Trading penny stocks for any investor, no matter how skilled, can be a boom or bust experience and should be undertaken with caution. Penny stocks are stocks that trade at a relatively low price and market capitalization, and choosing the right penny stock to invest in can be a challenging and head-scratching experience for the beginner. Sometimes, it seems you’re better off just throwing a dart at a stock listing and hoping for the best. Although there is no way to predict how any one stock will perform, there are certain indicators to look for that will narrow the playing field and make trading penny stocks easier and less risky.
Start by opening an online investment account with a reputable broker. There are many that specialize in the over-the-counter market, where all penny stocks are traded. Some brokers have minimums to open an account, but their per-trade commission is relatively low.
Watch out for the "pump and dump" scheme. It's a form of stock manipulation by shady stock traders or PR firms that artificially "pump" or inflate the price of a stock through false or misleading statements to sell their cheaply purchased stock at a higher price. Once the operators of the scheme "dump" their overvalued shares, the price falls and investors lose their money. This scheme is usually practiced through email spam campaigns and newsletters.
A beginner should be aware that penny stocks are generally traded over the counter (OTC) rather than on markets such as the New York Stock Exchange or Nasdaq, where there is more control and transparency. The major difference is that OTC securities are unlisted, so there is no central exchange for the market. It's easier to manipulate a stock when there is little or no independent information available about a company.
When trading penny stocks, the beginner should look at the price-to-earnings ratio for a company's stock, which is the current price per share divided by its earnings per share. For example, if a company is currently trading at $40 a share and its earnings over the last 12 months were $1.50 per share, the P/E ratio would be $26.66 ($40 divided by $1.50). In general, a P/E ratio helps determine whether a stock is overvalued or undervalued. An investor should always compare the P/E ratio of one company to other companies in the same industry to get a better idea of a company's performance.
Next, look at the price-earnings-to-growth ratio to determine the value of a stock while considering its earnings growth. The PEG ratio is a widely used indicator of a stock's potential value. It is favored by many analysts over the P/E ratio because it also accounts for growth. In general, the P/E ratio is higher for a company with a higher growth rate. Thus, using just the P/E ratio would make high-growth companies overvalued relative to others. By dividing the P/E ratio by the earnings growth rate, you get a ratio that is assumed to be better for comparing companies with different growth rates.
Consider the company's debt ratio. This indicates what proportion of debt a company has relative to its assets. Obviously, the more assets and the less debt a company has, the better. This will give the investor an idea of the potential risks a company faces in terms of its debt load.
Examine the cash flow of a company, which is essential to solvency. Cash flow is also crucial to survival. Having adequate cash on hand will ensure that creditors, employees and others can be paid on time. If a business does not have enough cash to support its operations, it's not solvent and is a likely candidate for bankruptcy.
Stay away from penny stocks with low daily-trading volumes. When a stock averages only a few thousand shares a day, there's probably not much interest in it, and you'd be hard-pressed to sell your shares when you wanted, especially if you held a considerable amount. Instead, look for those companies that trade over a million shares a day. You're more likely to buy and sell at a price you desire.
Follow one simple, last rule, which applies to any type of investing: Never gamble on a stock and never invest money you cannot afford to lose. Don't go it alone. Seek the advice of a qualified financial adviser or broker. Remember, many so-called "experts" have lost a lot money believing they knew more than everyone else.
Anthony Potenza began writing in 1985 as a publicity and staff writer for 20th Century-Fox Film Corp. He has written a number of articles online, focusing on topics such as food and wine, photography, fly fishing and personal finance. He holds a Bachelor of Arts in English from New York University.