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5 Tips for Investing in Penny Stocks

5 Tips for Investing in Penny Stocks

While we all dream about investing in the next Microsoft or the Home Depot, and actually mentally start calculating the profits, the sad truth is that the odds of finding out that once in a decade, success stories are slim since these companies are either start-ups or have purchased a shell company as it was cheaper than an IPO, or they just do not have a business plan that is good enough to justify investment banker's money for an IPO. This doesn't make them a bad investment, but it should make you be realistic about the kind of company you are investing in.

Trading Volumes

Look for a consistent high volume of shares being traded as looking at the average volume can be quite misleading. If ABC trades a 1 million shares today, and doesn't trade for the remaining week, then the daily average will appear as 200,000 shares but to get in and out at an acceptable rate of return, you need a steady volume. Also, look at the number of trades per day. Is it one insider selling or buying? Liquidity should be the first thing to look at since if there is no volume, you will end up holding "dead money", where the only way of selling shares is to dump at the bid that will put more selling pressure, and lead to an even lower sell price.

Does the company know how to make a profit?

While it's not unusual to see a new company run at a loss, it's vital to look at why they are losing money. Ask questions like - Is it manageable? Will they have to seek more financing (which will lead to dilution of shares) or will they have to seek a joint partnership that favors the other party?

If your firm knows how to make profits, the company can use that to grow their business, and that increases the shareholder value. In fact, you have to do some background research to find these companies but when you do, then lower the risks of a loss of your capital, and increases the odds of a much higher return.

Have an entry and exit plan and then stick to it.

Penny stocks are volatile and they will quickly move up and move down just as quickly. So, remember that if you buy a stock at $0.10 and sell it at $0.12, which represents a 20 percent returns on your investment since a 2 cent decline leaves you with a 20 percent loss. Many stocks trade in this range daily so if your investment capital is $10,000, a 20 percent loss is a $2,000 loss. Do this five times and you will run out of money. Keep your stops close and if you get stopped out, move to the next opportunity. The market is saying something to you and whether you want to admit it or not, it's usually good to listen.

If your plan was to sell at $0.12 and it now jumps to $0.13, either gain 30 percent or better still, place your stop at $0.12. That ways, you can lock in profits while not capping the upside potential.

How did you find out about the stock?

Most people find out about penny stocks through a mailing list and some excellent penny stock newsletters, however, there are just as many who are pumping and dumping. They, in cohorts with insiders will load up on shares, then pump the firm to unsuspecting newsletter subscribers and these subscribers buy while insiders sell. Guess who wins here!

Not all penny stock newsletters are that bad; having worked in the industry for the last eight years. The difficult job then is to spot the good companies from the bad? Just subscribe to a penny stock newsletter, and track the investments. Was there a legitimate chance to make money? Find out whether they have a good track record of providing subscribers with opportunities?

Another important tip that I would like to offer is never to invest more than 20 percent of your overall portfolio in penny stocks. You are investing for money so it is recommended to preserve capital to fight another battle. If you put too much of your capital at risk, that will automatically increase the odds of losing your capital and if that 20 percent grows.