The Dos & Don'ts of Buying Penny Stocks

Penny stocks, which are also known as microcap stocks, can be a fun and exciting way to invest. While they are inexpensive to buy -- usually costing less than five dollars per share -- they can also be a way to lose a great deal of money. Before investing in the penny stocks of small companies, understand what you're getting yourself into. Then you can properly research the opportunities and manage your risks.

Use Risk Capital

Penny stocks are inherently risky. Legitimate companies that are penny stocks are still usually either very small, or are large companies that have fallen on hard times. Either has a higher chance of going out of business than a more stable company. One way to minimize the overall risk from a portfolio-wide perspective is to only invest money that you can absolutely afford to lose. That way, if your penny stock investments don't go well, your overall portfolio isn't being jeopardized.

Research the Companies

Penny stocks vary greatly in their promise, and buying one on an Internet tip can be dangerous. Doing your own research, which includes reading the fine print on any newsletters or other promotional pieces, can help you see if a recommendation is trustworthy. It can also give you an opportunity to gauge the company's prospects. As you do your research, though, remember that penny stock financial reports don't have to be audited the way that a company traded on a major exchange's financials would be.

Trade Short-Term

While it might be tempting to hold onto penny stocks for the long term in the hope of getting large gains, that strategy can be risky. Instead, stock market author Michael Sincere recommends setting smaller goals like making 20 or 30 percent profits. That way, you can pocket your returns if they come up without taking the risk of holding onto the stock for the long term.

Small Positions, Big Volume

One of the challenges in trading penny stocks is that many have very low volume. If a company only trades once every few days, you might not be able to find anyone to buy your shares when you want to sell. One way to mitigate this risk is to look for penny stocks that trade frequently and to only buy a block of shares that is a small fraction of the daily volume. This helps to increase the chance that you'll find a seller when you want to buy.