If you are already investing in stocks you may have noticed that the returns you are generating can sometimes be disappointing, especially when you are putting your money into blue-chip stocks.
So maybe its time to take a look at penny stocks, the perennial bridesmaid of the stock market.
Working the penny stock market can revitalise your investment strategy and give your portfolio a much-needed boost.
What are penny stocks?
There isn’t a universally accepted definition of a ‘penny stock’ but in general these are shares in companies that come in under the $5.00 price point and mostly under $1.00.
Often they are traded on the OTC (Over The Counter) market and will be in new start companies, or businesses that have fallen out of favour with the traditional broker or analyst.
Also known as microcaps or small caps, penny stocks can still be traded on major exchanges like the NYSE which brings with it the protections of a highly regulated market.
What is the attraction?
A penny stock by definition is a low priced entry point into the market place.
This means that you can grab a lot of shares for a small amount of money making it feel more like a real trading strategy.
This type of stock is much more volatile than other shares and this means that a small change in the share price brings a big gain in terms of your portfolio.
As such, penny stocks are more dynamic and to a large extent more exciting than investing long-term in blue-chip stocks that may not move a whole lot.
For example, a $0.01c movement in the price of a stock listed at $1000.00 wouldn’t even register as a gain but on a stock priced at $0.05c means a 20% win!
You may also find shares in smaller, local businesses being traded as penny stocks and this is an attraction for people who want to invest in companies based in their local area that they know well.
Is there a downside?
Without a doubt, there are downsides to investing in penny shares and it is important to fully understand what you are taking on before trading with real money.
We mentioned the upside of price volatility in the last section as a positive but the same can be taken as a negative.
Shares in small companies that are traded infrequently have an inbuilt volatility that can mean you can make a lot of money very quickly, but if you choose unwisely you can also wipe out your investment at a stroke.
If you are risk-averse then this volatility may not be for you.
The smaller the company is, the less liquidity in the market. This means that there are fewer buyers, so when you want to close your position you may not be able to sell your shares.
The same can’t be said for blue-chip stocks that will always find a buyer.
One of the charges levelled at penny stocks is that there are a large number of unscrupulous sellers in the marketplace.
This is true to a large extent and for the unwary, this can cause a major problem.
Shares that are traded OTC away from the main markets do suffer from manipulation and buying from pump and dump sellers is a sure way to lose money.
This is why it is generally better to buy stocks on the main markets where regulation is tighter.
How to make money with penny stocks
So with the significant downsides, you’d think that any smart investor would run a mile from penny stocks but actually, the opposite is true.
Just because the share price is low, doesn’t mean to say that the company is a bad bet, just that it has a low market capitalization and this can be for any number of reasons.
For the longer-term investor, a company can prove to be an extremely smart buy when it has sound fundamentals like a good earnings per share ratio and good liquidity.
For penny share day traders, the underlying fundamentals of a company don’t matter as much as what the market is currently doing.
Remember that day traders buy and sell usually within the same trading day, meaning that their only motivation is to spot price movements before they happen.
Making money from penny stocks can be extremely lucrative but the important point is that you must treat it as a serious endeavour, buying shares because they are cheap and you like the name of a company is not a strategy that is recommended.
Choose a sector to specialise in (nobody can cover everything) and do your research.
Look at the companies that are doing well and the ones that may have latent value.
Invest in a stock scanner to find listed stocks that fit with your investment strategy and above all consume as much information as you possibly can about your chosen market sector.
Education is the key here, understanding the market, trading and volatility all mean that you have a better chance of making money compared to the casual investor.
A good idea is to open an account with a broker that offers dummy trading accounts. In this way, you can test your theories and strategy with real shares in real-time but with no risk.
Dummy accounts are arguably the best defence against unwise trading strategies so you need to ensure you use them as much as possible.
You can win with penny stocks
Penny stocks aren’t for every investor but if you are prepared to work on your strategy, avoid the illiquid, overhyped stocks and trade using a method that you have tested in dummy accounts then you could see some significant gains.
For investors that are seeing increases of 2-8% in blue chips, the volatility of penny stocks can add a much-needed fillip to their returns and totally revitalise their portfolio.
As ever with these things, do your research and invest with your head, not your heart and you could be on to a real winner!