How To Trade Penny Stock - Understanding The Risks

For many investors, the subject of how to trade penny stock is one that will be forever an irrelevance. Whilst stories of high growth and investors become rich quickly from just one great investment now have a place in financial folklore, the reality for the majority is quite different.

The world of penny stock investment is often thought of as a place full of shady operators, financial newsletters and fast profits. On the surface, some of this is true, but the reality is one of hard work and careful analysis.

In the UK they are known as penny shares. To some in the United States they are dollar stocks because they trade on the stock market (information here) for one dollar or less.

These excellent opportunities are there - they always have been and always will be. But uncovering a nugget or gem takes work and effort. Just because small cap stocks are overlooked by the major investment banks does not mean that there are not analysts and obsessives scouring annual reports and filings looking for an opportunity. Remember that there are many people and organisations looking for value on every financial market and they aren't dummies.

There seem to be two main factors which make penny stock trading a higher risk activity than some other forms of investment. Firstly, in very small companies, liquidity can be a big issue. There may not be another investor trying to trade in the same stock as you for several days at a time. And when someone does come along who is willing to buy or sell, they might not be at prices which seem favourable.

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This might seem to be a minor inconvenience when looked at objectively. And it is. However, should the market decide that a company's fortunes have deteriorated, it may be impossible to sell a holding at any price. Clearly, this ups the risk significantly.

Conversely, should the expectations for a small firm be upgraded significantly, it may be virtually impossible to buy at any price. This will often force prices up very quickly. This makes liquidity something of a double-edged sword. The penny stocks to watch closely are those with a story, in a developing sector or country, with a competitive edge.

However, should you happen to be holding shares in a small quoted firm and an investment magazine or TV show profiles your firm, or a Wall Street analyst writes something positive, the lack of liquidity will be a joy for you to behold as day traders jump in to the new hot story and force the price skywards!

Your author can remember seeing a stock - not a penny stock actually - do this in the late 90s. Around 93% of the company was owned by major funds, strategic interests and the founder. As results continued to impress, demand increased and the stock literally took off - the graph was something to see. In a smaller company this is much more pronounced. Under these rare but amazing conditions any old dummy could have made money.

A second major factor which will influence risks and how to trade penny stock is that of information. Smaller companies generally operate under a lower burden of reporting requirements. This can be useful in saving them money in what would be full account preparation for a larger listed firm. However, it can make it very hard for an investor to fully understand and value a company.

Many smaller companies will be listed on an exchange designed specifically for newer firms. The Alternative Investment Market in the UK - part of the London Stock Exchange - is a prime example, as was - but is to a lesser extent now - NASDAQ.

One man, one vote?

These listings are targetted at companies who are small, fast growing and relatively young. This can often mean that a company cannot even supply the usual three years of audited accounts at listing. Such a lack of information and track record can make it possible for an unscrupulous management to manipulate the market.

Another related area where small cap stocks can be problematic concerns the rights of shareholders. Typically a small quoted company has one or a few very major investors. These are often the founders of the company and not only do they own a significant portion of company stock, they also tend to retain important positions within the firm, such as CEO or President.

For these people, the company is not a collection of people, contracts, products, services and clients: it is their baby. They have often devoted major parts of their lives to the growth and development of the firm. This can make them fairly volatile as owners.

Your author has learned this lesson the hard way. When someone that owns 30-50% of a company and holds a powerful position on the board decides that he has made a decision, that is that. Sometimes this can mean taking the company private again and buying the existing stock holders (perhaps you?) out at whatever price they like. Your 5,000 shares will not help you negotiate a better price. For this reason, I am sometimes forced to wonder are penny stocks for dummies since the stock holders are sometimes treated so poorly.

This is in contrast to blue chip stocks. The largest firms in the Dow Jones or FTSE also tend to have powerful and overbearing CEOs and Presidents. However, due to the size of the companies, these powerful directors often have more power outside their company. If they make a decision to close a factory or move a business process, the impact can be profound for thousands of families.

However, inside the firm will be a relatively stronger presence in the boardroom and while they may own a large amount of company stock it is not typically on the same scale as the founder would have. The presence of mutual funds and pension funds on their stock register and knowing that the national news media are following their behaviour tends to keep them more in line.

Additionally, there are many studies that show that the average tenure of a CEO in a major quoted company is now only two to four years. As the pressures of the owners for results grows, they are typically unable to retain their position for long. In direct contrast, a founder and major shareholder might be with the company for decades.

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Down and out?

As noted above, smaller stocks can be high growth firms with a very bright future. What if they aren't?

There will also always be small cap stocks that were once much larger. They have fallen on harder times, their business model might have endured changes and they have struggled to adapt or perhaps bad decisions made by management have hampered the company. Either way, times are tough. What to do then?

Close observation of this phenomenon has lead me to believe that as an investor these are very bad situations to invest in. Costly personal experience suggests to me that turnarounds don't turn.

For many of these companies, the changes in their marketplace (and we live in an age of incredible change) have caught them off guard and unable to respond. Some good examples would be the print newspaper industry in the internet era. For these firms, their business landscape has fundamentally changed, but many newspapers and magazines are going out of print and business because they are struggling to adapt. (This article about Newsweek offers some perspective).

Whilst the "old" management is in place, it is unlikely that the company will make the necessary changes to survive. Until the management are replaced, the firm will likely continue to bleed cash from one month to the next. As an investor this is the nightmare scenario - their stock price is unlikely to improve and only a bid from another firm will help it, but who would bid under such circumstances? These are cheap stocks for a reason and only predatory asset strippers (information here) are likely to be interested in them.

Despite this warning, many books will say otherwise. The basis of value investing (information here) as first proposed by Ben Graham relies on looking for undervalued stocks that hold some real tangible value on the balance sheet. While there is much merit in the concept, it is not an easy game to play and the world and the stock market have changed dramatically since he proposed it.

In Graham's days, there was very little oversight, regulation or duty of care from Director's. Therefore, much of his work revolved around analysis of company accounts to spot fraudulent accounting practices. In those days it was common for management to treat stockholders like dummies - something which is (thankfully) much rarer today.

The mechanics

The actual process of buying and selling penny stocks is the same as any other transaction on an equity market. However, while the actual operation is the same, it can sometimes be difficult to actually complete a trade in the smallest of firms, as mentioned above, due to liquidity issues.

One very obvious difference between buying a blue chip and a penny share will be in the transactional fees paid to deal (information here). The smaller number of trades and the loss of liquidity means that stock brokers are less inclined to enable a trade by purchasing themselves and waiting for a matching party. This means that the spread between bid and offer price will usually be higher than for the larger firms.

There can also be problems in finding accurate penny stock quotes. After all, if there are very few people trying to trade, the broker might simply be forced to offer you all there is, and that price might be different to your hopes. While the prices quoted in the daily newspaper such as Wall Street Journal or Financial Times, or online at Yahoo! Finance, may have been accurate, if there is no trade on a particular day, they use the last trade as a guide price. Thus, it might only be possible to trade at an unattractive price.

While most of the time these price differentials are simply the way things are and the penny stock quotes are just a little volatile, it can be that the prices are being manipulated. Thinly traded stocks are often the targets of the less than scrupulous operators (read this and try not to be scared away!).

Therefore, not only are the risks higher but so are the costs!

It will usually be possible to buy and sell via your normal broker (information here), firms like E*Trade, Charles Schwab and Scottrade will be able do the deals for you.

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For day trading, they will likely be using much more sophisticated methods to pick stocks and make trades. Day trading strategies require the ability to buy and sell immediately, so hot stocks are much more likely targets than any others as there is usually action to be had.

Whilst this page would seem to be warning a trader or investor away from penny stocks, your author has 'dabbled' in this on many occasions. It can be a very lucrative and satisfying experience - especially to have 'got in first' and been right about a product or company early on.

So please do not be put off. If there is one word of advice I would offer about how to trade penny stock, it would simply be, flexibility.It is also vital to be willing to embrace change and new technology. Many small quoted companies are trying to develop an amazing new product that will change the world. They will all describe their product as "revolutionary" and "game changing", the question for the private investor is which ones really are?

This is an area that requires bravery and confidence - so be sure that you are up for the challenge. With the risks being so much higher, trading in penny stock should not be an activity for the majority. Are penny stocks for dummies? We think not...

Any investor or trader in small and illiquid companies needs to have few emotional attachments to a holding and be ready, willing and able to sell at a moments notice should market sentiment change. As we English might say, it is wise to be 'fleet of foot'.