A Primer on Penny Stocks

If you have been considering whether or not to buy penny stocks, it would be advisable to do a reasonable amount of research before "jumping in with both feet", so to speak. The world of penny stocks has often been glamorized by various investment advisory services as well as so-called "stock gurus", but in reality you have to approach investing in penny stocks with a sober-minded attitude as well as a degree of caution and level-headedness. While it is true that extravagant profits can be made in the penny stock arena, it's also true that there are more losers than winners, mainly because many people jump into the markets prematurely, blinded by the allure of quick wealth with a relatively small up-front investment. It would behoove any would-be penny stock investor to do his or her homework before committing their hard-earned money. That being said, hopefully this article will give you a better overall understanding of the penny stock arena and why they are a viable investment if used in the right manner.

What is a Penny Stock?

The most widely accepted definition of a penny stock is any publicly-traded company whose stock trades at $5.00 per share or less. Some have argued that the share price should be $1.00 or less to be considered a true penny stock, but for the purposes of keeping things simple, we will keep the $5.00-or-under definition. Most publicly-traded penny stocks are traded on the Over the Counter Bulletin Board Exchange (also known as OTC-BB), or on the "Pink Sheets" (somewhat of the "Wild West" of the stock market). These companies are usually valued as having less than $4 million in net tangible assets, and are normally companies that don't have any type of extensive history. This would by default include many start-up companies and "one-man shows". Penny stocks are also known as "micro-cap stocks" due to their relatively miniscule share value.

The Potential of Penny Stocks: The Power of Leverage

The power of a penny stock is the fact that the shares are normally priced so low that there is an incredible amount of leverage available to the investor that isn't often seen in the "blue chip" stocks, such as Google, IBM, or FedEx. Think about it: The average "blue chip" company can trade in the neighborhood of hundreds of dollars per share, which means that the stock would have to make tremendous advances in order to double. Conversely, a penny stock that's trading at literally pennies per share can double rather quickly, thereby doubling whatever initial investment you put into the purchase of those shares. As an example, it would be much easier for a stock trading at 10 cents per share to double to 20 cents per share (a 100% return), while a "blue chip" stock trading at $300.00 per share would have to do some serious "financial gymnastics" to double to $600.00 per share. Again, the return would be the same (100%), but the likelihood of the penny stock doubling is much higher than the "blue chip" ever doubling due to the hefty price per share of the "blue chip".

Leverage is a Two-Edged Sword

Although there are some fantastic opportunities that exist in the penny stock arena due to the power of leverage, the potential for loss is also greater. A slight fluctuation in the price of a "blue chip" stock may only mean a 1% or 2% drop in your investment, while that same proportionate fluctuation in a penny stock is much more violent, generating potential losses of 50% or more. This volatility factor is the primary reason that penny stocks have often been labeled as "risky".

Invest Wisely

The most reasonable way to approach a potential investment in a penny stock is to go into the trade knowing that you could possibly lose your entire investment. If you can live with yourself in light of that knowledge, then you may be ready to handle the ups and downs of the volatile world of penny stocks. If you're not ready to completely part with your funds, and any loss of your initial capital would cause a major financial crisis, it would be advisable for you to stay out of the markets. The old adage is true, "Never risk more than you're willing to lose". This holds true especially in the arena of penny stock trading. You must be willing to approach the markets with a sense of balance and patience so that you can execute a trading plan based on sound principles, and not on hype.