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Penny Stock Investing Tips

By Charles Hopkins Published 03/13/2006 | Finance

Stocks that are traded at a very low cost under 5 a share are given the name 'Penny Stock'. In some cases penny stocks may trade for under 1 per share, and sometimes even for under a penny.

Though transacted at very low price, penny stocks can be quite risky. That is why most wise financial investors avoid them even though there is money to be made in this market. High risks exist in this market because of the wildly fluctuating prices of penny stocks. Therefore the first tip for the penny stock market is: try to avoid investing here.

Secondly, if you feel in some way specially attracted to this market, perhaps because you hope to invest small money and gain high returns, be sure to investigate the relevant companies thoroughly and exhaustively before taking a single step in any direction.

Next, when you feel ready to move, be extremely careful. Most penny stocks come from newly formed companies which are virtually unknown, so the investor has hardly any information to depend upon when attempting to make an investment decision. Sometimes belong to companies that are in a very serious financial problem or may be almost on the verge of bankruptcy. It is best to avoid buying unless you know some of the insiders dependably well.

One essential and very dangerous difference between penny stocks and other stocks is that penny stocks can escape state regulatory oversight. In the United States, penny stock companies are not required to release audited financial records. Shareholders have virtually no verifiable information regarding the inner workings of these companies while low per-share price looks highly alluring. As a result, it is easier for corporate insiders to act fraudulently against shareholder interests, and the low per-share price reflects this increased risk of fraud.

This reputation for fraud is often reflected in some terms often used by insiders.

One common technique is known as 'Front Running', or the 'Pump and Dump'. This happens when a small group of traders surreptitiously buys a large block of inactive penny stock shares. As their positions become loaded, they use mongering extremely positive sounding rumors about the company so that the price is pushed up to yield a large profit.

Conversely, spreading false rumor for driving the price down is known as the 'Poop and Scoop'. Anybody rash enough to have invested in these stocks may soon end up penny wise and dollar foolish!

However, it should be remembered that the price being sub-5 or sub-1 does not necessarily imply a weak, near-bankrupt company. In the aftermath of the great bear market of 2000, a number of legitimate, fully reporting companies found their shares valued in the pennies. They were technically penny stocks. But the major exchanges typically allowed such companies short-term exemptions to stay listed as long as they meet SEC reporting guidelines.

Hence, trading in such penny stocks may not always drive you towards fraudulent companies and potential losses. This makes the case even more complicated, and stresses the need for deep research before taking entry or exit decisions.

There is yet another high risk pitfall coming from the important difference in how penny stocks are traded. Major exchanges such as the NYSE and Nasdaq do not list penny stocks; instead, they are consigned to secondary markets to the Pink Sheets, for example.

The liquidity measure of how easy it is to buy and sell a stock is much lower in secondary markets than they are in the majors. As a result of the low per-share price, it is not unusual for individuals to hold hundreds of thousands of shares. Often the liquidity disappears soon and it becomes impossible to exit such large positions without severely driving down the share price further.

Hence try not to be attracted by the high liquidity of low stocks in secondary markets. Look before you leap is the word for investing in penny stocks.

The best tip is: never invest in anything you dont understand. If you dont understand the penny stock at deeper layers, let it pass.