Penny stocks, as they are called in the U.S., are actually known by a variety of names. In the U.K. they’re dubbed ‘penny shares’ while other places call them ‘cent stocks’. Their name isn’t set is stone, nor are the standards by which they’re defined very clear. Unfortunately, they also have a bad reputation. Some finance experts even liken penny trading to gambling—and warn against their risks.

Mired in controversy as they are, are penny stocks really that bad?

Should you invest into trading penny stocks?

Can penny stocks yield significant dividend gains?

We’re about to tell you everything there is to know about penny stocks in this post. It’s a newbie’s guide, rife with definitions and examples. It’s also an advanced lesson in how to trade—and come out successful.

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Despite their bad reputation, penny stocks are definitely a financial instrument worth exploring, especially if you’re interested in achieving financial independence (not to mention an early retirement).

Now this doesn’t mean that trading in penny stock is easy. If it was, everybody would be doing it!

There are also some risks involved. It is not uncommon for some companies and investors lie to ‘pump and dump’ penny stocks on unsuspecting beginner traders. But you needn’t be vulnerable to such tricks.

Read on to learn how to spot a fake, face failures in trading, and come out on top as a winner.

What is a penny stock?

Here’s the brunt of it: there is no standard definition of a penny stock. Some even consider the phrase a misnomer for this very reason. Some set the cut-off point for penny stock prices at $3, while others mark it at $1.

However, if the Security Exchange Commission (SEC) is anything to go by, it is self-evident that micro-stocks are defined by their market capitalization. Micro-caps are also subject to various approaches, but, by and large, anything ranging between $50 and $300 is a micro-cap. Anything below $30 million is considered a nano-cap. Here’s what the SEC’s definition of the penny stock looks like:

A penny stock is a security traded at less than $5 per share, outside major market/national exchanges.

Both the SEC and finance and trading experts have several other criteria for penny stocks. These include:

• Low liquidity;
• Low capitalization, a.k.a. low market caps;
• High volatility and risk;
• Ample bid-ask spreads.

What a Penny Stock is Not

In the U.S., penny stock trading is regulated by the SEC and the FINRA (Financial Industry Regulatory Authority). These two authorities also explain what a penny stock is not:

–          A stock traded on the New York Stock Exchange (NYSE) which trades under the $1.00, while seen as a low price security, cannot be considered a penny stock. That’s because major market securities are seen as more stable and less likely to be subjected to manipulation.

–          A small company stock traded at over $5 can’t be considered a penny stock, due to its higher than normal price.

By and large, penny stocks belong to companies whose listing requirements are limited and which are also mandated to abide by fewer standards for filing and regulation. Most penny stocks in the US are traded via the Over-The-Counter Bulletin Board (OTCBB) and pink sheets.

While the OTCBB is an actual quotation, Pink Sheets are just a quotation publisher. The OTCBB has an obligation to maintain some requirements for listing, which, limited as they may be, still add some legitimacy. For this reason alone, trading penny stocks that are only listed on the Pink Sheets will always be riskier.

If you are still confused about the definition of penny stocks, check out this funny video from Investopedia, where they walk you through just what a penny stock is.

Things to Know About Penny Stock

Let’s face it: all penny stocks are risky by sheer nature. However, based on the factors outlined below, some are riskier than others. Here are three important questions to ask yourself, before trading any particular penny stock:

–          Do I have enough information as to make an informed decision?

If the answer is ‘no’, then your decision on whether or not to invest should also be negative. This is always true when trading stocks, but it’s particularly applicable to penny stocks because of their filing requirements.

While companies trading on the OTCBB are mandated to file with the SEC, the same can’t be said of those listed on pink sheets. This opens a Pandora’s box for speculators and other manipulators, who are more than eager to provide less than credible information to gullible, inexperienced traders.

–          What’s the company’s history?

The penny stock pipe dream is that you might stumble upon the next Microsoft or Walmart, while dabbling in less regulated markets. That’s because they are ideal for companies that are just starting out and don’t have much of a track record to show for.

Ask yourself: Are you willing to take a risk on a newly-formed company? What about companies on the brink of bankruptcy? If you can’t access their documentation on record, how can you tell if the shares have any potential or not?

–          Can you handle low liquidity levels?

Before you answer this one in the affirmative, bear in mind that low liquidity is often an opportunity for price manipulation tactics (see ‘pump and dump’ below). Furthermore, if you own stocks with low liquidity you might have a hard time finding a buyer that thinks your holdings are attractive. Until you do, you might have to lower your selling price.

∙        Is this a  ‘Pump and dump’?

The problem with thinly traded stocks, which sell for very low prices (as low as a fraction of a cent, at times), is that they become an easy target for stock promoters and other market manipulators. A specific type of microcap fraud that targets penny stocks is ‘pumping and dumping’ them.

This kind of scheme starts out by pumping a stock, i.e. buying large quantities of it. These quantities can go up to millions of shares. Then, to help the price go up as far as it can go, they spread purported ‘inside’ info on message boards, in press releases, newsletters, and traders’ forums.

As prices go up, unsuspecting investors are led to buy more and more of these shares—only to have the share manipulators dump their stocks. This, of course, leaves those innocent to the scam in possession of numerous penny stocks worth next to nothing.

Using a pump and dump strategy on a penny stock can also be regarded as a supernova. It occurs because price action will typically influence penny stocks – which is not the case for regular stocks. Furthermore, the SEC halts trading on penny stocks that record significant price spikes. During the halt, the stock can still experience price fluctuations, while stock holders can do nothing with their shares, until the SEC lifts the trading ban.

Some notorious cases of ‘pumping and dumping’ include:

o   That incident when rapper 50 Cent took to Twitter to have the price of penny stock HNHI go up dramatically. Guess who made $8.7 million in profits from this? Yes, that would be 50 Cent, owner of 30 million HNHI shares.

o   That other time when Lithium Exploration Group (LEXG) promoted their standing in the lithium exploration group—even though their 10-Q form filed at the end of 2010 showed they had no assets and revenues. The company’s market cap rose to $350 million after their direct mail campaign, which they used to buy lithium production and exploration properties. Was the company pumping and dumping, or was it just legitimately promoting their own ticker?

∙         Is this a Boiler Room situtation?

Here’s how this undesirable scenario typically plays out: company A knows that it doesn’t have to register its stock, provided it sells it outside the United States. Company A finds an off-shore broker to sell the stock to, at very low prices. In turn, the brokers are set to make a hefty profit off the shares of company A, so they cold call potential investors and put the boiler room pressure on.

Then, much like in the 2000 film of the same name, the brokers disappear with your money, only to come back to bully you when you try to sell.

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How to Trade Penny Stocks

So, with all the talk of high risks above, are penny stocks worth it, or are you better off investing in other types of opportunities? Surely enough, if you can tolerate a fair amount of risk, you can, indeed, make a pretty penny out of penny stocks.

If you’re serious enough about this game, you’ll soon find that penny stock traders’ online message boards and forums feature success stories several times a year. The whole difficulty of the game is to find that one stock that can bring you 1,000% earnings in a matter of weeks. With penny stocks trading infrequently, at very low prices, it might be difficult to find it, but that doesn’t make it impossible.

There are three features that all good penny stocks have in common: solid financials, coherent footnotes, and strong underlying business. Let’s take a look at them:

Underlying business

A company’s underlying business is even more important for penny stocks than it is for stocks traded on the big exchanges, such as NYSE and NASDAQ. Why is that? Because, all too often, penny stocks are a veneer for companies that have been legally incorporated, but come up blank when you look into their business operations.

Such companies are also known as ‘shell companies’ in the stock trading world. They can constitute virtual goldmines for scammers. It’s all the easier to pump and dump a stock that belongs to a company with no operations, since you are essentially offered a blank slate. So, when looking for legitimate penny stocks to trade in, try to find those that belong to a company with sustainable business. They won’t always be fool-proof, but they’ll definitely bring you one step closer to penny stock trading success.

Financials

Any investor knows that a company’s financial statements is a priceless resource when trying to decide whether or not a particular stock is worth trading. This, once again, is all the truer for penny stocks. However, with these stocks it is often more about the quality of the statements than about the information inside them.

The quality of the statement will tell you a lot about the penny stock you are considering. Were they filed on time? Who audited the company behind the stock? Do the financials seem sound? if you find positive answers to all these questions you can greenlight the stock in question—for now.

But don’t forget to also take a look at the next section.

Footnotes

Let’s be honest about it: footnotes are sometimes blatantly overlooked, even by seasoned traders on the major stock exchanges. But while ignoring the footnotes on Apple’s or Google’s statements is not such a big deal, the situation couldn’t be any more different for penny stocks.

As explained above, penny stock companies are small. Their footnotes could contain some very ‘interesting’ and borderline unethical information, such as related-party transactions and accounting errors that don’t align with GAAP standards.

 

Penny Stocks to Watch and Penny Stocks to Avoid

You may have seen the online banner ads or Google AdWords ads. You may have even gotten a call from a penny stock promoter, or stumbled across the Twitter or Facebook account of such an individual. One thing they all have in common is the promise of a quick, major return on investment. To do so, they use carefully crafted, bombastic language from behind the protection of a disclaimer. These stocks are clearly not a good investment.

But does that mean all penny stocks are illegitimate and artificially hyped? Certainly not! Here are some quick rules that can help you tease apart the phonies from the legitimate opportunities.

#1. Don’t fall for the success story

If you don’t want to take my word for it, then listen to Timothy Sykes. Tim is possibly the biggest, most real success story of them all, when it comes to trading penny stocks. He’s all for full disclosure, too, and teaches thousands of students the world over his recipe for penny stock success. Not only is he a millionaire from playing the penny stock game, but he promises to help you start winning at it today, with his courses.

Image source: Metro

Sykes explains that you need to steer clear of the picture-perfect success stories you see glorified and over-hyped on social media. All they do is teach beginner traders to approach penny stocks as if they were lottery tickets. Instead, the seasoned long and short trader advises beginners to aim for stocks with a solid track record of growth and 52-week highs.

#2. Always read the disclaimers

The SEC mandates penny stock promoters to include disclaimers at the bottom of any public communication they issue, be it a free newsletter or email. Forget the hot tips hyped in the letter itself, but do take a close look at the fine print. It will usually tell you just who is paying these promoters to advertise a particular stock instead of another.

This, in turn, gives way to a conflict of interests which you had better be aware of before you spend your money. Promotion itself is normal and there’s nothing wrong with it—but, in the world of penny stocks, it all too often opens the door to fraud attempts. By reading the small print, you will at least know which companies it’s best to avoid.

#3. Be in it to win it

If you get good profit, get out fast. Many investors who end up believing the unfounded hype behind many penny stocks will not stop at substantial wins of 20, or even 30%. They’ll insist on getting a full 1,000% ROI or more. However, don’t ever forget that in the world of penny stocks, what quickly goes up will unfailingly come down at similar breakneck speeds.

This mentality will help to protect you from a good old pump and dump scheme. Instead of taking an unnecessary risk, take a hike, together with your profits.

Penny Stocks to Buy: Dividend-Yielding Stocks

There aren’t a lot of penny stocks that do pay dividends, but the ones that do stand to make you quite a nice profit. The reasons why their number is low is the penny stocks’ inherently small market cap and low revenue margin. However, you can always run a Google search for “penny stocks that pay dividends”. The results might surprise you.

A more educated method for finding such stocks is to filter for them via one of the many free online screeners, such as the Fool.com screener, Google Finance, or Zacks.com. Apply your own standards for the definition of a penny stock definition to the database and then further filter out those that have a dividend payout ratio equaling zero.

This second method will typically help you narrow down your choices to a list of 100 to 150 penny stocks. Research each of them individually, to decide which ones best suit your investment strategies and goals.

Why Invest in Dividend-Paying Penny Stocks?

The problem with penny stocks is that they’re not exactly goldmines for investors. A very small fraction of them actually stand to make you a profit. Most penny stocks will actually cause you to lose money. So, dividends will help you improve the overall quality of your portfolio. Check out the following example:

In one particular year, you buy 1,000 penny stocks, each worth $1, in companies ‘A’, ‘B’, and ‘C’. Stock A posts no change in price over the course of that year, stock B drops to $.5, while stock C doubles its price to $2 per unit.

Your net return on investment that year would amount to $500: $0 from stock A, -$500 from B, and $1,000 from C. If each of those stocks paid out $.05 in dividends, you’d be able to increase your ROI for the year by 20%. That’s $150, or 3,000 shares multiplied by $.05.

Bear in mind that dividends alone won’t make trading penny stocks profitable, but they can help reduce the margins of your loss.

Conclusions

There is a very important reason for which penny stocks regained their popularity in 2014 and 2015, as the U.S. economy started slowly regaining its momentum. They make this awesome promise of fast, great gains without work. But the truth is that, in order to make the right stock picks, you’ll need more than a crash course in day trading for dummies.

Even with the accessibility of eTrade platforms, Google company news alerts, and free reviews, becoming a millionaire from penny stocks tomorrow is still not a feat that anyone can achieve easily. So, before you go out and trade, we’ll leave you off with a couple of pointers:

• No forum, software, or listings website can give you an accurate and complete picture of this game.
• If you want unbiased advice for penny stocks, don’t listen to company management. Ask someone with brokerage experience, who will likely be able to tell if a particular stock is being pumped.
• With major exchange stocks, you’ll also find the hottest gainers in certain industries. It could be oil, marijuana, biotech, energy, software, tech, or pharmaceutical. Penny stocks don’t work the same way and are far more volatile.
• The cheapest stock is definitely not the best stock. In fact, how cheap a stock is should alert you to how unsafe for trading it might be.
• No, trading penny stocks will not turn you into today”s Warren Buffet. To achieve that kind of status, you’ll need a coherent investment strategy, with a long-term vision and goals.

If you follow what is outlined in this article and do your own in depth research, you will do well. As risky as penny stocks are, a smart person can play the game and win.