6 Most Important Secrets of Penny Stocks

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Yes, penny stocks can be risky. And yes, penny stocks can be extremely lucrative. What's the difference between taking losses in penny stocks, and turning big profits? It all comes down to knowledge.

For example, did you know that certain markets are terrible for penny stock investors (and destroy your chances of success), while others tilt the odds in your favor? Or that specific types of trading orders will take a massive bite out of your profits?

By increasing your awareness of how to successfully trade low-priced and speculative shares, you will see your results take a significant turn for the better. Keep the following secrets of penny stocks in mind as you delve into tiny and volatile shares, because each of these concepts will help you avoid the risks while finding the greatest companies.

The First Secret: Know the Neighborhood

There are both "good neighborhoods" and "bad neighborhoods" in the penny stock markets.

The Dark Markets, which include the Pink Sheets, the OTCQX, and the OTCQB, attract all the lowest quality companies. It is so easy to trade upon these types of markets that all the marginal and fiscally broken companies get listed there.

The Dark Market listing fees are much lower, the requirements to get added to their exchanges are near zero. There are very few expectations regarding reporting of financial results, as well concerning shareholder visibility and/or accountability.

Considering that there are approximately between 6,000 to 7,000 very low-quality companies, it stands to reason that nearly all of them (if they get listed anywhere at all), will do so on these Dark Markets. The end result is that there are several thousand companies which trade on the Dark Markets, with over 95 percent of them being horrible, ridiculous investments in our view.

When a company is somewhat financially stable, more professional, and serious about what they are trying to achieve, they will attempt to get a stock market listing on one of the higher caliber exchanges. This would include the Bulletin Board, or even the major exchanges such as the NASDAQ, AMEX, and NYSE.

The Bulletin Board is actually the best place to find higher-quality penny stocks. This exchange is owned and operated by the NASDAQ, and as such has many of the reporting and investor visibility requirements, as well as higher fees and a respectable vetting process to attain the listing in the first place.

Simply by focusing on the Bulletin Board, and/or perhaps the higher-level exchanges we mentioned above, you will increase your odds of profiting from penny stocks very significantly. When I say "very," I mean that you will be going from trying to find one or two stocks out of 1000, to trying to find one or two stocks out of a dozen.

The Second Secret: Stocks are Shares of a Business

Always remember that stocks are just shares of a business. Businesses move in months and years, not days and minutes.

When you buy a share of a stock, you are buying a share of the business. When that underlying business performs well, ostensibly by increasing revenues, market share, or earnings, then the share price almost always grows as well.

In fact, it's often a lot easier to understand how a business functions and its outlook, than it is to try and understand how various stocks will perform. 

When an individual is looking at a business, they typically understand that it may take months, or even years, for the business plan to play out. However, when we look at individual stocks (which represent a piece of that underlying business), investors very often get frustrated quickly and expect results in the very short term.

If you were to buy a part of a business, you wouldn't turn around and sell it a month later, or even a week or days later. However, when people buy stocks, that is exactly what they do — dumping the shares at the first sign of frustration, boredom, or impatience.

Typically, the absolute best method of investing involves purchasing shares in a business with the intention of holding that investment for decades, not years.

Anything might happen to any stock in the short term, but when you invest for years at a time an interesting thing tends to happen — you very often start attaining larger short term gains!   

Perhaps this is because your overall outlook is calmer, more intentional, and you make fewer investment commitments. Whatever the reason, a long-term view tends to lead to greater profits in the short term.

A bonus is that if you invested in a stock for the excessively long term, you would be less affected by the short-term price moves and news items which happen. This would suddenly remove almost all of the investing stresses.

The Third Secret: Research Produces Gains

Gains are directly proportionate to your research and analysis efforts.

Whatever level of investing due diligence you undertake, it falls short. You could do more, and you would benefit from the added efforts.

Said another way, you are not doing enough due diligence. Whatever degree to which you increase the amount of research and analysis you perform before you make a purchase decision, you will see an equivalent increase in profits which is directly proportionate to the amount of additional work you do.

So if you typically perform due diligence for an hour or two, you almost certainly will get outperformed by the individuals who perform three or four hours of research and analysis. While that is not always the case, if you doubled the amount of pre-investment work you do, you almost certainly will ramp up the percentage of profits to achieve from your trades.

We describe our analysis approach in this video.

The Fourth Secret: Limit Orders

Always consider using limit orders, rather than market orders, when you trade penny stocks.

Because penny stocks are often thinly traded, and/or have a significant spread between the bid price and ask price of buying and selling traders, anytime you purchase or sell with a market order you are exposing yourself to potentially receiving poor trading prices.

For example, if the bid for a penny stock is 25 cents, and the ask is 45 cents, a market order to buy the shares will result in you acquiring the stock for $.45 cents (and potentially even higher levels). This is true even if the last trading price of the stock was 22 cents, or 12 cents, or 30 cents.

The unfortunate truth of the matter is that the default setting with all brokers is to use market orders, not limit orders. If you want to name your price, and use a limit order, you need to specifically choose that option.

To stick with our example above, if you were to enter a limit order to buy the shares at 27 cents or better, the shares would find their way into your account for prices at that price you set, or even lower levels. So for example, you may acquire some shares at 25 cents, and some more at 26 cents, and still some more potentially at 27 cents… but you will never pay 28 cents or more for the shares.

The only downside to limit orders is that you may not acquire all the shares that you wanted. If you're trying to buy 20,000 shares of the stock at 27 cents, but there are only 10,000 shares available at prices equal to or lower than your limit order level, you may only purchase the 10,000.

The Fifth Secret: Avoid Free Stock Picks

Since penny stocks are thinly traded, and many are housed on the Dark Markets, they are frequently used by scammers and pump and dump artists. It is easier to manipulate the price of a penny stock than it would be with a large or multi-billion-dollar corporation.

One of the top ways that dishonest players in this industry try to trick you into driving the price of some obscure company to higher levels is to promote it to the masses through various free channels. Whether you hear about a penny stock pick in the postal mail, or through a free online newsletter, or you just get an unsolicited spam mail or fax, the promoters are trying to manipulate you.

If they can get just a small fraction of people to buy a penny stock, the price of the shares will typically increase. To make sure that they get critical mass in terms of buying demand, they will often promote the train wreck of a company to hundreds of thousands, if not millions of people.

Unfortunately for naïve investors who fall for the free stock pick ploy, the underlying companies are typically horrible investments, and pretty much always crash in value as soon as the promoter stops pumping the shares higher. Nearly every investor who gets involved with some free penny stock pick service ends up losing a massive portion, if not all, of their money.

A superior approach is always to get penny stock picks from a service which you trust, and which has a full team. It takes many people to do all the vetting and analysis required to make sure that the absolute highest quality, best low-priced investments are put in front of you at the perfect time. 

The Sixth Secret: Use Loss-Limits

With volatile, speculative investments, always use loss-limits.

In the penny stock game, you will take your share of losses. This is true whether or not you are the best penny stock investor in the entire world, or you're not very good at trading at all.

However, you can take many three percent and five percent losses before it's going to matter in the big picture. On the other side of the coin, when the penny stock you invest in increases in price, it will rise by significantly more than three percent or five percent .

One of the keys to trading penny stocks well is to limit your losses to small amounts, such as the 5% which we cited in the example above. The way to do this is to set stop losses, or loss limits so that you automatically sell the stock starts trading in the wrong direction.

For example, if you buy shares of a stock at $0.99, you might immediately establish a stop loss order at $.90. If the shares drop to your loss limit price, they will automatically be sold, and you've limited your maximum loss to about nine percent.

However, if the shares start moving in the right direction they're going to increase by a lot more than nine percent. In some cases, when the penny stock starts to climb, you may actually return 100 percent, or 500 percent, or even more.

Just be cautious about setting your stop loss level too close to the actual recent trading price. With volatile stocks, they may bounce around 10 or 20 percent in either direction, so if your stop loss orders too close (or "tight") you could get stopped out, only to wash the shares bounce right back to where they were in the first place.

Each situation and each stock will have its own appropriate level for the stop loss price. Establishing the appropriate level for each of your investments will go a long way to minimizing your potential downside, while you will always be open to upward moves in price.

Summary of the Secrets:

By observing the secrets of penny stocks, you will be ahead of, and ostensibly more successful than, the majority of speculative investors in low-priced shares. Always remember that trading penny stocks is incredibly fun, highly lucrative, and much easier than you probably realize.

In fact, taking the time to learn first (before you risk your bankroll) will almost always pay off. Get to know the secrets of penny stocks, decide on the types of investments you want to focus on, and get started making money from the very beginning, rather than taking a bunch of losses right away like most people (simply because they did not do the few hours of work required).