How to Find and Invest in Penny Stocks (ADAT, ANAD)

Experienced investors with higher risk tolerance sometimes turn to penny stocks. Penny stocks are those companies that trade with a share price that is below $5; however, often penny stocks can be less than $1, as the name suggests. So you can see why rookie investors get hooked by the dream of buying into a company for only a few cents and then selling shares for a substantial profit when the price trades back in the multi-dollar levels. The extremely low share prices allow an investor to hold thousands of shares for a relatively small amount of invested capital. With that scale, the gain of just a few cents per share can translate into sizable percentage returns; however, it is important to note the reverse is also true, of course. 

Of course, such stocks are considered to be highly speculative because of their lack of liquidity, large bid-ask spreads, small market capitalization, and limited following and disclosure. If you feel like you are ready to start trading penny stocks, though, here are some guidelines. 

Some penny stocks are traded on regular exchanges such as the Nasdaq. However, major stock exchanges, such as the NYSE and Nasdaq, have special listing requirements. For example, according to Nasdaq Rule 5550(a), failure to have a minimum bid price of at least $1 per share for primary equities will result in being delisted.

Thus, literal penny stocks that trade for less than $1 per share, as well as some stocks under $5 per share, are primarily traded on the over-the-counter bulletin board (OTCBB), and through the Pink Sheets. The Pink Sheets are merely a quotation publisher, while the OTCBB holds a bit more legitimacy as it maintains some minimum listing requirements. Pink Sheets stocks are not registered with the SEC, nor subject to any listing requirements, and therefore carry substantially more risk.

Stock brokers play a fundamental role in the trading business. They provide the necessary trading infrastructure and can significantly influence the preferences, behavior and trading patterns of investors.

When looking for a penny stockbroker, one aspect to pay particular attention to is their fee structure. Some brokers charge commissions on a per-share basis. This structure is usually set at a particular rate for the first specified number of shares, and then another rate for each additional share. This structure is better suited for investors who are buying a relatively small number of shares and may not be the best structure for penny stock traders. It may prove more useful to shop around for a broker that offers a relatively low flat rate per trade regardless of how many shares are traded. The lower the flat rate, the smaller the impact that fees and commissions have on the final return. Considering the above-mentioned concern areas and high risks associated with penny stocks, the case of penny stock brokers (and their roles) becomes more interesting. It's crucial to select the right advisor for highly speculative investments like penny stocks. 

Here is a list of regulated penny stock brokers in the United States. Brokers are listed in no particular order, and the list is not exhaustive; there are many other regulated penny stock brokers:

• ChoiceTrade: ChoiceTrade offers penny stocks on the Over the Counter Bulletin Board (OTCBB) and Pink Sheet markets. With Stock Plan "A" customers get commission-free stock trades. Stock Plan "B" customers get $5 stock trades. For all other stock trades, it charges a flat fee of $7 per trade. An additional $0.0007 per share charge applies to shares over 10,000. ChoiceTrade is registered with the Securities and Exchange Commission (SEC) and is a member of NYSE Arca, the BATS Exchange, and the Securities Investor Protection Corporation.
• Charles Schwab Corp: Schwab offers penny stocks trading through its standard stock trading accounts. One can trade Over the Counter Bulletin Board (OTCBB) and Pink Sheet securities online through the Schwab website and mobile app. The penny stock brokerage charges are $4.95 per trade.
• Interactive Brokers (IB): Interactive Brokers offers penny stock trading in selected stocks on the Pink Sheet and OTCBB through its standard equity trading account. It offers a fixed-rate structure and tiered structure. Fixed pricing starts from $0.005 per share for a minimum $100 trade order, while tiered starts from $0.005 per share for more than 100 million volume per month.

Beyond the list mentioned above, shares of penny stocks can also sometimes be purchased through an individual’s regular stockbroker. If you are exploring a new brokerage, though, here are some questions to ask and some key points to consider.

• Does it have an online (and mobile) trading platform or is it simply call-and-trade?

Most brokers today offer online trading and mobile apps. Relying only on the traditional phone-based call-and-trade facility can lead to undesirable results in price fluctuations while you're waiting for an order taker to get on the line to place your order—significantly impacting your trades, as prices fluctuate each minute. Additionally, there may be call-and-trade charges for each call you make. Self-help online options—a live screen with instant pricing and info available—are always better than waiting on the phone, not to mention that you won't have to pay for the cost of a phone call.

Depot and Nostro facility: A depot (depository) is your demat (dematerialized) account where you keep your shares. A nostro account is your bank account where you keep your money for buying and selling shares. All stock brokers offer depot but a select few offer nostro. It is important to choose a stockbroker offering both Depot and Nostro facilities (either on its own or with seamless integration with banks and depositories). 

Penny stock trading is a speculative game, where prices fluctuate each minute. Instant and reliable money transfers are essential for efficient and timely trading. If your capital transfers fail or get stuck through the multiple bottlenecks, or if it takes time to clear your money from your account to your broker's account, then your penny stock trading will suffer greatly. A broker offering both depot and nostro facility (or seamless integration across) is the best bet.

Charges, charges, and more charges: One important part of any stock trading is transactional costs, which gains further importance in the case of penny stocks since each penny price move matters.

Let’s take a simple example you intend to buy a penny stock currently trading at the CMP (Current Market Price) of $0.10 each. You expect the price of this to double to $0.20 for quick and high gain. However, if your broker’s commission structure is such that it effectively charges you $0.05 on each buy and sell leg of your trade, then all your profit opportunity is lost even though the stock price is doubling. You are already taking a risk on investing in high-risk penny stocks — additionally paying the high charges that direct your profits to your broker. This is clearly an undesirable situation. It is important to be fully aware of what you will pay to the broker for such high-risk investments.

Awareness of the following points, especially with regard to penny stock trading, is important when choosing a broker:

• Transaction charges: This is the general brokerage charge often listed on brokers’ websites as “Brokerage starting from $x per trade” or “3% per trade order”. Attention should be paid to any additional terms and conditions mentioned, like $x may be a promotional first month only offer, or $x may be applicable only after you make at least 20 trades per month; trading below that may have much higher charges.
• Minimum brokerage per share charges: The penny stock you intend to purchase may have a current market price of $0.10 only. Purchasing 10,000 shares should ideally cost you $1,000. However, the broker may have “minimum brokerage on a per share basis”, which may be (say) $0.03 per share you buy/sell. Hence, your total buy price will shoot up significantly by 30% to $1,300. But this is not all. The same may apply to the sell-side leg of your trade. Hence, to profit from this trade, your penny stock price will have to shoot up significantly (multiple-folds) to enable you to profit from this investment. For such “minimum brokerage per share charges”, the majority of the money is going towards the brokerage, leaving little room for your profit.

The above-mentioned details provide a few important points about what a penny stock trader should be aware of while selecting a broker. It's best to request a written/printed schedule of charges (and any additional conditions, top-up charges applicable) so that you are aware of all details up front.

A word of caution—most penny stock brokers heavily promote online account opening, offering big discounts or cash-back offers. However, online account opening will mean ignoring the conditions in fine prints and additional charges. It is advisable to thoroughly read and understand each detail, call up the helpline and ask for a written schedule of charges to keep your investments safe.

Let’s continue with other points beyond transactional charges:

• Is short selling allowed? Although short selling may be bound by regulatory requirements, a few brokers may disallow short selling in penny stocks, as a risk management measure at their own. Those allowing short selling may need higher margin amounts to be maintained for the short positions. Due to the highly volatile price patterns of penny stocks along with high margin requirements, traders short selling penny stocks should be prepared to provide additional margin money at short notice.
• The response time of the website and hold time on the phone: the high volatility in prices of penny stocks within a short period has an effect on both the buying and selling legs. A trader may not be able to get in or out of a position if the broker’s site or the hold time on the phone takes too long, leading to prices changing significantly away from the desired levels.
• Offered functionality and tools: Do you need a broad range of customer services? Special access to dedicated research tools and reports on penny stocks? Streaming data feeds and technical indicators on top of them? Any such features, although listed on promotional ads or websites, may not be free and may come at high (recurring monthly) costs. Be aware of the costs of special features and choose only the features that you need. 

Further considerations for foreign investors:

• Forex risk comes into play
• Forex markup fees increase the cost of trading
• Trading with foreign brokers increases the risk, as in the case of disputes the investors may have to approach the foreign authorities for a resolution, which may not be smooth and may turn out costly.

Penny stock scams (and how to avoid the pitfalls):

Anything that appears to offer high returns with low costs has as fraud potential. Certain typical red flags each investor should be aware of:

• Heavy unofficial promotions through internet/emails
• Promotions through brokers' boiler room telemarketing calls instead of open and fair marketing
• Claims about insider information leading to a penny stock being the multi-bagger
• Vaguely labeled newsletter and online forums filled with lots of “recommendations.”

Common traps that penny stock investors should be aware of are:

• Pump and Dump schemes: Promoters claiming access to “insider information” to inflate the prices, but in reality may be attempting to offload the earlier purchased low-cost lot at high profits. The investors who act on these tips may end up sitting with high-cost investments.
• Short and Distort: Another variant of pump and dump, working in the reverse direction. Promoters short sell the penny stock at a high price and then promote negative news about the stock to lower the price and square off their positions for a big profit.
• Long-term averaging techniques: A cyclic scheme, where investors are advised to keep on accumulating a penny stock with each price dip, with assurances of windfall profits once the stock prices take a positive turn. Recommendations from brokers play a fundamental role in such schemes. 

Now that you understand where to trade penny stocks, the next step is to determine what stock to trade. One popular method is to use stock screening tools, such as the one found on the OTC Markets website or Finviz. Screening for stocks with a price under $5 is the easiest way to narrow down the trading universe. From here, you can filter the list down further depending on your strategy and risk tolerance. For example, perhaps you are only interested in penny stocks that conduct business within the technology sector. In this case, you’d make the necessary adjustments and then run the filter.

If you're a beginner at using stock screeners, check out: Finviz.com Stock Screener: An Introduction. Once you get the hang of using Finviz’s stock screener, your list, based on the filter above, should look something like this:

When it comes to trading penny stocks, it's critical to understand the risk. In most cases, these companies are small-cap stocks and are susceptible to major volatility. Whenever money is put at risk in an attempt to make a gain, there is the risk of substantial loss. This is particularly true when it comes to investing in penny stocks, so tread carefully. Since most institutional investors have rules set up that prevent them from trading penny stocks, they generally lack a following in the investment community. Therefore, liquidity is a serious concern and should not be ignored. It's not uncommon for retail investors to get stuck in a position or for it to take several days or weeks in order for there to be enough supply or demand to enter or exit a position without serious price fluctuations. 

Share Price and Valuation

One of the biggest mistakes that retail investors make is that they view penny stocks as being affordable. There is a sense that one is getting a better bang for their buck when they buy thousands of shares rather than a couple of a company with a higher share price. At first glance, this thinking seems rational, after all, a $1,000 investment in a Company A that trades at $0.10 allows the investor to buy 10,000 shares rather than ten shares of a Company B that trade at $100. The key piece of information that is often overlooked is the number of shares outstanding. Let’s assume that Company A and Company B shared identical fundamentals with the exception of the number of shares outstanding. For ease of example, let’s also assume the companies have a market capitalization of $100 million. Here is the information in the table for easier understanding:

When share price is the only factor taken into consideration, a retail investor might think that the quality of the firm trading at $100 is much higher than the one trading at $0.10. As we’ve seen in the example, this may not always be the case since they are identical, so it is important to consider the number of shares available.

Beware Dilution

Another factor to be conscious of when trading penny stocks is dilution. The number of shares outstanding can often balloon out of control through the use of tools such as employee stock options, share issuance to raise capital and stock splits. If a company issues shares to raise capital, which many small companies need to do, then it can often dilute the ownership percentage held by other investors. For example, if Company A issued an extra 110,000,000 to raise capital then it's natural that the share price would decline to $0.09 ($.09 keeps the market cap steady at $100 million). In this case, the underlying business hasn’t changed, but the number of shares has, which has caused the share price to drop.

When trading penny stocks, it is important to find a company that as a strong grasp on its share structure because consistent dilution erodes the value of the shares held by existing owners.

How to Spot a Winner

Most companies that trade with share prices under a dollar have relatively small market capitalizations, but as shown above, this doesn’t always have to be the case. When it comes to investing, it is important to consider the strength of the company’s fundamentals. Does the management team rely on issuing new shares to raise capital? Is the company profitable or will it be able to turn a profit based on its current business structure? Can the company compete in its sector? For those willing to do their homework there are gems that can be found that meet these criteria.

As you can see from the monthly chart of General Growth Properties, Inc., the company’s share price got battered down into penny stock range during the financial crisis of 2008. For those who don’t follow the company, GGP owns, manages, leases and redevelops real estate such as regional malls in the U.S. Investors who kept an eye on the share structure, underlying fundamentals, and competition could have identified GGP as a prime candidate and profited from a tremendous rise in the years that followed. As of August 15, 2016, GGP is trading at $30.04. 

Another key factor to consider is that certain sectors are more common for finding stocks that trade under a dollar. For example, the metals and mining sector is well-known of the number of companies that trade in the pennies. Given the reliance on issuing new shares to raise capital to fund operations, increased competition and aggressive incentive plans it's particularly important for investors to pay attention to the factors mentioned above in order to be successful. 

Though risky, penny stocks have a potential payoff in the form of volatility. Typically, volatility is viewed as a negative. But in the realm of penny stocks, many investors hope to profit from sudden, large price jumps. Though it is rare to find companies that can make a successful jump from penny to power stock, when it happens, investors reap the benefits in spades. The numbers vary widely in the world of penny stocks, but investors have been known to bring in gains of over 1,000% in the period of a few weeks. The secret to success in this is, of course, doing diligent research to find the right stock.

Investing in penny stocks can be precarious, and is not for everyone. If you feel like you understand the risks and are ready to proceed, then the first step is to find a broker, fund an account and then find a suitable trading candidate. Stock screeners are probably your best bet in narrowing down the universe of stocks so that you can find one that meets your trading style and risk tolerance. If you would like to improve your trading skills, check out this online day trading course. 

Note: This story was created with reports from Casey Murphy and Shobhit Seth.