Risks in Penny Stocks

Fortunately, the majority of the pitfalls in penny stock trading can be easily avoided, with a little knowledge and experience.  It turns out that most trading mistakes in low-priced shares actually arise due to misunderstandings among newer investors, as well as from poor quality research.

To truly explore these sources of risk in penny stocks, we'll start from the very beginning. 

1. Where did the penny stock pick come from?

If you heard about a penny stock from a junk fax or spam e-mail, it's a losing proposition.

Not quite as bad as that, but still very dangerous, are penny stocks profiled on free websites.  These are only promoted to you because the publisher gets paid by the underlying company, or they own shares and are trying to drive the price up.

Maybe you heard about this penny stock from a trusted friend, co-worker, or relative.  These almost always lead to financial losses, as the source, despite good intentions, usually does not know what they are talking about.  They may like the company, but couldn't tell you anything of true importance, like the name of the CEO, the expected revenues, the debt load, or inventory levels.  In most cases, they heard about it from another friend, bought in, and are spreading the word.  A lot of times, although unknown to the innocent investors involved, this company is being talked up all over the place, perhaps as a result of an earlier pump by promoters.

Much more wise, although also more costly, are paid financial newsletters.  Penny stock pick sites with a price tag attached are numerous, but usually provide information that is a little more reliable.  Make sure to go with the more popular ones, which are more widely followed based on their results.  Less professional sites almost certainly have less profitable penny stock picks.

2.  What are your motivations for trading penny stocks?

Be honest with yourself?  If you're in this game to make a quick buck, you are much more likely to lose money.  If you're desperate, you're even more likely to lose.  Risks in penny stocks always seem to hit you harder when you're motivations are wrong. 

Only get involved if you have time and patience, and are looking to have fun rather than pay for groceries.

3. How did you do due diligence?

Don't be one of those investors who considers due diligence "checking out their web site."  Done properly, DD drives risk away, and opens up the road to profits in penny stocks.

Read their quarterly and annual financials, call the company to ask questions, try their products, and review their competitors.  Find out how much debt they have, and what results they expect to achieve in the next quarter and year. 

The more you learn about any penny stock, the more you'll be right in your investment decisions. 

4. What is your penny stock trading experience?

Make sure to understand all the ins and outs of the markets.  You need to know all sorts of concepts, like "good till close," "bid price," "market depth," and "limit order," just to name a few. 

5. How will you watch your penny stocks?

Have a plan ahead of time to monitor your penny stocks.  Will you check in from work, or trade from home?  Which web sites do you think will make for good research and monitoring tools?  How much time can you devote to your efforts? 

Risk in penny stocks can be great, and the rewards small.  However, if you consider these five points above, your risks will diminish while your potential rewards can balloon.  Just start slowly, keep track of your risk factors as you proceed, and only play with money you can afford to lose.