Many day traders with a keen to invest in the stock market prefer to buy ‘cheap’ stocks where they can allocate their funds and make an exit after a quick gain. As appealing as it may sound, investing in penny stocks is the riskiest thing that any stock trader can make. Since penny stocks trade at very low stock prices, their movements can go up more than 200% within a day. On the downside, if a stock can go up by 200%, it means that it can also go south in the same measure. There are many billionaires who have made their living by spotting opportunities, making moves and then cashing out within minutes or days.
According to the SEC, penny stocks are stocks of small-cap businesses which trade at less than $5. However, there are still large companies in major exchanges such as NYSE and NASDAQ which have their share prices in that range. A more significant definition of penny stocks is that they are companies with a market valuation of less than $50 million.
While the penny stock market is still very regulated, the fact is that most companies operating in this segment are poorly managed and highly indebted. For this reason, the SEC (Securities Exchange Commission) constantly updates investors on the state of these companies. In their website, investors can search for companies which the commission has warned against.
Large versus penny stocks
The fact is that investing in large-cap stocks such as Microsoft, Berkshire Hathaway, and Apple is an expensive affair open only to large mutual funds, hedge funds, high net worth individuals, and pension finds among others. For a small trader, buying shares of these companies is unaffordable and unsustainable. For instance, a single share of Berkshire Hathaway (A) goes for about $200,000. Who can buy that? A share of Apple is currently going for $218. With $1,000, you can only get 5 shares of the company which is insignificant especially in terms of dividend payout. With the same amount, you can buy more than 800 shares of a company with a share price of $1.5.
The key to succeed in day trading with a focus on penny stocks is due diligence. Before you buy any share, it is important to understand the company inside out. Here, your focus should be on understanding the company, its previous history, management, the debt to equity ratio, the price to earnings ratio, and how it makes its money. You should also search the company at the SEC portal to search for warnings and disclosures.
Researching one company should take a considerable amount of time because you want to be sure that the fundamentals are right from the word go. In addition, you should focus on the period of reporting so that you can avoid the uncertainty that comes from losses.
It is also important to avoid the long term view for penny stocks. Regardless of how good the companies’ numbers are, it is wrong to hold a long term bet on the company. Sure, it is possible to make a lot of money by this but the risks involved are simply ludacris. For penny stocks, I recommend buying and selling companies within a short period of time.
In addition, doing your due diligence is important because it puts you in a position where you can make sound decisions. In many cases, most small investors focus on ‘experts’ who have been in the business for a long time. They receive hundreds of messages on a daily basis promoting small-cap stocks. Blindly, they then go ahead and buy the recommended stocks and inevitably make huge losses. Remember, in penny stocks, a loss can mean wiping all your funds.
When doing your due diligence, you want to look at 3 main things: footnotes, underlying business, and financials. In terms of financials, you want to know a number of things such as: who audits the firm, how does it submit the results, are the financials healthy and what has been the trend? In terms of the underlying business, you want to know whether the company really exist because many shell companies are found in the small cap stocks.
After doing this assessment, it is important to position your funds in a good manner. Doing this will help you mitigate risks as best as possible. It will help you avoid making risky investments and to exit a trade that fails to go the right way.