How to Pick and Trade Penny Stocks

Penny stocks are loosely categorized companies with share prices of below $5 and with market caps of under $200 million. They are sometimes referred to as “the slot machines of the equity market” because of the risks involved. There may be a good place for penny stocks in the portfolio of an experienced, advanced investor, however, if you follow these steps.

1. Invest within your Means. Penny stocks are as risky as larger stocks if not traded wisely. Set aside sufficient savings to last three months in case the investment goes wrong.

2. Understand why penny stocks are considered a dangerous investment. Penny stocks are among the most volatile and most manipulated form of investment in the stock market. The companies usually have no track record of solid financial performance. In addition, the stocks are often manipulated by scam artists.

3. Get at least one year’s experience with mid- and large-cap stocks first. You should become adept at reading a balance sheet, income statement, and cash flow statement during this time.

4. Learn more about the specific aspects of penny stocks that make them both potentially lucrative and dangerous to your portfolio. Understand the mechanics behind money flow, market capitalization, and share structure. Also understand the purpose of a public company and the commonality of scams, dilution, and loss of investment value associated with penny stocks.

5. Know which stocks to reject off the bat:

  • stocks that aren’t traded on one of the major U.S. exchanges (aka bulletin board or over-the-counter [OTC] stocks)
  • companies that have less than $10 million in revenue annually
  • any company recommended in e-mails about penny stock trading (promoters are often paid to create hype so that the shares will sell)
  • companies in industries that you don’t like or understand well (based on your experience)

6. Look for “Red Flags” – Common attributes of companies running a scam or operating for the sole purpose of raising money via stock dilution.

7. Look for companies that have consistently generated cash and are growing their free cash flow over time. Avoid companies with a heavy debt load.

8. Instead of share prices, compare price per share against book value per share (assets minus liabilities).

9. Buy companies at a very low multiple on their cash flow (ideally under six times).

10. Limit any tiny stock to no more than 5% of your portfolio.

11. Trading is not a hobby, its a business. That means understanding and managing your profit and loss. Once this thought pattern is established, it makes the whole process so much easier. Simply ask, “Will this investment / trade / software / subscription make or lose me money?” Once an answer has been established, a clear course of action will present itself.

12. Get some great investment management software. These days, a speedy internet connection and good money management and investment software costs virtually nothing. Why spend the time and effort trying to figure out the best ways to do things when solutions already exist. Ideally, look to purchase two types of software. One will be for personal money management. This can be used for profit and loss and keeping track of the costs of subscriptions, stockbrokers and the like. The other will be used for tracking stock and fund prices, storing company news, technical and fundamental analysis and more.

13. Get an education. Warren Buffett has suggested in the past that every investor should be able to understand basic accountancy principles, an annual report and stock market history. You probably do not need to become an accountant, but being able to understand the scoring system of the game can only help.

14. Learn about money management. Every investor will have the occasional (at best) loser and it is vital that no individual trade can wipe out a portfolio. Understanding asset allocation is vital.

15. Read widely. Getting a wide-ranging education in personal finance, corporate finance, taxation, economics and investment theories will help. However, finding areas of the world or business in which you can become relatively expert can help in the process of finding good trades.

16. Find a good penny stock service to subscribe to. Many of the suggestions above can now be covered by joining a trade advisory service. These services now aim to pick stocks, offer trading and portfolio management software and educational services too. If things go well, then by investing in the stock market picks, the service can be paid for with profits. Though these services are often not ‘cheap’ they are generally very valuable and can help to make an investor or trader profitable whilst learning the ropes. This is a great way to learn or experience the stock market for beginners.

17. Know when to Quit. Setting a time to sell your stocks is important because it can change the course of your investments. Capping at 50% profits is already a good margin. Getting greedy and expecting further profits can make stocks wipe out the investments.

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This entry was posted on Monday, October 24th, 2011 at 7:26 pm and is filed under Finance. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.