How to Find & Choose Penny Stocks to Trade, Plus 3 Benefits & 4 Drawbacks

By Chika

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Last Updated: October 28, 2022

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Penny stocks are usually thought to be the abode of the brave and daring - and there is good reasoning.

Fundamentally, penny stocks should not look appealing to the average investor because a penny stock could belong to a company that was delisted from larger exchanges. It could also be the stock of a new company which has little financial history.

This is why these low priced stocks are usually susceptible to high volatility and pump-and-dump schemes.

However, if you conduct your due diligence, trading these stocks can be profitable. Shares of the large corporations like Ford, Monster Beverage and General Motors once traded as penny stocks.

This suggests that trading in penny stocks could be like digging for diamonds in dirt - you just have to know where to look. 

In this article, we look at how you can find these diamonds for cheap, including how to trade them. 

 

 

What are Penny Stocks?

A penny stock is the stock in a small company that trades for less than $5 a share.

They were once referred to as equities that traded for less than $1 a share. However, the Securities and Exchange Commission (SEC) later amended this  categorization to include shares that trade less than $5.

The majority of penny stocks are traded over-the-counter (OTC) through the OTC Bulletin Board (OTCBB) or the privately operated OTC Markets Group. However some of these stocks are found on larger exchanges like the NYSE.

 

 

3 Benefits of Trading Penny Stocks

1. Don't need huge capital.

One benefit of trading penny stocks is that they are cheap, and as such you don't need a lot of money to get started.

 

2. Low entry barriers.

To get started trading these stocks is easy.

Unlike traditional brokers, where you may be required to have a minimum amount to get started, plus other requirements as demanded by the broker, all you need to get started is your money. 

 

3. Potential for huge profit.

Because they are priced low, these stocks have a huge upside potential.

Though many penny stocks will fail, if the company has strong fundamentals, your chances of making profit are high. As such, as a penny stock you can benefit by being an early investor.

 

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Drawbacks of Trading Penny Stocks

1. Lack of public information.

When considering stocks to invest in, it's important to have enough information.

This is part of due diligence and help you to make an informed decision. For some penny stocks, information on corporate, its management, financial records etc. can be very difficult to find. When this is the case, investing in such a penny stock is akin to shooting in the dark and hoping to hit something.

 

2. No minimum standards.

Publicly listed companies on exchanges are subject to stringent listing standards that require maintaining minimum amount of net.

On the contrary, stocks on the OTCBB and pink sheets do not have to fulfill minimum standard requirements to remain available for sale through OTC exchanges. 

This is a major drawback for investors because investors cannot know the financial standing of the company or any other information that may help them in their decisions.

Also such companies are not held accountable by regulators, meaning when investors lose their money to fraudulent schemes, they cannot seek recompense. 

 

3. No fair value.

They usually have low trading volumes as there are few buyers. As a result, investors won't be able to sell the stock at its fair value which could lead to losses.

 

4. Low liquidity and fraud.

Penny stocks are highly volatile due to their low liquidity.

This presents an opportunity for unscrupulous traders to manipulate share price through  pump-and-dump schemes on the stock.

 

 

How to Find Good Penny Stocks

To find quality penny stocks to trade, more research is needed than for normal equities.

There are a few locations, though, where you can hunt for good penny stocks to trade. Here are a few of them for your consideration.

 

1.OTC Markets

Penny stocks are traded on exchanges on over-the-counter (OTC) markets.

These are markets where securities not listed on major exchanges are traded. OTC markets have 3 tiers - OTCQX, OTCQB and Pink Securities. Apart from OTCQX, penny stocks are traded on the OTCQB and Pink Securities.

OTCQB 

Also known as "The Venture Market",  OTCQB is the mid-tier OTC market. Founded in 2010, OTCQB consists of early-stage and developing domestic and international businesses that can't meet OTCQX regulations.

Penny stocks traded in this OTC market are less speculative and volatile than those traded on Pink Sheets.

 

Pink Sheets

This is the lowest tier of the OTC markets.

The name comes from the color of the sheets (paper) on which quotes of stock prices are published - though they have been phased out following the introduction of electronic trading. Stocks listed on Pink Sheets are highly volatile and speculative. 

 

2. OTCBB

You can also find penny stocks to trade at the Over-the-Counter Bulletin Board (OTCBB).

This is an electronic system that shows real-time quotes of over-the-counter securities. Though you cant trade penny stocks on this platform, you can use it as a catalogue to find them and track their price movements.

 

3. Brokers

Apart from markets, there are some brokers that offer penny stocks to traders on their platforms.

Brokers such as Charles Schwab and TD Ameritrade offer penny stocks. However, when trading penny stocks through brokerages, you have to confirm the translation costs and commissions as it is usually on the high side. 

 

 

How to Choose Penny Stocks

If you are wondering how to choose these stocks, here are some factors you should consider.

 

Price action

Price action is the term used to describe how a security's price changes over time.

This can serve as the foundation for evaluating the risk or volatility of trading a security. The price action of a penny stock should be taken into account because it enables the trader to assess the risk involved in dealing with such a stock.

Through price action, a trader can confirm liquidity and if the stock trades like a pump-and-dump scheme. 

 

Type of business

This factor helps to determine the long-term prospects of a company.

By looking at its industry, government policies, business models, competitors and market, a trader can predict to a certain extent the growth trajectory of the company. This would enable the trader decide if the penny stock can grow into a regular stock over time.

 

Fundamental factors

Fundamental factors help a trader understand the financial standing of a company.

Metrics such as these provide an insight into the financial health of a business:

  • free cash flow
  • balance sheet statements
  • quality of management
  • industry forecast
  • number of customers
  • operating expenses, assets, liabilities etc. 

This enables you to make an informed decision on the stock. 

 

Industry Life-Cycle Analysis

Apart from looking at fundamental factors, it is important to consider industry life-cycle analysis when looking for penny stocks to trade.

Some penny stock companies are in a sector still in its “pioneering phase." This initial phase is characterized by the presence of a large number of small-sized competitors with novel products and concepts. 

However, the pioneering stage is also marked by high costs and little-to-no-sales to date. As such, most of these penny stock companies may not survive the first five years due to lack of funds, government policy or poor market penetration.

 

Trading volume

Trading volume gives you an insight into the liquidity of the penny stocks.

This determines how quickly they can sell a stock for cash and if you can trade it at a fair value. Penny stocks that have low trading volumes are much riskier to trade than those that have high trading volumes.

Additionally, they are less prone to sharp price movements or pump-and-dump schemes that could result in portfolio losses.

 

 

Final Word

Penny stocks are like a double-edged sword.

They could cause you huge losses or gains. The best way to reduce your risk is knowing where to find them, and how to select them. By considering the factors listed above, you could find a diamond waiting to be discovered. 

Photo by Jeff Weese

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One comment on “How to Find & Choose Penny Stocks to Trade, Plus 3 Benefits & 4 Drawbacks”

  1. This article is very misleading, if you don't have a lot of money to get started then that eliminates the potential for huge profit. You won't make a great return if you only invest a couple of Benjamins.

    Example: You buy $100 worth of stock at $1 per equaling 100 shares. If it triples you only made $200, not life changing. Obviously if it turns into a legit stock (which could take years) it's a good investment but those are few and far between. And who have little to invest usually can't afford to lose it.

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