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Things To Consider Before Trading Penny Stocks

Many people ask me about trading penny stocks (and many times forex) as if they are easy money and anybody who gets involved in trading them realizes success. One of the reasons the easy money delusions persist is because the barriers to entry are low. Penny stocks by definition are those stocks that trade under $5.00, so you can essentially get started trading penny stocks with only $5. But like businesses with easy barriers to entry, you’ll see profits dwindle as more and more participants enter the market.

You can make a lot of money with penny stocks, but you can also lose a lot of money. I think most people would find the latter applies to them. Penny stocks are subject to manipulation and are famous for “pump and dump” schemes. In such a scenario, criminal brokers will “pump up” the stock as the next big thing while holding shares themselves then selling (dumping) their shares at the inflated price. All those people who bought on the “pump up” lose their shirt. It’s Wolf of Wall Street type stuff. Don’t be the Sheep of Wall Street.

Trading penny stocks can be risky.

Even without manipulation, penny stocks can prove disastrous for traders. With bigger stocks like General Electric (GE) or Apple (AAPL), you can pretty much sell and buy them for the same price, plus or minus a few pennies, seconds after making the initial trade. Stocks like GE and AAPL are also traded all day in the millions to hundreds of millions of shares. A penny stock’s spread may be in the dollar range or measured in quarters. You could buy a penny stock for a $1.00 and be able to sell it for only $0.75 a few seconds later. Such a disparity may persist for days as not many people trade in the penny stock’s shares. Perhaps a hundred or fewer trades occur every day in the stock.

A good company can trade for $5.00 or less but some of the qualities outlined above may pertain to such company’s stock. With the diminished liquidity and major swings in the short-term, you really have to have a solid long-term view on the company and believe its share price will appreciate due to good business fundamentals. In essence, you could be really right in the long-term but be horribly wrong in the short-term. You also have to ask yourself if you’re the type to panic. If you can buy a stock and see its price decline 25% or more virtually overnight without losing your head, then you might have the stomach for penny stock trading or investing. If not, avoid penny stocks.

If you’re just starting out with investing or trading, then penny stocks probably aren’t for you. Once you get a solid foundation and are keenly aware of the risks and benefits, then maybe you can dabble in the penny stock arena. Until then, stick to what you know and invest in or trade stocks whose prices will not swing violently for legitimate or illegitimate reasons.

- Andrew Sebastian

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