It sometimes seems like everyone has a good story about how they bought a penny stock for under $1 per share and watched it soar to a much higher price. You might open your email inbox and find it full of tempting claims of penny stocks set to rocket to new price highs. Unfortunately, penny stocks are not typically the great investments they are said to be by the stock promoters and your friends.
What Penny Stocks Are
Penny stocks are low-priced stocks -- under $5 a share -- that usually don't trade on an organized exchange. They are normally traded between institutional stock trading desks that fill orders from investors. This is the over-the-counter, or OTC, marketplace. Also known as "pink-sheet stocks," they represent small companies that might not even be registered with the Securities and Exchange Commission and thus aren't required to publish their financials and key company news. This means they are mostly unregulated and, according to the SEC, are highly speculative investments. However, some penny stocks represent excellent small companies that eventually become market leaders.
What Makes a Penny Stock Soar in Price
Favorable company announcements are often the catalysts for a substantial rise in the price of a penny stock. Since most penny stocks have relatively few shares trading in the market and are thought of as somewhat illiquid, any good news can spark a quick rise in price because traders, trying to buy shares to fill orders, raise their bids to attract selling by stockholders wanting to take profits. The dark side of penny stock investing is the pump-and-dump done by stock promoters who have been paid for their services in company stock -- a common practice. They pump the stock by sending out stock tips touting the stock's imminent rise in price, and when the price rises, they dump their stock on the market to take profits. Normally, the stock price will decline back to its previous level, leaving gullible investors with losses.
Finding the Right Penny Stock
Nearly every large, solid company trading on an exchange has spent some time as what the industry calls a micro-cap company -- one with a market capitalization between $50 million and $300 million. That proves it's possible to find a good investment among penny stocks if you research the company's fundamentals and technicals. Fundamental stock analysis consists of learning about the industry, scrutinizing the company's financial reports and evaluating the quality of its management and business model. Look for insider buying of company stock, contracts with larger companies, attractive products and reasonable financial performance. Technical analysis involves analyzing a chart of the stock's price over time and looking for a consistent price rise, without evidence of spikes due to stock promotion.
How to Find a Potential Breakout
Use technical analysis to identify a stock that is poised to move to a higher price level. Many investors accumulate large positions in a good penny stock over time, buying additional shares as good earnings and company growth appear more certain. Look for an unexpected rise in the volume of shares traded as a possible hint that good news is imminent. Strong volume and a rise in price can indicate the stock is ready to break out into a higher trading range. This doesn't guarantee the stock will soar. Before you buy, check one of the websites that list possible pump-and-dump operations to protect yourself against being suckered into buying a stock that is being promoted. Stock promotion doesn't mean it is a bad company to invest in -- just that the price might be artificially high.
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