Penny stocks offer the allure of huge profits, but before you invest in these stocks, you should acquaint yourself with the pros and cons. Penny stocks are very low-priced stocks that typically trade under $5 and have a market capitalization of less than $300 million. Without exception, they are high-risk and subject to market manipulation. Bob Frick, senior editor at Kiplinger’s, reported that many people find solicitations for penny stocks in their spam email folders. Still, these stocks can appreciate substantially, and by taking proper precautions, you could make an income trading penny stocks.
1. Research before you invest. When dealing with penny stocks, this step is not always as easy as it sounds. Companies with less than $10 million in assets do not have to file with the Securities and Exchange Commission, which is a typical source of financial information about companies. With little or no information about a company available, investors may fall prey to stock fraud schemes. Investment advisors recommend it’s prudent to invest in companies that voluntarily report to the SEC and disclose pertinent financial information to the public.
2. Check the EDGAR database. If a company files with the SEC, it will be on EDGAR and you can look up the reports. If the company is not listed there, check for state registration through the North American Securities Administrators Association. This website tells you whether the company has the legal right to sell securities in your state.
3. Investigate a company’s fundamentals before you invest. Understand what the company does and familiarize yourself with its products or services. If you can’t explain the company to a friend or fellow investor, you don’t have the proper grasp of it. This might be because the company you are considering doesn’t have a clear direction. Invest only in companies that you understand.
4. Start slowly. Kiplinger’s Frick recommends that you set up a separate brokerage account devoted to penny stocks. Limit your investments in these high-risk stocks to five percent of your assets. If you lose the entire amount, you won’t have lost much.
5. Purchase shares in a company over time instead of all at once. This helps you avoid buying artificially inflated stocks, a common penny stock scam that the SEC calls “pump and dump.” Some unscrupulous promoters create a buying frenzy over a short period, which inflates the stock price. Once enough people to buy, the promoters sell their shares and investors lose.
6. Diversify. Besides investing in different companies, invest in diverse market sectors as well to minimize risk. That way, if one market sector is in a slump, some of your other penny stock investments may be profitable.
7. Know when to sell. Set up an order with your broker to automatically sell when a stock drops to a certain point. Some people, for example, instruct a broker to sell if a stock falls 10 percent below what they paid for it, which limits their loses. You should also instruct your broker to sell when a certain profit is achieved, so that you’ll reap those gains and not lose by holding the stock too long.
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