Many investors see an opportunity to make significant profits by investing in penny stocks. However, investment in penny stocks also have the potential to lead to heavy losses. Profiting from penny stocks is not as simple as it may appear. You need to limit the risk associated with investing in penny stocks.
The fact is that few penny stocks eventually turn into high-growth successful companies. Most such stocks flounder after the promise of initial success or investor interest wears off, and often disappear from the board altogether.
Know the History
Penny stocks are what they are for a reason. It could be a company that’s on the verge of bankruptcy, or one which will or has gone through a Chapter 11 process. Surviving a bankruptcy does not necessarily indicate a significant change in its future growth path.
Or, it could be a company which has reverse listed itself by acquiring a listed shell company. In such cases, where the normal IPO process is not followed, the company may not have the support of major investors in the market, resulting in a sluggish share price dependent on the company actually achieving its promised growth.
More often than not, the stock of a company is cheap because the market does not perceive the company to have attractive growth prospects. You will need to convince yourself of the company’s prospects, and know that you are betting against the market consensus.
Consistent Trading Volumes
Liquidity in the stock is important for any equity investment. In other words, it must be actively traded and there must be a sufficient free float, or stocks available to the public to trade. There should be sufficient trading for you to easily implement your entry and exit.
You should not rely on the daily average trading figure alone, since that may be skewed by a single large trade. You need to look at the actual volume and number of daily trades over a period of time, to ensure that there is adequate and consistent liquidity on a daily basis. Otherwise, you could be forced to dump your shares at the price some bargain hunter is prepared to pay.
You need to look at the nature and trend of the buying or selling in the stocks. Is it insiders buying or selling, or are investors perhaps dumping their shares? This will give you an indication of the possible future price trend and whether it is safe for you to enter the market.
The Company’s Prospects
Your investment in penny stocks should be based on sound research both of the market and the company’s prospects. Pay specific attention to recent announcements, which may indicate a change in profit or sales expectations. Penny stocks are often associated with companies which have been making losses. You then need to determine whether there has been a change in strategy or circumstance which will return the company to profitability.
There are many factors which may affect the future growth of a company. For example, the company may have acquired additional finance, or entered into a partnership with another business in the industry, or perhaps found a new market for its products. To ascertain whether the company’s newly found growth prospects stack up, you will need to take a view on the potential impact of the change.
Having an Entry and Exit Plan
Having an entry and exit point, and placing stops, to limit your losses and maximize your profit potential, is generally the preferred way of trading in stocks. However, penny stocks often display volatile and unpredictable price movements. Placing your stops too close will inevitably result in you being taken out, before you get the opportunity to make any money from your investment.
Due to the low price you pay for penny stocks, a movement of just a few cents translates into a significant percentage move. Hence, many investors treat their penny stock positions as call options on the future prospects of the company. In other words, your maximum loss is the investment in the stock, with unlimited potential on the upside. This implies that you should be prepared to write off the amount you invested, if it does not turn out as expected.
Many people seem to put all their research efforts into knowing what penny stocks to buy and when to buy them, and don’t know when they should sell. Some sell too early, as soon as the position shows some profit. Others become emotionally attached to their investment, and hold on for too long, unwilling to admit that their initial assessments were wrong. You need to detach yourself emotionally from the trade, and have a per-determined exit plan based on news flow and results announcements.
Evaluating the Information Source
Most people find penny stocks to invest in through investment newsletters. Whilst there are a number of excellent penny stocks newsletters, there are also those which are simply “pump and dump” operators. They will load up on the stock in advance, and then sell them at a profit to unsuspecting newsletter subscribers.
You would therefore be wise to subscribe to a newsletter and track its investment recommendations over a period of time, before you implement any of its suggested punts. Do your due diligence by checking the reviews and recommendations of newsletters online.
Limiting Your Investment in Penny Stocks
Whilst the rules for investing in penny stocks are not much different from trading in large cap stocks, the risks are larger. Of course, if you’re prepared to do your homework, they can prove to be very remunerative.
Nevertheless, given the uncertainty and volatility associated with penny stocks, you should limit your investment in such stocks to a relatively small percentage, of say less than 20%, of your overall equity portfolio. If you put too much of your capital at risk, you increase the odds of losing more than you can afford.