What’s a Penny Stock?

If you’re new to the game, you might be wondering what exactly a penny stock is. And that’s not a bad question — especially since the answer might be different depending on whom you ask. While some experts say that penny stocks are anything that costs less than $1, others will tell you that’s not the case.

We recently put a report together explaining this a little clearer. Check it out here: Investing in Penny Stocks.

But of all investments out there (well, at least other than subprime debt), penny stocks usually get the worst rap. That’s because with low prices and lower liquidity than most other stocks, they’re easier to manipulate. But don’t let that scare you away from penny stocks.

The Risk-Return Tradeoff

Even though penny stocks are more volatile, they also present investors with the most profit potential. That’s because of the risk-return tradeoff — a principle that says an investment’s payoff rises along with its risk.

Every day there are penny stock success stories, even in a year like this when the S&P has taken a tumble. If you read the Penny Sleuth two weeks or so ago, you heard me recommend XFML, a Chinese financial media stock. Since then, that stock is up 45%, even though the market remains flat.

It’s because of returns like XFML’s that I like to call penny stocks the “Wild West of the investing world.”

Are Penny Stocks Harder to Buy?

But let’s go back to the question at hand: “How do you buy penny stocks?”

The simple answer is, simply, just as you would buy any other stock. Place a trade with your normal broker.

But, to be fair, there is a little more to it than that.

First off, if you’ve never traded penny stocks before, your broker will need to approve you for investing in them, and will send you an information sheet about the risks of penny stocks. But these are mainly formalities.

Two places where you will see a difference with investing in penny stocks are in the commissions you pay and your ability to use margin. Most brokers have a slightly different fee structure for stocks that cost less $1.

Also, some brokers either won’t allow you to use margin to trade penny stocks, or will make you maintain higher minimum margin requirements than you otherwise would have to. As always, it’s best to ask your broker about how trading penny stocks will affect your brokerage account.

If you don’t have a brokerage account yet, check out this free report on picking the right one.

Taming the Wild West of the Market

Hopefully, this little primer on buying penny stocks has shown you that the learning curve for these kinds of investments isn’t quite as steep as some would make it seem.

Penny stocks can be a risky investment to be sure, but if you make informed decisions and approach your penny investments with the same thoroughness and gusto that you would with anything else, you too can unlock a whole lot of profit potential.

Cheers,

Jonas Elmerraji
May 5, 2008

P.S.: I told you about XFML the other week — the company I said has gained almost 50% already — but if you want to hear about the really small stuff, the stuff we can’t talk about in a popular newsletter like the Penny Sleuth, my colleagues Greg Guenthner and Jim Nelson are working on a new issue of Penny Stock Fortunes as we speak.

How to Buy Penny Stocks was originally featured in the Penny Sleuth.