The term “penny stocks” usually correlates to instruments that small companies issue and trade at less than 5 dollars per share. Many of these OTC stocks are small companies in growth stages. Most traders like to further classify them by separating shares that are under a dollar from those that are over.
Companies with shares that trade for less than a dollar are popular choices with new traders. And, while there are stories of incredibly successful penny stock traders, they are very risky purchases. Most of the time, they trade for under a dollar for a reason. Usually, that reason is that the company’s financial metrics are poor. Poor metrics lead to general uncertainty when it comes to the future of the stock.
Typically, penny stocks are traded OTC (Over the Counter). That means they are not on lists of formal exchanges such as NASDAQ; instead, you can find them on OTC Bulletin Boards or trade them as Pink Sheets. In fact, if a company drops under 1 dollar while trading on NASDAQ, NASDAQ will remove it from their lists after a certain period. That means the company will have to convert to Pink Sheet or OTCBB.
With that in mind, you should still know that not every company that trades Over the Counter is a penny stock company. A lot of them are just trying to grow their business and step up to a major exchange like the NYSE. So, if you manage to identify the stocks that will do that, you are golden. Of course, it is fairly challenging to avoid those that are extremely risky.
Choosing Your Broker
There are some things you should consider before selecting a broker for penny stock trading. First of all, make sure that there are no commission gimmicks. You want a broker with flat fees that charges per trade. Anything else might cost you a lot more money in the long run. Especially if you plan on trading with a lot of money eventually.
A lot of brokers will charge you additionally per share. And that is on top of the base fee. And, remember, these are penny stocks – you will be buying shares by the thousand. Even if the brokerage with this type of fees has a maximum cost limit, they will be far more expensive. Allow us to break it down for you with two examples.
The first example: You find a broker that will charge you a flat fee per trade. Let’s say they charge 5 dollars per trade (which is on the low end, but not uncommon). You enter the position with and buy stock worth 5,000 dollars. The fee remains 5 dollars. Now, let’s see the other situation.
The second example: You find a broker that charges half a cent per share and buy 5,000 shares of a company that trades for 80 cents. That means you just bought 6,250 shares and had to pay $31.25 in fees. As you can probably see, the difference is quite noticeable, especially if you plan on making hundreds of similar trades each year.
So, to help you out, here is the list of top five brokers for those who want to trade penny stocks:
- E*Trade
- Interactive Brokers
- Charles Schwab
- Fidelity
- TD Ameritrade
Beware of Frauds
In most of the cases, penny stocks are that inexpensive for a good reason. That usually leads to large institutions avoiding them, which further leads to little liquidity. Due to the liquidity issue, the difference between the ask and bid prices can be very noticeable. And that can make them perfect targets for various frauds.
The most famous method of manipulating penny stocks is the “pump and dump” strategy. The person performing this scheme will first acquire a huge number of shares. They will then use various paid services to promote the stock and flood the Internet with false reports and fake news to encourage people to buy the stock. They will send out millions of emails to people around the world and have fake accounts on social media networks promoting the stock. Once the stock reaches a sufficiently high value, they will sell everything they have to make a profit. But they won’t even stop there. Since the cost was artificially inflated, you can expect that stock to plummet. So they will start shorting shares of that stock to make even more profit.
Don’t Believe In Every Myth About Penny Stocks
For some reason, a lot of people believe that you are getting more for your money when buying inexpensive shares. However, that is not true at all. In fact, these stocks can be a lot riskier than stocks that trade for tens of dollars. After all, the stronger shares will have support from larger investors. And, not to mention the listing on major exchanges such as NASDAQ.
Of course, there are ways to make a lot of money through penny stocks. That is why they are still very popular, and people trade them every day, especially since the low cost of the share can mean an incredible increase in value. It is relatively easy for a stock to double its price if it initially went for 15 cents.
The Takeaway
To summarize this article, there are five essential tips you shouldn’t forget when trading penny stocks.
- Penny stocks are risky
- Don’t get caught up in a pump and dump scheme
- Ignore the promotional emails regarding shares
- Do your homework and always research the stock yourself
- Stick to flat-fee commissions
Follow these tips, and you will drastically improve your chances of turning a profit at the end of the year.
