Penny Stock Basics - High Risk, High Reward

Today's guest blogger is PennyStocksVIP. They have kindly offered to share sections of their members' only PDF with our blog visitors today. Although risky, penny stocks have a certain charm. These excerpts will share simple definitions and information about these high risk, high reward stocks. Learn more about PennyStocksVIP and their complimentary alerts.

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What are Penny Stocks?

First, let us define what a penny stock is. While there is no real definition that is commonly agreed upon, how investors behave with certain stocks give us clues. Most stocks trading at below $5.00 are treated as Penny Stocks. This, even though being the mist defining of the criteria, is not all there is to look at. There are three major guidelines to follow to see if you are looking at a Penny Stock.

1) Price per share: As mentioned above, the trading price range helps determine if a stock is a penny stock. The lower it is, the closer it is to being a Penny stock, although there is no exact point when this happens.

2) Markets: Depending on where a stock is traded, such as Over The Counter Bulletin Board (OTC-BB), Canadian Venture Exchange (CDNX) or Pink Sheets, it may categorize a company as a Penny Stock. As Penny Stocks trade on different market exchanges, one will need to know where their stock of interest is trading before setting up an order.

3) Market Capitalization: A Market Cap is the value of each stock multiplied by the number of stocks which are owned by the public (Outstanding Shares). This gives the trading value of the ENTIRE company. If this number is low it is more likely that the company will be treated as a Penny Stock. For Example, if a company has 10,000 shares in public hands and the valuation per share is $1.00, then the company has a value of $10,000. Since share values can fluctuate heavily, a stock may start the day as a Penny Stock with a low Market Cap and end it above the $10.00 per share mark. As such, a Penny Stock is ALWAYS seen as a risky investment. This is the one thing that is agreed upon about Penny Stocks, they are high risk, high reward investments and should not be entered into without that in mind.

Risk

The reason why these stocks are high risk is due to the small size of the companies and their lack of transparency and their relative newness. This makes them unpredictable, and others may prey on your lack of information. This is based on unsolicited stock picks and stock advice that may come through either spam emails, telephone calls or even fax messages. Newsletters can also be risky as well, even though the information about the stock and its progress may be correct, it may also be possible that the email is leaving out some relevant information that would make you want to pass. Other problems occur with the lack of listing standards. There are no real rules that these companies need to follow, unlike the NASDAQ. Penny Stocks need no minimum of assets or shareholders.

Payoff

The volatility involved in Penny Stocks are exactly what makes them so rewarding. Also, given the degree of difficulty in finding accurate and pertinent information, should you get a hold of a tip earlier than the rest, you’ll be able to capitalize on that. One of the most provocative aspects of penny stocks is their potential to garner incredible gains with a minimal investment ; the extent of the rewards is simply a matter of choosing the proper stock at the proper time. Many investors view penny stocks as an entry in order to gain stake in emerging prospective companies before they become lucrative. For those who are new to trading, it is an excellent way to learn about stock market fundamentals with minimal commitment - it is easy to see why over time we are seeing an increase investors of all age groups and skill levels participating in penny stock trades.

It is not uncommon to see a stock soar to 100% of purchasing price or very quickly, within hours of purchase, and as such many are drawn in to try their hand. They key to success lies in choosing the right stock before it takes off. The following will be to show you exactly how to do that.

Key indicators and How to Use Them

There are many indicators which determine how a stock can react in the market, helping you earn money if you know how to. These are often patterns or tip offs that help predict Penny Stocks as well as provide insight into when is best to buy and sell. For now we will cover basic indicators, and leave the more complex analysis for later. Some indicators need more research than others to be helpful, but the more you take the time to look into a stock, its history and the market in general, the more likelihood there is you will be able to make the right choice. Never underestimate the value your time spent researching, since in the end each of us are accountable for our own investment decisions.

Volatility

Penny Stocks are volatile, that is not questioned. However, the magnitude, frequency and cause of the volatility are exactly what is needed to predict a stock well. A spike or drop in share price of 20% is not uncommon, and is actually to be expected. If you look at the historical trend of a stock you may get an idea of how common such highs and lows occur, and how large they are compared to past shifts. Often press releases of a company can send a stock shooting up or down, and keeping an eye on what has been announced before as well as what the company expects to come (Pending FDA approval for a new drug, for example) helps you stay ahead of the curve. Unusual behavior should be capitalized on, since a stock may go back to its usual valuation or be leading up to a large change in the future.

Spread

This simply is the difference between the price that someone bids for a share and the price someone is asking for the share. This is when the asking price is larger than the bidding price, since a price is not agreed upon, unlike when the ask is less than the bid and a trading price can still be agreed upon. Imagine a stock is falling in value and you are trying to sell it and you ask $1.00 per share. If however no one wishes to bid more than $0.80 for a share, there is a spread of $0.20, and no transaction can occur. A large spread can make it very difficult to sell a stock. Sometimes it is worth ‘bridging the gap’ of the spread in order to sell a stock sooner rather than have it devalue any further.

Company Maturity and Life Cycle

Companies which trade in Penny Stock range are usually young businesses. Growth of value in a stock is partially determined by how far along the company has come from its infancy. That is to say, an established company like Apple will not enjoy the explosive growth that it could have expected when it began. Young or newly innovative companies are more primed for this explosion than the Large Cap ones that are established.

If a company is young it has the greatest risk and potential benefit. If it succeeds it will have unprecedented growth, but it also has a higher chance of bankruptcy. finding potential winners and losers can be tricky, but knowing the age, size and market infiltration of a company can help. Companies that succeed must survive until they can enter the stock market, and then again must keep their company going until they are larger and established.

Takeovers and Acquisitions

Small Cap companies are often subject to mergers, acquisitions and takeovers as they struggle to increase their size and success. Takeovers by a larger company are usually beneficial to stock value while mergers can go either way. If two companies merge that are complimentary to each other and have similar management practices, there is a good likelihood of success.

No matter what, news of a merger or takeover will create a buzz in the stock, making trade volume rise significantly. That always makes these good opportunities to capitalize on the upcoming changes.

Sectors and Industries

Penny Stocks, being small and somewhat fragile are heavily influenced based on what is going on around them. The price of commodities, trends in consumer interests or rival companies succeeding of failing all mean big news for Penny Stocks associated with said events. It can be summed up by the large doing what they can, the small doing what they must. A small company has little power to affect markets and is at the mercy of what is going on around it and does all it can to survive and grow. A larger company is more of a trend setter, affecting the market itself.

Financial Statements

Many Penny Stocks have a atrocious balance sheet, with high debt and few sales. This matters less in Small Cap companies than in Large Cap ones, since such stocks are fundamentally risky. Penny Stocks are not expected to start off well, but finding the cases where products catch on or new opportunities open to them are key in choosing stocks that succeed. Don’t let the poor balance sheet sway you too much, Penny Stocks are fundamentally speculative, and having debt now does not translate into failure in the future.

How to Avoid the Most Common Risks of Penny Stocks

Although the potential gains to be earned from investing in penny stocks can be provocative, investing in penny stocks has also brought with it certain risks. In this article, we wish to bring these risks to light in hopes that our members and subscribers will be diligent with their investment decisions. For those who do their trading online, make sure you are executing your trades from a private computer where your network and passwords are protected. Public computers do not have secure networks and user names and passwords can be easily compromised by hackers in order to buy up stocks while selling their own. Another thing to be cautious about are the emails you receive. Although the information about the stock and its progress may be correct, it may also be possible that the email is leaving out some information. This brings us to “Do Your Own Due Diligence”.

Doing your own research is extremely important, research just about anything you can. You want to make sure the following elements are sound: the company’s history, financial history, its management team, its product or mission and any future prospects for the company. You do not want to be caught unawares when a a poor product is released or a rival receives a critical contract, leaving your shares falling in value.

Finally, many investors have been known to say “Never put all your eggs in one basket” - It’s true! Diversifying and maintaining a well-balanced portfolio is the best way to keep your money sound during both an up and down economy. Why would anyone want to risk investing their money that potentially may not be “a sure thing”? This is even more true with such uncertain investments as Penny Stocks. Because there are no strict regulations when it comes to listing and trading penny stocks, it does unfortunately make the market susceptible to exploiters - but a positive aspect of penny stocks (besides their gains) is that penny stock traders are not slowed down by strict requirement when it comes to trading their shares, making a quick and dynamic market for those willing to put in the effort.

Insider Trading

Insider trading can provide wonderful clues as to what a stock may do. Although there are many pitfalls involved in this method, being able to read past the explicit information allows access to the true motives behind insider trading. The first thing to remember is that Inside Traders are human, don’t think they all have every company secret. Since many attempt to follow insider trading, it is a given that insiders know their actions are being heavily monitored. Since it is illegal to trade based on internal information not made public, large selling or buying after a press release is more likely.

Volume Warnings

There are a few tricks to understanding ups and downs in stocks concerning the volume of transactions. A rule of thumb is that high volume spikes that are losing volume from day to day are usually losing steam and shares should be sold before money is lost. Likewise a low volume dip is temporary, returning to a higher point relatively soon, and shares should be held on to. Keep an eye on the volume of transactions and how they progress over initial changes in a stock price. And as with any Penny Stock advise, a quick reaction time to these sometimes subtle changes will be key to capitalizing on them before others take the opportunity. For a simple tip such as this, it is especially true to be ready to act quickly.

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