced stocks is that they are more easily manipulated and can become a target for Pump-and-Dump schemes. Such schemes are where the hot penny stock is heavily hyped and promoted to create buying volume even when there is no merit to the claims and promises being touted.
When the cheap penny stocks price goes up due to the increased volume that the false hype has created, the scheme’s perpetrators, having made the increased demand for the stock, sell their stock at a profit and leave the scene so that the stock price will collapse. Such schemes are very unethical and illegal, but they happen every day.
Precautions to take when starting out with penny stocks
· Until gaining experience and becoming adept at trading, avoid the OTC stocks and limit trading to those listed on the NYSE, the American Stock Exchange, and the NASDAQ.
· Decide on a minimum daily minimum trading volume, for instance, 250,000 average for the prior three months. That information is available when looking up the activity on financial websites such as Finance Yahoo.
· Learn to read stock charts at a superficial level, buy up-trending stocks and preferably stocks that have broken out from prior resistance levels and stocks that are reaching higher highs.
Know when to exit a stock position
· Whether winning or losing, it is vital to follow guidelines on when to sell. Establish a percentage loss that can be tolerated when losing, say 10% or 15% or whatever and be firm and execute a sell order when the loss reaches that mark.
· Remember that the stock has to be sold to capture the profit when showing a profit. Countless times traders watch a profit evaporate because they refuse to take a smaller gain and try to capture the ultimate high. Set a target, whether it be at 25% or 50%. Only selling all or part of a stock position allows for gaining a more significant amount of working capital.