Ask any financial advisor and likely ten times out of ten, they will guide your core holdings to dependable, well-established blue chips. While this investment category ranks highly for overall stability, they don’t have anywhere near the upside potential of penny stocks.
Often derided as casino plays, penny stocks carry a poor reputation. Certainly, investing in small businesses under $5 per share qualifies as a high-risk, high-reward venture. Nevertheless, lay observers usually have the wrong idea about this market segment.
For one thing, some of the biggest companies in the world such as Microsoft and Apple started as penny stocks. This segues into the second point: not all penny stocks are inherently trash investments. You just have to learn how to research and analyze this speculative category, deciphering winners from losers.
Of course, the market is a dynamic environment, and you won’t get all of them right. But with proper money management, you can deploy these tips for greater penny stock success.
1. Mind the Spread
Before you get involved with any speculative trade, you must account for the spread, or the difference between the bid and ask price of your target stock. You may notice that blue-chip stocks have narrow spreads, which indicates high liquidity. And high liquidity means low risk because you have reasonable assurances that a buyer will be available when it’s time to sell your shares.
In contrast, penny stocks have wide spreads, which means that you may have difficulty selling your stock when it’s time to cash out. Therefore, it’s better to pick names with narrower spreads relative to other penny stocks. And be sure not to get greedy. When demand is strongest is when buyers are obviously most plentiful.
Always keep this in mind: you can win on paper but it doesn’t mean anything until you actualize those gains.
2. Ignore the Fundamentals and Go Technical
One of the main reasons why professional financial advisors almost never consider penny stocks for their clients is that the old rules don’t apply in the speculative ecosystem. Whereas metrics such as earnings growth and price-to-free cash flow may be akin to a caffeine boost to the staid Wall Street types, they’re not going to provide much information for high-risk publicly traded companies.
Frankly, a majority of penny stocks have poor financials because they’re usually in the early growth phase. Therefore, it’s more appropriate to rely on technical analysis or the interpretation of chart patterns.
While it’s impossible to capture the full essence of the technical approach in one blurb, penny stock traders fortunately have access to a library of free literature. But just learning the basics, such as the bearish head-and-shoulders pattern or the bullish pennant (continuation) pattern can help you separate the duds from the studs.
3. Consider the Short Squeeze
While the best penny stocks offer unparalleled profitability over a very short time period, a major hurdle is that this market is saturated with competitors. In order to find viable opportunities without wasting precious time on low-probability affairs, you should use filters that seek out only equity units meeting specific criteria.
Among the most intriguing is stocks with heavy short interest. Advanced traders not only profit from positive trajectories but also downside movements as well in a practice called short selling. Basically, shorting a stock involves borrowing shares from a broker, then immediately selling them in the open market. Hopefully, the stock goes down in price, where you can then scoop up the borrowed shares at a discount, return them to the broker and pocket the difference.
However, the risk is that stock in question might rise in value. In that case, short sellers will buy back borrowed shares at a premium to cut their losses (since shares can theoretically move higher indefinitely, short sellers risk unlimited losses). This buying pressure creates a short squeeze and going long on the right short-squeeze candidate can generate incredible profits.
4. An Opportunity for the Prepared
While trading penny stocks imposes significant risks for the average investor, it also presents a chance for incredible profitability for the well prepared. Like anything worth pursuing in life, you must be willing to do the work and exercise money management discipline. If you do, you may find this market segment to be both satisfying and financially rewarding.