Many investors are content to be passive about their holdings. They buy a few blue-chip stocks. They walk away. They go about their lives. They check in on their portfolio now and then just to make sure society hasn’t collapsed. They know they’ll see gains over the long term.
Some investors, on the other hand, have what you’d call a wilder temperament.
They’re aggressive. They’re active. They don’t seek the safe route to financial well-being. They want the big payday. They want to make killings on explosive profits, surround themselves with luxury, and see themselves portrayed in a Leonardo DiCaprio movie someday.
The vehicles many of them choose to pursue these admittedly outlandish dreams? Penny stocks.
Penny stocks are the epitome of “high risk/high reward” investments. They’re priced to move and generate hype. They can be incredibly volatile. For many investors with military-camp discipline and a fondness for roller coasters, penny stocks have paid off handsomely.
They fly in the face of long-term financial planning. Many of the world’s richest investors don’t trust them. But what about you? Can you make money with penny stocks?
What Exactly Are They?
Before you start on your quest to make millions with penny stocks, it might be practical to ask: What are they?
Penny stocks are shares in small companies that are priced very cheaply. The Securities and Exchange Commission (SEC) generally defines them as any stock shares priced below $5. The vast majority of penny stocks are attached to small, up-and-coming companies.
Why are penny stocks so cheap? Primarily because the companies they’re connected to don’t yet have a strong presence in the market. They haven’t established themselves. They may have generated a lot of buzz, but they haven’t crossed over into the mainstream yet.
Companies offer penny stocks to drum up investors and raise capital. They hope the lower price will encourage some to buy multiple shares. Investors, consequently, load up on penny stocks in hopes that they’ll eventually — but rather quickly — blow up in share price and create a windfall of profits.
Some penny stocks are sold on the major stock exchanges, but many are not. Instead, they’re sold in over-the-counter (OTC) markets, where two parties conduct trades without an intermediary. These transactions are less regulated than ones that occur on the New York Stock Exchange (NYSE).
That’s one of the reasons penny stocks are considered extremely risky. Which, let’s be upfront, they certainly are. They’re often offered without a ton of background information. When investors buy them, they do so out of extreme speculation. They’re very volatile and often used to carry out some terrible scams.
But the lure of penny stocks is undeniable. If one’s very shrewd, diligent, and ready to work hard, they may eventually make money with penny stocks. And the profits can be gigantic.
We underscore: It will not be easy. It really won’t. But if you’re game, here are some ideas that might improve your chances with penny stocks.
Find Companies in Good Financial Shape
Penny stocks are perceived as enormous risks because the companies they represent are usually new and unproven. They haven’t maximized their cash flow yet. Their assets may be limited. Many of them are saddled with debt because they’ve taken out loans to maintain operations.
Some penny stock companies, though, have better balance sheets than others. They’ve created a product or service that people want. They may command a small but significant sector of the market. And they’ve maintained a debt level that’s at least manageable, potentially favorable.
Look for penny stock companies that make money. It doesn’t make sense to buy shares in companies that lose money, no matter how inexpensive those shares are. A viable penny stock contender should also have sufficient cash reserves and assets to offset losses.
Penny stocks are, with some exceptions, not necessarily candidates for long-term investment. Their nature encourages more active trading. Stock market players get out of penny stock positions quickly after they turn profits. So these companies need to be making money now — not later. There’s always some future speculation with penny stocks, but the less you need to speculate, the better. Focus on present results.
Keep an eye on the company’s debt ratio. One good rule is to only target companies whose long-term debt is less than half their shareholder equity (total assets minus total liabilities). If they owe $750,000 in debt, their shareholder equity should be $1,500,000 or greater.
Of course, financial information may not be readily available, especially with companies on the less-regulated OTC market. But legitimate companies looking for capital won’t shy away from providing financial data, especially if it’s favorable to them. Be skeptical about those that don’t.
Shore Up Your Risk Tolerance
Stock trades are easier to execute now than ever before. That leads some novice investors to be careless about the risk they’re taking on. If it’s so easy to do, it can’t be that risky, right?
That’d be a big “no.”
If one wants to make millions with penny stocks, one needs to be prepared to withstand their inherent volatility. If you’re going to pour excessive capital into multiple shares, you need to know there’s a great chance your investments will be wiped out, leaving your investment account bone dry with no ability to get that money back.
And you need to be okay with that.
Only get involved in penny stocks if you have a high, fireproof tolerance for risk. Consider this point very deliberately and honestly. Don’t shrug this step off. Your trading days will be filled with unpredictability and occasional bouts of terror. Be sure you can deal with the chaos.
Know the Businesses You’re Investing In
The most successful day traders are fearsomely smart and informed. Their being so curbs the apparent recklessness of their enterprise. They don’t move on a company until they understand as much as they can about the company — including how it makes money.
Penny stock trading presents a lot of varied, wide-ranging, and very specific business models. It’s crucial to know what products or services penny stock companies provide. More than that, penny stock investors need to understand the context of that service as well.
For example, a lot of penny stocks these days are for companies focused on 5G technology. You may know what 5G is — almost every current commercial for a new smartphone mentions it — but do you know how it works? If a company says they provide “analog signal processing chips,” do you understand what those are, and how they relate to 5G? (Note: This writer does not.)
One rule of thumb among investors is to be able to explain exactly what the companies they hold shares in do in one or two sentences, tops. At the very least, get to know as much as you can about the business and the industry it’s in. Connect as many dots as you can.
Diversify Your Holdings
We say this all the time, and we’ll say it again: Portfolio diversity is a key to stock market profits. This goes for every style of stock trading, active or passive. It’s no different with penny stocks.
Diverse portfolios are more protected against economic downturns in certain sectors. If you only own tech stocks, your entire investment is tied to one sector. When that sector enters a recession, your investment account balance takes a whopping hit. But if you also hold shares in utilities, real estate, healthcare, or other sectors that aren’t going through a recession, you’ll likely lose much less.
However many penny stocks you end up buying, spread them out among several different businesses and industries.
Watch the Charts
As we mentioned, penny stocks are mostly short-term holdings. You’re not looking for companies with long, durable histories of consistent upward movements. You’re looking at quick movements in a much briefer span — often just one day.
A commonly used tool for figuring out what penny stocks to buy is the Relative Strength Index (RSI). This assesses the effects of recent price changes on the valuation of certain companies. If a penny stock has an RSI figure over 70, it’s traditionally considered in prime position to pull back in value (so you should sell it now). If it’s under 30, it’s undervalued — and could be in line for a jump in the future (so you should buy it now).
When you’re looking at a penny stock’s charts, look for patterns that support certain trade executions. A stock that seems to have leveled out in price after a long, sloping downturn may be bottomed out, so it could be time to pick it up. The exact opposite situation — long ascent, new plateau — may indicate it’s time to sell. Sudden, inexplicable price dips may be opportunities for investment that will vanish as soon as they rebound.
Penny stocks that are performing in ways opposite to current trends are especially important to watch. If the IT sector is going through a steep recession, but there’s one IT penny stock that’s either going higher or losing far less, that’s a good sign that it’s worth the investment.
There are many more chart-watching strategies that work especially well with penny stocks. Get to know them all and use them religiously.
Can you make money with penny stocks? You can. But it takes confidence, fortitude, dedication, and a whole lot of homework. Make sure you check all those boxes before you start. In fact, check them twice.
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