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Penny Stock Investing for Dummies – 4 Tips for How to Buy & Research Penny Stocks

By Kurtis Hemmerling

penny stockFew investment phrases can create as much excitement as these two words: penny stocks.

But what’s the fuss over cheap share prices? Do hot penny stock picks actually live up to their money-making hype?

What’s a Penny Stock?

The problem with penny stocks is that their definition is ambiguous. The U.S. Securities and Exchange Commission (SEC) defines them as low-priced speculative securities of very small companies. In this article, we’ll further restrict penny stocks to shares trading under one dollar.

So why do traders go wild over penny stocks? What is the appeal of these low priced shares?

There is an undeniable adrenaline rush from trading stocks that can easily jump 100% inside a week. New traders are often lured by the prospect of quick gains and not needing to keep capital invested for years at a time.

But not all penny stock traders are playing the little jumps. Some long-term, “buy and hold” passive investors buy penny stocks with the aspiration that these tiny companies will grow into giants over many years.

I have witnessed some of these stocks jump from pennies to just under $20. However, I have also seen them go bankrupt or fall to half their value in the blink of an eye.

What tips might help a penny stock trader stay out of harm’s way and increase his chances of being profitable?

4 Penny Stock Trading Tips

1. Use a Fundamental Stock Screener

Where do you find a list of penny stocks and cheap stocks to trade? Some investors will gravitate to message boards and forums, or just wander aimlessly from stock to stock without having a clear idea as to which company is a suitable pick. You can avoid this fate and find some of the best penny stock picks by using an automated screening device.

Bing Finance is one fundamental stock screener that filters through companies not listed on major exchanges. Over The Counter (OTC) Markets is another screener that currently has 9,981 securities listed, many of which are penny stocks.  This number gives you an idea of how many companies you might miss if you focused only on the major North American stock exchanges.

Using a stock screener will help you filter stocks based on the following:

  1. Book or intrinsic value
  2. Growth, earnings, or revenue
  3. Dividends
  4. Cash flows

Just keep in mind that some OTCBB exchanges have few requirements for companies to report income statements and other financial filings. Stocks with spotty reporting may not show up on your radar, but that could be a risk worth taking.

2. Make Use of Support and Resistance Levels on Charts

Many people cringe when technical analysis is brought up. They may feel that it is convoluted, complex, and subjective. This can be true of some technical analysis. If you are new to chart trading, stick to simple analysis techniques such as support and resistance levels.

  • Support Levels - When the shares fall down to a price and then bounce back up, it is called a support level. The more often this happens at a specific price level, the stronger the psychological support becomes.
  • Resistance Levels – When prices go up only so far before falling back down, the peak price becomes a roof that creates fear. This is known as resistance.

A simple technique is to look at a 6 month price chart using daily data. Draw a horizontal line underneath and above prices that the penny stock bounced off of. Consider buying on support and selling before resistance.

3. Look at Liquidity

Some penny stocks will only trade a few hundred shares a day while others will trade hundreds of thousands or more. To get an idea of how liquid a company is, multiply the amount of shares by the price to see how much money flows through the company each day. Penny stocks on major exchanges will generally have higher liquidity than Pink Sheets or other Over The Counter Bulletin Board trading.

Highly illiquid stocks with only hundreds or a few thousand dollars traded per day can experience extreme volatility. It is difficult to invest a few thousand dollars in such small companies without driving the prices up. Also, when it comes time to sell, prices may plummet since there are few immediate buyers.

Ensure your stock has enough liquidity for a fair, average price. Consider using limit orders, which set an overhead ceiling on maximum share price. Limit orders on illiquid stocks may take many days to fill, but the savings are worth it.

4. Don’t Look for Penny Stocks that are Jumping on High Volume

Is more liquidity always better? When a stock goes up 50% on high volume, is this a great buy? Probably not. Here’s why:

A study by Charles M. C. Lee and Bhaskaran Swaminathan titled, Price Momentum and Trading Volume highlights the link between winning stocks and volume. Consider some of their findings:

  1. Stocks with decreasing volume are more likely to rebound in price
  2. Stocks with a massive surge of volume are more likely to correct in price

The worst performing stocks were ones that jumped in price on very high volume. This seems highly counter-intuitive, but you should reach your own conclusion only after reading the paper. Based on their study, some simple techniques can be employed:

  1. Buy stocks that previously went high in price on high volume, but are now trading at decreased volume levels
  2. Buy stocks trading down in price toward support levels on decreasing volume which indicate selling is drying up

Final Word

While there are many methods and strategies to trade these low priced shares, the best tip is to do your own due diligence with each and every penny stock. Thus, you can be more sure that you are not simply the target of a “pump and dump” scheme. Companies with small market capitalization and few governing regulations are the playground of manipulative traders. If you are careful and do your homework,  you will maybe, just maybe, find a hot penny stock to invest in.

Do you invest in penny stocks? What are some of your best success stories and tips that you can share?

(photo credit: Shutterstock)

Kurtis Hemmerling
Kurtis Hemmerling is a personal finance enthusiast that has been putting his passion into writing since 1998. His goal is to demystify the investment world to benefit the readership of Money Crashers.

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  • http://www.yesiamcheap.com Sandy @ yesiamcheap

    Any thoughts about the whole 50 cent penny stock pump thing? I wouldn’t buy stock under $1 because it’s too risky, but if you’re talking about the $5 range, I would take that risk. In fact I’m following something at $7 now. I’ve seen it go out to almost $8.50 but I need enough money to make a difference.

  • Kurtis Hemmerling

    To avoid the pump and dump operation, pick stocks that have analyst coverage, high liquidity, and on a major exchange. Stock under $5 can have a large cap too. Look at Citigroup with 142 billion market cap, Lloyds Banking Group with over 75 billion, and Sprint with over 13 billion. This stocks have millions or even hundreds of millions of shares traded daily (C). Stay away from illiquid stocks with little coverage on small exchanges if you want to lessen risk of pump and dumps.

  • http://www.manhattancalumet.com/ Dennis The Menace

    I have many years of experience with these type of stocks.I would like to take a moment to talk about low price stocks not classic penny stocks or stocks under one dollar the term most people most often think of when the word penny stock is used. The single most important thing that investors must realize about low price stocks or stocks under five dollars is this’ their are companies of really decent quality trading under five dollars’ but for every one company trading under five dollars that is of decent quality their are maybe ten of poor quality. So the really big difference between those investors that are tremendously successfull when it comes to investing in low price stocks and those investors that lose enormous amounts of money investing in stocks under five dollars’ is having a great deal of knowledge and experience when it comes to low price stocks’ or having a total lack of knowledge and experience when it comes to low price stocks. Finding quality stocks under five dollars requires a lot more research than finding a decent stock above ten dollars.

  • http://www.manhattancalumet.com/ Penny Stock Investing

    .Did you know that the shares of apple computer traded below 5 dollars a share in 1998 surprise suprise suprise yes they traded at only 4.50 cents a share in 1998 now apple computers shares trade at over 500 dollars a share hows that for a stock rallly. Now you might say oh well thats just a fluke Right. Wrong. Did you know that the shares of Laboratory Corporation of America also traded below five dollars in 1998. The stock traded at just 3.00 dollars a share in 1998 today the shares of Laboratory Corporation of America are trading at 90.00 a share. Did you know that Petsmart shares traded at just 2.00 dollars a share in the year 2000. Today their trading at 58.00 a share. The shares of Tractor Supply Traded at Are you ready 1.30 in october of 2000 Yes thats one dollar and thirty cents a share in october of 2000. Today the the shares of tractor supply are trading at are you sitting down 87 dollars a share.

    These stocks are just a few examples theirs dozens of other stocks that once traded under five dollars a share that have seen enormous increases in the price of their shares but theiirs not enough time or space to list them all here. Now who still believes that all stocks trading below five dollars are bad investments.

  • moylanjames81

    Their is often little info available concerning small unknow companies trading on the pink sheets or on the over the counter. Recent up to date info is really important when selecting stocks trading below five dollars…

  • Bruce Willis

    This is a great topic you have covered here. I can use the tips to help myself in the future investment opportunities. Keep writing. Cheers!

  • http://onlineroboticstocktrader.com/ allenrodger

    When playing the centime just double your money is great. That is real easy to do when buying line s at less then a penny . If you think about it, doubling your money on a stock Charles Frederick Worth $0.001 is a plenty easier then doubling your money on a stock worth $0.1

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