Penny Stocks — A Guide To Investing On The Cheap

In this article, you will learn the basics of penny stock investing.

Updated: May 18, 2024
Matt Crabtree

Written By

Matt Crabtree

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Penny stocks are an investment type that, if done correctly, can lead to a truly remarkable return. They are inexpensive yet extremely capable of earning high gains, making them appealing to all types of investors.

In this article, you will learn the basics of penny stock investing and how to maximise your profit potential by making wise and informed decisions. By mastering the art of penny stock investing, you can become a successful investor and confidently navigate the stock market.

What Are Penny Stocks?

Penny stocks are a type of stock traded in the stock market that comes with a lower price tag than more traditional stocks, often offering investors the opportunity to acquire a large number of shares for a relatively small sum of money. However, Penny stocks are highly speculative and can be extremely risky for investors to buy and sell.

Penny stocks, or securities that trade for less than $1/£0.83 per share, can generate high returns for investors with an eye for risk and are willing to time the purchase and sale of these stocks correctly. While penny stocks come with a great deal of risk, they can also provide investors with a relatively inexpensive way to get into the stock market and potentially obtain attractive profits.

The appeal of penny stocks lies in the fact that they are typically priced at a lower level than traditional stocks. This allows penny stock investors to purchase a large number of shares without having to invest a significant amount of capital. Furthermore, penny stocks carry the potential for substantial returns. As the price of the stock increases, investors can gain a significant percentage of their investment back in profits.

Like any other form of investing, penny stocks come with their own set of risks. These are typically higher than traditional stocks due to the smaller size of the organisation behind the stock and their lack of liquidity. As such, penny stocks tend to be more volatile, so investors need to be aware of the market environment before buying penny stocks.

Another risk associated with many penny stocks is that they are often issued by smaller companies and start-ups. These companies are often highly speculative and have a greater chance of failure than larger ones, so investors should thoroughly research their options before investing.

In addition, penny stock trading typically requires more research than other investments because of the limited amount of information available about these stocks.

Finally, due to the low price of penny stocks, investors should be aware that there is a greater chance of fraud and manipulation. These stocks often get manipulated by “pump and dump” schemes, where stock promoters encourage investors to purchase stocks and then dump them as soon as their prices increase.

This type of activity is illegal and can be avoided by thoroughly researching any stock before investing in it.

Penny stocks offer potential investors the chance to purchase many shares of stock for a relatively small amount of money. While the potential returns of these stocks can be lucrative, they also come with a greater degree of risk, so investors need to understand the risks involved and research any stock they are considering investing in.

With the right approach, penny stocks can provide investors with solid returns and an excellent opportunity to get involved in the stock market.

Examples

In order to gain success with penny stocks, it is essential to do your research and be aware of the risks involved.

With that said, here are some examples of successful penny stocks that have gained significant value over the past few years:

DNR

One example of a profitable penny stock is renewable energy company Denbury (DEN). In 2020 it traded at around $0.25 per share on the New York Stock Exchange, but by 2022 it reached over $104 per share. This is a great example of how a penny stock can appreciate in value.

TSLA

Finally, electric car manufacturer Tesla (TSLA) is an example of a penny stock that has seen tremendous growth in recent years. In 2012, it traded around $2 per share, but in 2021 it reached $400 per share. This shows how an investment in penny stocks can potentially pay off handsomely if done smartly.

Although penny stocks can be very volatile and risky investments, they can also reward investors with incredible returns if done right. Investors must do their due diligence and understand the risks involved with penny stocks, but with the proper research, investment strategies and understanding of the market conditions, they can be lucrative investments.

What Are the Risks of Investing in Penny Stocks?

Volatility

Penny stocks have become a popular investment vehicle for traders seeking to profit from speculative investments. On the surface, penny stocks offer traders the potential for high returns on investments while minimising the risk of a large loss.

However, investing in penny stocks can be a risky endeavour, as the high levels of volatility in this asset class can drastically increase the risk of a trader suffering a significant loss.

For traders who are unfamiliar with the stock market, volatility can be an especially risky factor when trading penny stocks. Volatility is a measure of the amount of price movement of a stock over a certain period of time.

The higher the volatility, the greater the potential for a stock to quickly and drastically move in either direction over a condensed time period. This added price movement increases the risk that a trader may lose money if they buy at the wrong time.

For example, let’s say a trader buys a penny stock when it is trading at £0.50 per share. If the stock suddenly spikes in price to £1.00, the trader stands to make a 100% return on their investment. However, if the stock suddenly drops in price to £0.25 per share, the trader has lost 50% of their investment.

This is the risk that traders face when trading penny stocks, as there is no way of predicting when a stock’s price will suddenly and significantly change.

Another reason penny stocks are volatile is that they are traded on smaller exchanges like the Over-the-Counter Bulletin Board (OTCBB) and the Pink Sheets. These exchanges often lack the trading volume and liquidity that are found on major exchanges, meaning that prices can move quickly and there may be fewer buyers and sellers of the stock.

Lastly, the stock price of penny stocks are often driven by rumour and speculation rather than actual performance. This means that the stock price can be illogical and the stock can quickly become overvalued. As a result, penny stocks can be subject to wide price swings and sudden drops in value.

Low Liquidity

Liquidity is a measure of how easily assets can be converted into cash, and is an important factor for traders to consider when investing. When looking at penny stocks, it becomes clear that these assets have extremely low liquidity.

This low liquidity means that it's difficult for an investor to find someone to buy or sell their stock, and even if there is a buyer or seller, the price can fluctuate drastically over a short period of time.

The low liquidity of penny stocks can also lead to wide spreads, or the difference between the bid and ask prices. These wider spreads, combined with the low liquidity, can cause large fluctuations in price, meaning that investors can be quickly burned by their investments if they make a wrong move.

This lack of price consistency also makes it difficult to gauge how successful an investment will be in the long run.

Low Information Availability

Penny stocks are typically seen as a quick way to make money in the stock market, but their lack of transparency and limited information can be existential for traders and the Securities and Exchange Commission (SEC).

This is because the highly volatile nature of these stocks makes them susceptible to manipulation by unscrupulous individuals and entities, leading to the creation of the penny stock reform act in 1990.

When trading in penny stocks, the absence of accurate or plentiful information can lead to poor decisions regarding investments. As penny stocks are usually low-traded, they often don’t meet the listing requirements of the major exchanges, which means they may not be subject to the same regulations and oversight as more established stocks on the exchanges.

This lack of oversight can lead to market manipulation and fraudulent activities, potentially causing huge losses for investors.

The SEC has sought to address these issues and has introduced greater transparency in the penny stock markets by requiring all stock trades to be reported and made available for public viewing. This is an important step in preventing market manipulation, but it does not entirely protect traders from the existential risk posed by lack of transparency and limited information.

In addition, the SEC has put in place comprehensive regulations to reduce the risk of manipulation and fraudulent activities. These include rules to require brokers to give customers more detailed information when recommending penny stocks, as well as restrictions on short-selling and market maker activities.

Despite these efforts, faceless penny stock companies can still be very harmful to traders.

Many potential investors, especially inexperienced traders, may not be aware of the risks associated with trading in these stocks and may be easily fooled by false information or suspicious sales tactics.

How to Analyse Penny Stocks

Consider Market Sentiment

To start, it is important to understand what market sentiment is. Market sentiment is the feeling or attitude of investors towards a particular security or market. It is derived from the collective opinion of investors and traders, which is why it is essential information for any investor.

When it comes to investing in penny stock companies, the market sentiment can be especially important because penny stocks trade in lower volume and the market is often illiquid. This means that the price of the stock often experiences more volatility due to the demand and supply dynamics in the market.

Furthermore, information about penny stocks tend to be scarce and unreliable, making it difficult to get a true understanding of their value and outlook.

Therefore, it is important to pay attention to the market sentiment associated with penny stocks before investing. You can gauge the sentiment by studying the trading volume, price movements, social media, and other market news. Of course, if the sentiment is poor, you should avoid investing in that penny stock company and instead look for a different company.

It is also important to remember that sentiment can change quickly. Therefore, it is important to actively monitor the sentiment before investing. Doing so can help you make more informed decisions and possibly avoid costly mistakes.

Use Technical Analysis

One of the best tools to have in the trader’s arsenal is technical analysis. Technical analysis is the practice of using past price action and trading signals to forecast where price is likely to move next. It is a vital component of successful trading, as it allows traders to make more informed decisions and increase the chances of making a successful trade.

Technical analysis is compelling because it does not rely on fundamental analysis; traders can make their decisions based solely on price. This is particularly beneficial in penny stock trading, as the nature of the asset class means that fundamental data can often be limited and unreliable.

By using technical analysis techniques, traders can focus on analysing price action to identify potential trading opportunities.

Technical analysis can also provide traders with valuable information about the strength and direction of a stock’s trend. By keeping an eye on the trend, traders can make more informed decisions about when to enter and exit a trade.

For example, if a stock is in a strong uptrend, the trader can look to buy on the dips and profit from the large moves higher. Conversely, if a stock is in a downtrend, the trader can look to sell on strength and take advantage of the large moves lower.

Finally, technical analysis can be used to identify important support and resistance levels. By understanding these levels, traders can better manage their risk. Support and resistance levels can act as price ceilings/floors, and by knowing where these levels are, traders can use them as stop losses and take profits.

This gives the trader better control over the trades, ensuring that losses are kept to a minimum and profits can be taken when price has reached its maximum potential.

Tips for Investing in Penny Stocks

Set Clear Investment Goals

Before you invest in penny stocks, it’s important to set clear investment goals. Consider your risk tolerance, your financial goals and the time frame you’re willing to commit to the investment. Knowing your boundaries upfront can help you make better decisions during the investing process.

Identify Undervalued Stocks

When it comes to penny stocks, it's essential to learn how to identify undervalued stocks. This means finding stocks that are trading at a price lower than the company's actual value. This can be a great way to get in on a stock that has the potential to increase in value over time.

Know When to Sell

One of the most important tips for investing in penny stocks is to know when to sell. Set sell limits in advance and be sure to stick with them. This can help you protect your investment, instead of trying to hold onto a stock and hoping it will increase in value.

Avoid Pump and Dump Schemes

Finally, it’s important to avoid getting caught up in pump and dump schemes. These scams often involve stock promoters hyping up a certain penny stock in order to get people to buy it at a higher price and then selling it off once the stock’s price has increased. Be sure to research any penny stock you’re considering investing in and be wary of any stock promoters making outrageous claims.

Conclusion

Now you have an understanding of the potential rewards and risks associated with this type of investing! Armed with this knowledge, you can begin searching for appropriate penny stock trading opportunities.

You can buy penny stocks in a variety of places, including online brokerages, full-service brokers, online auctions and more. Remember to do your research and due diligence on any company before investing in their penny stocks. With a little bit of time and effort, these penny stocks could become a great addition to your investment portfolio. Good luck!

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