Penny Stocks For Dummies. Peter Leeds

good news is that everything you need to know to trade penny stocks successfully is included in this book. I have no doubt that you will become a phenomenal investor in low-priced shares if you follow the suggestions discussed in these pages.

      However, my biggest hope is that you go a step further and help protect your friends and family from getting burned by the wrong kinds of penny stocks. They’ll never know that you saved them thousands. They’ll never thank you. But isn’t that the best kind of reward?

Comparing Penny Stocks to Their Blue-Chip Cousins

      Many differences exist between penny stocks and higher-priced shares. By being aware of how smaller companies and their lower-priced shares behave, you can position yourself in the right kinds of investments and make better trading decisions. More important, you’ll have an idea of whether this type of investment is for you.

      Investors typically organize stocks into the following categories:

      ❯❯ Large cap companies, also known as blue-chip stocks: Any company whose shares value the business at $5 billion or more are known as large capitalization companies, or large caps for short. Some investors use the value of $10 billion as criterion to apply the large cap moniker, while others use different parameters.

      Shares of the very biggest companies, which are valued at billions of dollars, are known as blue-chip stocks. Many of these companies are household names, such as IBM, McDonald’s, Disney, and Exxon, and trade on the New York Stock Exchange (NYSE) or on other major stock markets (see Chapter 3 for details on the various markets).

      ❯❯ Mid cap companies: The term mid cap is short for middle capitalization, but you’ll probably never hear the long version of the name. These companies are typically valued between $500 million and $5 billion, but again this depends on who is providing the definition.

      ❯❯ Small cap corporations: These companies have total values of between $50 million and $500 million.

      ❯❯

      Micro caps, also known as penny stocks: Any company whose total value is less than $50 million is considered a micro cap. Because penny stocks typically represent smaller, growing corporations, they’re often in the micro cap category. This category of stocks reacts to situations that are unique and material to it, even when the same events would have little impact on much larger companies.

      

Although micro caps are similar to blue-chip shares, only smaller, they play by their own set of valuation and price behavior rules. To become consistently successful trading penny stocks, you need to understand this concept and the specific ways in which these micro cap shares behave.

      Volatility and speed

      In terms of percentage of the share price, penny stock shares make greater moves, and more quickly, than their better-capitalized counterparts. Several factors cause faster and larger price changes:

      ❯❯ Starting from lower prices: The lower the price of the shares, the greater any moves in them will be, proportionately. If a penny stock increases from 20¢ to 30¢, that’s a 50 percent gain. The same ten-cent jump in a stock priced at ten dollars per share only represents an increase of 1 percent.

      ❯❯ Earlier phase of corporate life cycle: When a company is new, its potential is wide open. It may end up at point A or point Z, or anywhere in between. Any event or shift in the mind-set of investors can result in major changes in expectations for the company’s future. With any early shift in that anticipation comes significant adjustments to what investors are expecting from it, and those adjustments directly impact the share price.

      ❯❯ Thinly traded: As penny stocks are generally traded by fewer people, and in smaller amounts, a large buy or sell order can move the price significantly. If there is a limited supply of shares for sale at lower prices, any significant buying demand may push the price up into higher prices.

      ❯❯ Changes in speculation and potential: The prices of penny stock shares have a much greater basis in speculation and potential. In other words, what a company theoretically “could” do has a lot more value when it is just getting started or is in the early phase of its life cycle. Unlike quarterly financial reports, or gradually improving client lists, for example, massive shifts in speculation can occur quickly and have a dramatic impact on the potential for the underlying company and its share price.

      ❯❯ Fewer, more meaningful events: Newer and smaller companies typically experience fewer major events. When they do have something to report, such as a new client win or a patent approval, that event will have a proportionately greater impact on the company.

      

To invest in penny stocks well, you need to understand the reasons behind the larger, and more rapid, price moves. Proper knowledge leads to improved anticipation, clarity, and wiser trading choices.

      Safety and risk

      Most people in the financial world consider larger companies to be safer investments, and for the most part they are correct. Companies tend to grow in size as they become successful (as expressed by a higher share price and larger market cap). And the bigger a company gets, the more financially stable and resilient it is. In contrast, newer, smaller, or less-successful companies generally see their stock trading for low prices. From this perspective, penny stocks are typically riskier or lower-quality investments than larger companies.

      The risk and perceived lack of safety associated with penny stocks are what create the opportunities for penny stock investors to reap substantial rewards. If the underlying companies were not in a financially precarious state, penny stocks wouldn’t trade as penny stocks at all, but would instead be priced at much higher levels.

      Investors who can identify and accept areas of concern for a company, or anticipate improvements in those risk factors, can find numerous values among low-priced shares.

      

Opportunity exists for those penny stock investors who can

      ❯❯ Accept the risk. As long as you’re aware of the greater perceived risk and are willing to accept it in exchange for the potential of greater returns, you can find opportunities among penny stocks.

      ❯❯ Find overblown risk perceptions. When investors are overreacting to a company’s risk factors, they may greatly undervalue the shares. Investors who recognize that the concerns are overblown can accumulate shares at very low prices. For example, if a drug development company with 12 products fails to get FDA approval for one of them, the shares often collapse in response. But investors who remember that the company has another 11 drugs in development will scoop up the shares for a fraction of what they’re actually worth.

      ❯❯ Identify shrinking degrees of risk. Often the risk factors keeping the shares of a company down eventually abate or change for the better. Usually there is a delay of weeks or months between when circumstances improve for the company and the resulting share price increases. That delay represents an opportunity for people to invest in a penny stock that’s being held down by perceived risk that’s no longer a factor.

      Investor following and visibility

      Larger companies generally trade on bigger stock exchanges (I tell you all about stock exchanges in Chapter 3). Those companies have more investors, a greater number of people following their shares, and larger amounts invested in them.

      When a massive company trading on the New York Stock Exchange needs to raise money, it generally doesn’t have a problem getting that cash. Given its high level of visibility among investors and its large following of institutional investors and analysts, it is able to generate the funds it requires.

      Penny stock companies, on the other hand, have far fewer involved parties and are usually listed