Penny Stocks: 3 Do's, 3 Don'ts

There Is a Right Way to Trade Penny Stocks, and a Wrong Way

Two Men Talking Between Coin Stacks
Coin Stacks and Business Men. Topic Images Inc.

When it comes to penny stocks, there's a right way to do things (meaning you make a profit), and a wrong way (meaning you lose money).  The beauty is that the risks and mistakes can be easily sidestepped, while you get involved with the right types of companies at the right trading prices.

Since the downside is so easy to avoid, I will get into the "Three Don'ts" of penny stocks right away - if you take the few small steps, you will be protected from most of the risks.

 At the same time, you will still be open to capturing the big gains.

The 1st Don't of Penny Stocks: The Dark Markets

Never invest in shares of companies which are trading on the Pink Sheets, or the other Dark Markets (OTCQX, OTCQB).  Since these markets have almost nonexistent application and reporting requirements, they become like a magnet for the less serious, unprofessional, extremely low-quality companies.

Simply by avoiding the Dark Markets, you are significantly tipping the odds of success in your favor. Do not take risks among the nearly 10,000 financial train wrecks which list upon the Pink Sheets, the OTCQB, and the OTCQX.

You will have more success if you focus on the high-quality companies which have taken the time (and expense) to become publicly traded on a proper, regulated exchange; NYSE; AMEX; NASDAQ; the Bulletin Board.

The 2nd Don't of Penny Stocks: Free Stock Picks

Never, under any circumstance, follow a free stock pick.

 Remember, when you hear about an investment for free (especially in relation to penny stocks), there are all sorts of unseen, hidden motivations which are pushing or promoting that investment.

For example, con artists and pump and dump scammers use thinly traded penny stocks as a vehicle to take advantage of naïve investors.

These vile players will throw some lipstick on a pig, and talk about how amazing and life-changing their current penny stock is going to be for shareholders.

The sad fact is that any company which is going places, or moving in the right direction operationally, does not and will never need to publicly promote themselves to the mass market. High-caliber companies don't need to raise money from thousands of individuals because they can generate any amount of money they need from institutional investors and investment banks.

You will never hear about an incredible, up-and-coming company through a free promotional pitch.  The ones you see on free newsletter sites, or through unsolicited emails or faxes, are low-quality investments, and most individuals will lose money on them.

Whenever you hear about a penny stock... and how great it is... and how great it is going to be... ask yourself who is promoting it to you (and why).  Free stock picks are the tool of the scam artist - don't take the bait. 

The 3rd Don't of Penny Stocks: Liabilities Greater Than Assets

Do not invest in any penny stock that has greater liabilities than assets. If an individual has $10 in liabilities, but only $4 in assets, technically they're worth negative six dollars.

Many penny stocks have only a few million in assets, even when they have tens of millions of dollars in debt. Any company which has much more debt than assets may be heading towards bankruptcy, or at very least will be running into operational difficulties.

Ideally, when you look at the balance sheet, you will find that the company owns a lot more than they owe. However, when the company owes a lot more than they own, they are in a financially precarious situation.

The 1st Do of Penny Stocks: Buy What You Know

Buy what you know. There are certain things that you probably are passionate about, or know a lot about, especially when compared to the investing masses.

This gives you an advantage when you're looking at companies engaged in the related space. For example, if you are a doctor, you will have an advantage trading in biotech companies.

If you run an Internet business, you would probably have an advantage when it comes to looking into technology companies.

Focus on those business spaces which you understand, and which appeal to you. Avoid the areas where you are a complete newbie, or where you don't have any better of an understanding of the industry then the majority of investors in the space.

The 2nd Do of Penny Stocks: Start by Paper Trading

Start by paper trading. I know that you probably want to put real money into a real stock immediately. After all, why waste time trading smoke and air, when you could be buying and selling penny stocks?

The truth is that almost all of us are going to make some pretty big mistakes at first. Some of these errors will be caused since we are new investors, or perhaps don't understand all the rules of the penny stock game.

By trading at first with imaginary money, you will learn everything you need to know, without first risking your actual money. As well, by paper trading, you will be able to refine your strategy, learn about the types of stocks that you want to buy and sell, and even about which information sources you can trust.

The 3rd Do of Penny Stocks: Call the Company

Call the company.  Every publicly traded company has a responsibility to provide an investor relations contact - it is their job to answer the questions of current and potential shareholders in the company.

For any penny stock, you're interested in, you can call the company and speak to the investor relations contact to get the answers to any questions that you may have.

Most people will put in about 50 percent of the effort needed to be an incredible investor. A lot of the difference between success and failure comes down to taking the extra steps.  With a bit of extra work, you can have the clarity you need about your investments.

Sometimes, all you need to do is give the company a phone call. Ask them a couple of questions, and get a feel for the morale and prospects of the company.  Find out what they expect the price-drivers to be, for coming months, and years.

As well, just through one or two quick conversations with a few companies, you will have greatly enhanced clarity about exactly which penny stock to buy, how the business is going to grow, and how long it's going to take to produce results.

The Right Way to Trade Penny Stocks

When it comes to penny stocks, there is a right way to do it and a wrong way.  By observing the three don'ts of penny stocks you will sidestep the risks, and be insulated from the downside. By implementing the three do's of penny stocks, you open yourself up to finding the really high-quality companies, which operate in industries which you understand and are passionate about.

In other words, mind the three do's, and three don'ts of penny stocks.  By paying attention to the content in this article, you'll be significantly closer to becoming a profitable penny stock investor.