Imagine if you had bought into Apple or Amazon when they were tiny startups with stocks as cheap as chips. Today you’d be laughing all the way to the bank. Every investor dreams of backing a star of the future, and penny stocks offer just such a possibility.
What are penny stocks?
Penny stocks, also referred as microcap stocks, are shares that trade at low prices: usually less than £1 in the UK, and $5 in the US. They typically aren’t found on major exchanges — like the London Stock Exchange or New York Stock Exchange — and are instead listed on minor exchanges like the AIM, or bought and sold over-the-counter.
You’ll usually find that penny stocks are cheaper than other shares because they are often issued by young companies without much trading history.
How do penny stocks work?
Penny stocks work just like the stocks of a mid or large-cap companies — by investing, you’re taking ownership of part of a company. As the company increases or decreases in value, so does your stock. You can profit either by selling your shares on for more than you bought them for, or from dividends.
Why invest in penny stocks?
Penny shares, offer a very deep pool in which to fish — there are hundreds of cheaply valued companies which are often overlooked by the big investors as simply too small for them to own. And a handful of those minnows ended up as very big fish. Notable success stories from AIM in recent years include online fashion retailer ASOS, luxury goods company Mulberry, food wholesaler Bookers and Domino’s Pizza. But there have also been plenty of flops.
Essentially, penny stocks are speculative stocks that you buy cheaply and in the knowledge that there’s a good chance they may not perform but, if they do, you could make a really good return on your small initial investment. This is what makes trading them exciting for beginner investors.
But, as with all speculative investments, they are likely to be volatile and your capital is at risk, so never invest money you can’t afford to lose.
Small mining and commodity exploration companies are a classic example of this. A few strike it lucky and find the next big metals or oil deposit. But many more spend a lot of money looking without finding viable deposits.
Where are the risks of investing in penny stocks?
Not every penny stock is a bad investment but investing in penny shares carry higher risk compared to the stocks traded on established exchanges.
It can be hard to find trustworthy information about companies trading over-the-counter because they are not subject to the same disclosure regulations as companies trading on established exchanges.
Highly volatile price
Penny stocks have a higher level of volatility, thereby resulting in higher reward and higher risk for the investors.
Penny stocks often have low liquidity and at times are difficult to sell.
Penny stock scams typically involve “Pump and dump” method whereby companies and scammers purchase a considerable amount of penny stocks resulting in value inflation, which attracts other investors to follow the hype.
Tips for investing in penny stocks
If you’re still interested in dipping a toe into the world of penny stocks, here are ten tips to help you get started:
Run a paper portfolio
Fund managers do this to test out a new portfolio before they launch it. It’s a bit like picking a fantasy football team. You give yourself an imaginary pot of money to play with, then pick the stocks you would choose, note down when you would have bought and sold them and at what price, and then wait to see how your investments perform. Some trading platforms allow you to do this with features like a virtual portfolio or a demo account.
Learn from your mistakes
When you start trading for real, keep a record of which trades worked, and which didn’t, to become a more successful trader in the future. You don’t necessarily have to buy new companies with no track record. Look for companies that are cheap because they are restructuring or have hit a bad patch, as you might be able to make a decent profit if the business recovers.
Find a good broker or online trading platform which can offer you a good choice of stocks
If you’re going to be trading individual shares, fees can rack up quickly, so compare charges across different providers and look for one with low costs per trade or a cap on monthly trading costs. Don’t trade in and out unnecessarily or your fees will erode your returns.
Do your research
Find an experienced mentor willing to share their knowledge. Read DIY investing publications and the financial press, but make sure you use reputable sources. It is not unknown for unscrupulous people to talk up a company’s share price with misleading information before dumping their shares at a profit.
Look for quality companies, not just cheap companies
Penny stock traders risk getting caught out by boiler room scams and value traps if they don’t do their homework. For a company to have the best chance of performing well in the future, it needs to be a good business. Why is the stock cheap – is it a recovery story or a new company, or does it simply have little intrinsic value?
Spread your risk
Don’t chase big wins by piling all your cash into one stock you’ve heard is tipped for greatness. Smaller investments in a range of companies could reduce your potential for losses and boost your chances of getting a great return. Accept that liquidity will be lower than on the main market because there are fewer buyers and sellers for penny stocks. Ideally you should look for companies that have a few hundred thousand shares traded every day so you are more likely to be able to trade when you want to.
If you have set a buy limit, make sure you stick to it. It’s easy to get carried away and end up paying more than the stock is worth. Don’t be afraid to take some profits when a stock is doing well, but don’t settle for less than the best price you can get when it’s time to sell.
Penny share trading is not a ‘get rich quick’ scheme, although some will claim it can make you a millionaire. But you can have a lot of fun learning how to trade penny shares and, although you’ll no doubt experience losses, you might get lucky and land a ‘ten bagger’ somewhere along the way.
How do you buy and sell penny stocks?
You can buy and sell penny stocks by using a stockbroker. Most penny-stock investors trade online, via a desktop platform, or mobile trading app.
How do you start penny stocks trading online?
Here’s how to start trading penny stocks:
- Open a share dealing account. You can open an account with trading platforms quickly and easily.
- Do your research to learn what moves stock markets.
- Place your first trade. Choose how many shares you want, and get invested in seconds.