All About Buying Penny Stocks

Is That the Devil Speaking or Can Buying Penny Stocks Be a Good Strategy?

Is the temptation for buying penny stocks spawned by the devil to rob you of all your trading capital? Sometimes I wonder if that’s what some people think based on the scorn that comes up when people talk about this area of trading.

Before you decide to just listen to old-fashioned advice and anyone gets worked up about them let’s take a fair look at what a penny stock investment really is. Traditionally, buying penny stocks is purchasing stocks priced under $5 a share. You might be surprised by some companies in this price range such as Sprint (S), Rite Aid (RAD), Eastman Kodak (EK), Sirius XM Radio (SIRI), Tenet Healthcare (THC) and Wendy’s (WEN).

Another example is Ford (F) which was under $2 in 2009 and if you look at that chart you’ll see it traded over $18 in 2011. I’ve traded Sirius XM Radio (SIRI) which trades in the $1-$3 range. I’ve made some good gains on SIRI, but I wouldn’t have if I avoided what people generally refer to as “penny stocks.” It may be more appropriate to call stocks between $1-5 lower value stocks rather than penny stocks.

What to Stay Away From and Why

The kind of penny stock trading that is super-high risk are real penny stocks that trade for a few pennies a share and sub-penny stocks or stocks that trade for under a penny per share. These guys are very risky and usually have relatively low volume. This sets up as a situation where certain traders can control the price of the stock. If you’ve ever heard of the “pump and dump,” the real share value of a penny stock arena is where this takes place. This is not where the majority of traders want to be trading. It’s just not worth the enormous risk.

Even if you are attracted to the idea of stocks trading for a few pennies or less because you only have $100 or less at a time to invest, buying penny stocks isn't the way to go. There are online stock trading brokerages that will allow you to buy incremental shares of stock like BuyandHold.com and perhaps Sharebuilder.com, so don’t worry about the share price of a stock.

The key is to be educated, risk averse and have one or two really good stock trading strategies. With these aspects of trading in place, there are some very good opportunities to be found in traditional penny stocks priced at $1 to $5 or lower value stocks.

Measure Risk

There are a couple of things to be aware of with buying penny stocks.

The main issue to be aware of is volume. You have to make sure that the average daily volume is high enough so that when you want to sell, there are buyers.

Set limits of price and volume that you’re comfortable with. For example, it might be stocks over $1 with an average minimum of 250,000 shares traded a day are comfortable for you. (Be careful of stocks trading recent prior days with really low volume – you’re looking for an average volume per day). A safer combination might be stocks over $2 that trade a minimum of 200,000 shares a day. That’s $800,000 in real dollars trading hands each day making it more liquid than just $200,000 moving around.

One other thing is to be aware of how you position size when in lower value stocks. One way to position size is to use a stock price’s ATR which will give you the risk level of any particular security and guide you in how much capital to trade.

Outside of measuring risk, penny stocks are similar to higher priced stocks and all the same rules of your stock trading plan apply.

Why Penny Stocks Can Be Good

Penny stocks are nimble and can provide greater gains in a shorter time frame. They have great setups and can be sold as easily as other stocks as long as the volume is there.

When I look to take a position, I target stocks that I think I can gain approximately 20% or more and in penny stocks it's more likely because of their price point.

One strategy that looks to traditional penny stocks is the rolling stocks strategy. However, they can be very nice gainers in an uptrending market as well.

The main reason I’m a fan of penny stocks is how quickly and well they can move. You’ll see this is true if you take a look at the stocks in the Best Stock Trading Charts of 2010. Many stocks from 2010 and 2009 started out at a lower price point.

So, all in all, I'm all for buying penny stocks priced between $1 and $5 and you might consider it too if it fits into your trading plan.

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