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Trading in Penny Stocks Can be Risky Business

By Features Bankrate.com

Dear Dr. Don,
I have been looking for a way to get into investing in penny stocks and the stock market in general. Do you know if there is a class or any online information that could get me on track? I have been looking, but everyone seems to have a program. Do you have suggestions of one that might be credible?
-- Philip Pennies

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Dear Philip,
Let's call it what it is. It's not investing; it's speculating. I'm of the opinion that there's room in most investors' portfolios for some speculation, but you don't start thinking about the speculative part of your portfolio until after you've funded an emergency fund and have started to build an investment portfolio. The speculative component in your portfolio should be no more than 5 % to 15 % of your overall investment portfolio.

The definition of a penny stock varies by source. Some include stocks trading for less than $5 per share. Others define it as a stock trading at less than $1 per share. According to the Securities and Exchange Commission, the term "penny stock" generally refers to low-priced (less than $5) speculative securities of very small companies.

Penny stocks generally are quoted on two electronic exchanges -- the Over-The-Counter Bulletin Board, or OTCBB, or in the Pink Sheets. But they also may trade on securities exchanges, including foreign stock exchanges. In addition, penny stocks can include the securities of certain private companies with no active trading market.

Penny stocks are considered speculative because the stocks typically have wide bid-ask spreads. The companies also lack liquidity, are thinly capitalized, and have limited financial and market information available about them.

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Speculators run the risk of getting caught in the turbulence surrounding these stocks. In some instances, investors can find themselves the victim of a "pump-and-dump" scheme and buy into a stock based on lofty claims from fraudsters. The scammers already have a position in the stock and sell it after its price rises, leaving the unwitting investor with worthless shares.

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One of my favorite trading stories is about a man who keeps buying shares in a low-priced stock only to see its price go higher and higher. He finally decides to get out of the position and tells his broker to sell. His broker asks, "To whom?"

What's your attraction to penny stocks? Most speculators like the idea that they can buy 1,000 shares of a $1 stock. Then, if it goes to $2, they've doubled their money. But if it goes to zero, they've lost it all. I'd rather own 50 shares of a $20 stock than 1,000 shares of a penny stock that I bought for $1. Both trades give you the opportunity to double your money. Speculators think there's a higher probability that the $1 stock will go to $2 than of the $20 stock going to $40. I don't buy that premise.

Several major investment websites offer investor education for free. I like the Investing Classroom on the Morningstar website. I can't recommend trading schools or trading programs. A simulated stock-trading portfolio is a good way to test your mettle without draining your funds as you try different approaches to trading.

You need to decide what your approach will be toward speculating in penny stocks. Are you going to look at the company's fundamentals, even with limited information? Will you use charts or technical analysis or just try to outwit the market? Take a simulated portfolio for a drive over the next six months, and see how you do. The market will still be waiting for you six months from now.

Bankrate's content, including the guidance of its advice-and-expert columns and this website, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this website is governed by Bankrate's Terms of Use.

Copyright 2012, Bankrate Inc.

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