Investing in penny stocks gives traders the opportunity to dramatically increase their profits, however, it also provides the same opportunity to lose your trading capital quickly. These 5 tips will help you lower your risk of one of the riskiest investment vehicles.
1. Penny stocks are a penny for a reason.
While we all dream about investing in the next Microsoft or the next Home Depot, in reality, the chances of you finding that once-in-a-decade success story are slim. These companies started and bought shell companies because it was cheaper than an IPO, or they didn't have a business plan that was attractive enough to justify the investment banker's money for an IPO. This doesn't make them a bad investment, but it should make you realistic about the type of company you invest in.
2. Trading Volume
Look for consistently high volumes of traded stocks. Looking at the average volume can be misleading. If ABC traded 1 million shares today, and did not trade for the rest of the week, the daily average would appear to be 200,000 shares. To enter and exit with an acceptable rate of return, you need consistent volume. See also the number of trades per day. Is 1 person in selling or buying? Liquidity should be the first thing to look at. If there is no volume, you will end up holding “dead money”, where the only way to sell the stock is to discard the bid, which will put more selling pressure, resulting in a lower selling price.
3. Does the company know how to make a profit?
While it's not uncommon to see start-ups losing money, it's important to see why they're losing money. Can it be managed? Should they seek further financing (resulting in dilution of your stock) or should they seek joint partnerships that benefit other companies?
If your company knows how to make a profit, it can use the money to grow their business, which increases shareholder value. You will have to do some research to find these companies, but when you do, you lower your risk of losing your capital, and increase the chances of a much higher return.
4. Have an entry and exit plan – and stick to it.
Penny stocks are volatile. They will quickly move up, and move down quickly. Remember, if you buy a stock for $0.10 and sell it for $0.12, that represents a 20% return on your investment. A drop of 2 cents costs you 20%. Many stocks trade in this range every day. If your investment capital is $ 10,000, 20% loss is $ 2000 loss. Do this 5 times and you run out of money. Keep your stops close. If you quit, move on to the next opportunity. The market is telling you something, and whether you want to admit it or not, it's usually best to listen.
If your plan is to sell at $0.12 and jump to $0.13, take a 30% profit, or better yet, place a stop at $0.12. Lock in your profits without limiting the upside potential.
5. How did you find out about the stock?
Most people find out about penny stocks through mailing lists. There are many good penny stock newsletters, however, there are also plenty of pumps and throws. They, along with insiders, would load the stock, then start pumping the company into unsuspecting newsletter subscribers. These customers buy while insiders sell. Guess who won here.
Not all newsletters are bad. Having worked in this industry for the last 8 years, I have seen my share of unscrupulous companies and promoters. Some are paid in shares, sometimes in limited shares (a contract whereby shares cannot be sold for a predetermined period of time), others in cash.
How to distinguish a good company from a bad one? Just subscribe, and track the investment. Is there a legitimate opportunity to make money? Do they have a track record of providing great opportunities for customers? You will start to notice quickly whether you have subscribed to a good newsletter or not.
One other tip I will offer you is not to invest more than 20% of your entire portfolio in penny stocks. You invest to make money and maintain capital to fight again. If you put too much of your capital at risk, you increase the chances of losing your capital. If that 20% grows, you will have more than enough cash to generate a healthy rate of return.