Some traders liken penny stock trading to gambling due to the fact that the vast majority of these stocks don’t pay out. A penny stock is defined as any stock that trades for less than $5 per share, although the old definition of the word referred to a stock that traded for less than $1 per share, which meant that you could garner a 1000% ROI (or better) if the right company took off.
Due to the unpredictability of penny stocks, conventional wisdom suggests that you should create as diverse a portfolio as possible in this realm. If you have $1,000 to invest, and you place $100 in 10 different stocks, all it takes is for one of them to take off for you to make a profit.
In other words, your wins can easily make up for your losses, even with a 10% success rate in your bets. You could also think of a diversified penny stock portfolio as buying affordable insurance for your net worth due to the fact that penny stocks don’t cost much per share, allowing you to diversify more effectively with a smaller investment.
Less Fees, Lower Minimum
Many penny stocks are over the counter (OTC), which means that trading for these with your broker will require lower minimums and lower brokerage fees compared to costlier stocks. Another advantage to diversifying your penny stock portfolio is knowing sooner rather than later whether or not your investment will work out.
Movement happens quickly with penny stocks, which tend to fluctuate quickly. This means that you can make the decision to ride it out or get out faster than with other stocks. It’s relatively common for a penny stock’s share to double overnight, while in some cases, a micro-cap stock can soar to become a mid-cap stock before you know it.
In these cases, your return can surpass the 1000% mark, which means that you’ve already made a profit even if your other nine penny stock investments take a hit. As a result, you will have more capital that you can use to trade more aggressively moving forward.
Penny Stocks Terminology
Here are some terms in the penny stock trading world you should be familiar with:
- Ask: This refers to the price at which investors are willing to sell their shares to buyers.
- Averaging Down: When a stock has been declining but you still believe it has spike potential, you may buy new shares of that stock at a lower price because its price has been averaging down.
- Hedging: This term is pretty straightforward–it refers to the concept of hedging your bets with penny stocks by buying two stocks that may oppose each other, such as an airline stock and an oil stock with the hopes that one will take off.
- Market Capitalization: Also known as market cap, this term calculates a company’s financial value by multiplying the number of shares the company has by the price of its share. Naturally, a price spike has the potential of doubling or tripling a company’s value, while a decline will take a toll on its value.
- NASDAQ SmallCap: While most of the stocks you’ll be trading for will be OTC, there is a segment of the NASDAQ exchange that includes penny stocks valued between $1 to $5 per share.
- Risk Tolerance: This term refers to how much money you are willing to lose with your investments due to the unpredictability of penny stocks. If you’re willing to lose your investment but you’re aiming for large returns, you have high risk tolerance.
Two Contrasting Penny Stocks
Context is everything when trading for penny stocks. In the case of Walter Energy Co., the stock price reached a high of $143.76 per share in 2011 before falling to $0.16 per share and eventually going bankrupt. This occurred due to the fact that the company was in the metallurgical coal industry, which was on the decline.
On the opposite end of the spectrum, there was Inovio Inc., which traded for under $1 per share in 2008, topping $10 per share in 2009, as well as 2013 through 2016. This success can be attributed to the biotechnology company’s innovative cancer vaccine portfolio, which showed great promise at the time.
Understanding a company’s industry, how that industry is doing and the company’s role within that industry will give you an idea of whether or not the stock is a viable investment vehicle.
It’s worth considering that there are plenty of penny stocks out there that will take your money 99% of the time. There are shifty traders who take part in pump and dump schemes where they artificially inflate the price of a penny stock through misleading positive statements in order to push beginner investors into buying into that stock.
These shifty traders buy into that stock early, inflate the price and then sell their shares of the stock at their peak, causing the stock price to plummet. You can keep an eye out for these by verifying the reputation of an investor who is pushing you to buy a certain stock, as well as whether or not they are being sponsored by that company to push that stock.
A good way to determine whether or not you should invest in a penny stock is by examining what a stock looks like over time. This allows you to identify patterns that you can take advantage of by anticipating when a stock will increase or decrease, prompting you to buy or sell respectively.
In a Nutshell
Diversifying your portfolio and hedging your bets is always a smart move in the world of penny stock trading. Taking this route will not guarantee a profit, but it will increase the chances of one stock taking off and netting you a positive ROI.
And even if all your stocks turn out to be a bust, you will have garnered some experience in the penny stock trading world, which could inform your future decision-making by learning what went wrong with each stock.