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Penny Stock Trading Considerations

There are many differences between penny stocks and other types of investments, which means that your investment approach towards penny stocks must be adapted accordingly.

(For a full discussion of all the differences, be sure to read Big Stocks vs. Penny Stocks, in Chapter Two of Understanding Penny Stocks.

Compare Penny Stocks to More Conventional Blue-Chip Stocks

	Penny Stocks	Blue-Chips
Value and Predictability	Less actual value, greater perceived potential, less predictable	Safer but boring, no potential for a price explosion
Speculation	Highly speculative. For some penny stocks, speculation is all they have going, while others see their shares soar on speculative buying.	Little or no speculative value.
Fundamental Analysis and Information Availability	Poor visibility levels, lower reporting responsibility. Can be researched properly if the Leeds Analysis method I describe in Chapter Three is applied.	Well known, heavily followed companies have a wealth of information available.
Technical Analysis	TA methods can not be applied to penny stocks, except for the proprietary techniques and indicators I describe in the second half of Leeds Analysis later in this book.	TA can be easily applied to high volume shares.
Volatility	Highly volatile, with more frequent profit-taking opportunities, and greater price swings.	More secure and insulated from volatility.
Spread	Greater percentage difference between prices of buyers and sellers.	High volume stocks have very little spread between the bid (buying offer) and the ask (selling offer) prices.
Risk / Reward Ratio	The risks are higher, while the potential rewards are much greater.	Less risk, less reward potential.
Ease of Acquisition	More complicated to purchase some types of penny stocks, such as those trading Over-The-Counter.	Much easier to trade through your broker, no special commission rates.
Revenues and Company Life-Cycle	Lower, or no actual revenues. Initial or growth stage companies.	Mature or advanced companies, less growth but greater revenue streams.
Revenues and Company Life-Cycle	Lower, or no actual revenues. Initial or growth stage companies.	Mature or advanced companies, less growth but greater revenue streams.
Dividends	Very rarely pay or are in the position to pay dividends.	Many blue-chip stocks pay dividends.
Takeover or Acquisition Targets	More likely to be taken over by another company, which is usually very beneficial to the price of the shares.	More likely to be the company purchasing or taking over the smaller player, which is usually detrimental to the price of shares.
Industry and Sector Influences	Highly exposed to sector influences, to the potential benefit or detriment of the shares.	Insulated to the impacts of the sector and industry.
Economies of Scale and Niche Marketing	Niche marketing is more important, because penny stocks can not compete with the economies of scale of the bigger players in their field.	Benefit from economies of scale, but can not respond, react, or adapt to the smaller companies quickly enough. Often leave niches exposed for penny stock companies to capitalize.
Driving Factors vs. Fiscal Situation	Share price is not strongly tied to fundamental results and the balance sheet.	Fundamental results and the balance sheet are the most important factor to the share price.
Irrational Spikes and Profit Opportunities	More frequent and extreme spikes and dips, from less provocation.	More stable, less volatile.
Broker Policies	For certain types of penny stocks, brokers can charge greater commissions, or be problematic.	Brokers will not be problematic for trades in blue chip stocks.
Investment Horizon	Gains can be seen in short time frames, from hours or days, to weeks or months.	It often takes larger, slow-moving companies years for their share prices to advance meaningfully.

Large Price Spread

The difference between the bid and the ask price is generally greater for small cap stocks. (To learn more about price spread, review the section of Understanding Penny Stocks entitled Trading Stocks).

This is due to two factors

Fewer parties are involved in the trading of penny stock shares.
Appropriate valuations are much more difficult to estimate for penny stock companies.

The spread between bid and ask prices for small cap stocks can often be greater than 10%, so it is very important to use a LIMIT order rather than a MARKET order, so as to ensure the trading price of the shares you buy or sell. (Learn about market and limit orders in Chapter Two, in the section entitled, Trading Stocks.

Volatility

Penny stocks are often very volatile and can make large percentage moves in short time frames. This means that investors should keep a watchful eye on their investments, rather than buying and holding for the long term. While there are many penny stocks available which may be long term investments, they still need to be monitored very closely due to their volatility.

Conventional Rules Don't Always Apply

Forces driving penny stocks are very different than those affecting the share prices of other types of investments. For example, speculation, promotional efforts, seasonality, and 'potential' are a few criteria which should be examined in greater depth with penny stocks than other investments.

As well, depending on the type of company, patents and technological innovations, success of surrounding exploration claims, past management effectiveness, and corporate alliances can also play a major role in the direction of the share price.

While other criteria do apply, such as technical indicators, standard fundamental analysis, insider trading, and institutional sponsorship, they impact the underlying stock differently depending if it is a small company or a large company.

Takeover and Acquisition Targets

The smaller relative size of many penny stock companies makes them more likely to be taken over by larger companies in the same industry.

As well, many smaller companies have the rights to important exploration lands, technology patents, or strategic market share which they don't have the resources to effectively exploit, meaning that larger corporations can move in and benefit where the smaller company was unable to.

When a company gets taken over it is usually to the benefit of the shareholders, as they often realize a price increase in their holdings.

Investor Expectations

The reasons for investing in penny stocks generally involves the hope of large, significant profit. The average investor will hold their shares in a penny stock company for shorter time periods than they would for a blue chip corporation, and will hold out for significant profits before selling their shares. This is important to consider when gaining an understanding of investor sentiment towards a particular company, and extrapolating share price movements from that understanding.

Investor expectations are also different as they relate to company operations. It is generally more acceptable for a small cap company to be losing money, over-spending on research and development, or growing very rapidly.

It is less than acceptable from an investor's point of view for a penny stock company to be undergoing negative or nil growth, to be paying dividends, or to be diversifying among non-related industries.

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