Penny Stock Strategy

Penny stocks can be very risky, according to the Securities and Exchange Commission. The risk is so great that the law requires brokers to provide clients with a form outlining these risks. Investors must sign and return that form before they can place their first penny stock trade. Despite the warning, penny stock trading continues to attract investor interest. Speculating in microcap stocks can be profitable, with proper research and risk management.

The Risk in Penny Stocks

• The SEC has found the biggest risk factors in trading microcap stocks are due to low trading volume and lack of reliable information. The lack of liquidity causes a number of problems. It can be difficult getting out of a position once your in it. Accurate pricing can be problematic when quotes aren't available. Low trading volumes can cause larger bid/ask spreads. Since many microcap companies don't file financial reports with the SEC, reliable information is scarce. That makes it easier for fraudsters to spread false rumors.

Invest in the Company Not the Stock

• Standard metrics cannot be applied to these companies. Many are new and without any proven track record. Some have no assets, operations or cash flow. Typically, these companies have products or services that are still in development. Since liquidity is usually limited, traditional technical analysis provides little insight. It's better to view an investment in these companies as latter stage venture capital. That requires intimate understanding and familiarity with the people behind the company, their products and industry.

How to Research Microcap Stocks

• First hand knowledge of a company and its principals is very advantageous. Still, it would be prudent to stick to those penny stocks that have publicly available information. Though not every company is required to file reports with the SEC, many choose to do so voluntarily. The SEC's EDGAR system (where these reports are stored) is accessible for free on the their website. Also, check with your state securities regulator, reference books, commercial databases and the secretary of the state where the company is incorporated. This amount of research is necessary due to the pervasiveness of fraud that exists in this environment.

Pump and Dump - The Most Common Scam

• This scam occurs when company insiders or paid promoters illegitimately create a buying frenzy in a thinly traded stock. They post tips on Internet forums claiming to have inside information about an impending move. Some use telemarketers to call investors directly with a high-pressure sales pitch. More recently, telemarketers will intentionally dial a wrong number, pretending they're leaving a stock tip on their friend's voice mail. The resulting buying frenzy causes a sharp, but fleeting, run-up in price. The fraudsters then dump their stocks on the market and the price plummets. These insiders profit handsomely, while the rest suffer.

This is Speculating and Not Investing

• You are not investing in a proven company. You are speculating that an unproven one can become successful. Manage your risk accordingly, and be prepared to lose your entire investment.