All About Penny StocksUnderstanding Penny Stocks by Peter Leeds

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Big Stocks vs. Penny Stocks III

Industry and Sector Influences

While Disney (DIS on NYSE) may be impacted by trends in movie go-ers, travellers, and advertising, the day to day and month to month changes in these underlying criteria do not sway the stock too dramatically.

In comparison, most penny stock companies have exposure to one facet of the economy, and are highly leveraged against that driving force. Gold penny mining stocks suffer extreme swings as the price of the precious metal fluctuates, and a biotech company could be crushed if a competitor releases a superior drug.

In other words, penny stock companies are usually one-tiered, highly leveraged entities, that suffer and enjoy extreme price fluctuations whenever their underlying industry shifts.

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Economies of Scale and Niche Marketing

Larger companies have more resources and capital at their disposal, and usually enjoy stronger strategic alliances with bigger companies, as well as more pervasive name recognition for their product or service.

This creates problems for penny stock companies looking to enter a pre-existing market that already has a dominant force. In these scenarios, the penny stock company generally performs best by capturing a niche market, rather than going head to head with a competitor.

For example, take a look at one of my favorite stocks in recent years. Paravant Computers had no hope of surviving a market share war with Dell, Compaq, IBM, and all the other players in their saturated sector. However, since they were in the niche market of developing rugged laptops and computer peripherals for outdoor and military use, the company thrived and the stock soared. They enjoyed better earnings and lower debt loads than all of their bigger competitors, and developed name recognition and reputation in the niche market that mattered to them.

Several times over the years I had told members of penny stock all about Paravant, and they made money on it each time. After September 11th, PVAT soared as military spending increased.

Driving Factors vs. Fiscal Situation

Penny stocks often have too much debt, no revenues, or ugly balance sheets. Looking closely at their fiscal results can be frightening. However, investors often ignore the fundamentals of speculative companies, because of the potential the shares could enjoy if the company's product catches on.

For example, Xerox once had a horrible financial situation when they first started out. However, that did not have much impact once their technology became the standard - long before they were actually turning a profit.

Irrational Spikes and Profit Opportunities

Penny stocks can often spike (or drop) based on the slightest provocation, even if that driving factor is of little significance.

Pretend that a change in CEO seems like a great turn of events for an anxious trader, who disliked the old CEO. The investor dives into the market for $10,000 worth of shares, which could result in a 50% leap in share prices because of the buying pressure. However, the new CEO may not be enough to justify a 50% increase in the overall value and market cap of the corporation.

Part of the process is to understand which driving factors are accurately priced into the shares. If you do not share our exuberant investor's faith in the new CEO, you may want to take this opportunity to exit your position and take profits as the stock spikes 50% higher.

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Broker Policies for Penny Stocks

Due to the lack of visibility of penny stocks, the markets they trade upon, their volatility, and their risk factors, some brokerage houses have instituted strict policies for trading these investments.

Shares that they consider 'penny stocks,' which are usually stocks for $5.00 and under, are not option eligible. This means that you can not sell short, set stop loss orders, or buy on margin. For most traders this would not be an issue anyway, because these are all more exotic trading methods, and ones that I strongly warn against.

As well, depending on the stock exchange that the shares are listed on, you may not be able to use limit orders to buy or sell, and will have to take the best available market price. There is much more on buying and selling coming up on this site.

Penny Stock Investment Horizon

Traders generally tend to hold penny stocks for shorter time frames, and attempt to get their returns from the stock in a matter of months rather than years.