How to Buy Penny Stocks: A Beginner's Guide

Penny stocks (or micro-cap stocks) are not too difficult to understand. They are essentially stocks from companies trading for a share price under $5. Some of these shares can cost just pennies - hence the name - and many people sell and invest in them.

You may wonder why they’re so risky if they’re so cheap: First of all, penny stocks can be traded on a regular stock exchange, but that is rarely the case. Instead, they’re usually bought and sold in over-the-counter transactions. What’s more, they are infrequently traded, because they belong to small companies, which makes them very difficult to sell.

As a result, they’re considered very speculative, as you’re buying something very cheap, that you can’t always trade, in the hope that it will someday rise in value enough to be traded regularly.

Why Trade in Penny Stocks

With such a high level of speculation attached to buying penny stocks, you might wonder whether they’re worth it. What are the benefits of investing in them or trading them, and is it the right choice for you? Well, just like any other stock, penny stocks have the potential to give you excellent returns:

One of the benefits is just how many options they give you. You have a vast market of companies to choose from, many of which are largely overlooked, and therefore cheap, but could one day end up being great choices. On the flip side, most penny stocks won't increase in value in any significant way.

Trading or Investing

Each of these options can give you different benefits, as well as various drawbacks.

Investing in Penny Stocks

This will make you a shareholder, with all of the rights and responsibilities that come with it. You will have voting rights and receive dividend payments, and you'll have to pay the total amount of your investment right away. If you want to make a profit, you'll have to do so by selling your shares for more than you bought them.

Trading Penny Stocks

Trading penny stocks allows you to buy and sell them quickly. Most penny stock traders make their money with short-term gains by acting as day traders, rather than long-term investors. However, because the stocks are so volatile, their price can change significantly literally as a trader is making the call to trade.

Where Penny Stocks Are Traded

Finding the right platform often means looking away from stock exchanges. Most penny stocks priced under $1 will be found on the over-the-counter bulletin board (OTCBB) and through OTC Markets.

Major stock exchanges set a number of requirements for listing stocks, which usually include that shares must have a price of at least $1. However, you can also find shares that fall under the definition of penny stock priced between $1 and $5 on major stock exchanges such as the New York Stock Exchange.

Choosing a Broker

There are several things to consider if you want to find the right broker for your needs.

Because your gains from penny stocks will usually be relatively small compared to other types of investments, you don't want your profits to be eaten up by the fees that the broker charges. If a broker charges on a per-share basis, buying lots of shares will be particularly expensive.

A flat fee makes more sense for penny stocks: Just make sure the broker you choose follows SEC regulations in the United States and allows for trading penny stocks.

Other important broker facts you need to be on top of include whether short-selling is allowed, how quickly you will be able to make trades (either online or on the phone), and what tools are provided with the broker's platform.

Watch Out for Scams

Scams are highly common here, and you can look out for some key signs that you're dealing with a fraudulent trade, not a genuine opportunity to make money.

Some of the warning signs of a penny stock scam include:

• Unregistered financial advisors guaranteeing returns
• Promises of quick and large returns
• Pitches the play on the latest trends and news stories
• Unofficial promotions
• High-pressure telemarketing calls from brokers
• Forums and newsletters with no clear affiliation offering advice and tips

Knowing some of the common scams can help you to avoid them. These include scams such as pump-and-dump and dump-and-dilute schemes.

Pump-and-Dump Schemes

These schemes are when promoters try to boost the price of a stock over time using misleading information or exaggerated statements. Investors who fall for it are often left with investments they can't sell. A variation of this is short-and-distort schemes, where promoters short sell stocks at high prices and then try to lower the prices with negative news.

Dump-and-Dilute Schemes

Dump-and-dilute schemes involve companies issuing shares just so that they can take money from investors. They will usually reverse-split the stock by consolidating shares to raise their value.

Chop Stocks

Chop stocks are bought for pennies and then sold on for dollars by illegitimate brokers and promoters to inexperienced traders. This often involves brokers being paid through unofficial channels.

Practicing Before You Buy

Various brokers and trading platforms offer free simulation tools for getting used to the ins and outs of trading. A demo account will give you virtual funds to play with and teach you how to navigate a live trading environment. It's a no-risk way to make sure you understand what you'll be doing.