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What are penny stocks? Penny stocks are low-priced, small-cap stocks and are used for swing trading.

When most people hear the words "penny stocks," they assume that they are stocks trading for less than $1. However, the SEC definition of penny stocks is all shares trading below $5.

Although most penny stocks do not trade on the major market exchanges, there are some large companies that trade below $5 on major exchanges like the NASDAQ.

What are Penny Stocks

Penny stocks are small companies whose shares are highly illiquid and speculative. The company typically has limited listing requirements and fewer filing and regulatory standards.

They are companies that are often near bankruptcy or are highly overleveraged. This makes penny stocks very volatile and risky. Given the level of risk, they also have higher potential returns.

Because penny stocks are cheap and can promise big profits, they may appeal to many traders, especially new and inexperienced traders.

For example, if you buy a 5,000 shares of a $0.50 stock for $2,500 and it goes up to $1, then you would have made $2,500 profit and doubled your money.

Given the high level of risk associated with investing in penny stocks, they should be traded with precaution.

For example, you should have a predetermined stop-loss order before making a trade. You should know what price to exit the trade if the market moves in the opposite. This will help you cut your losses.

Should I Invest in Penny Stocks?

Generally, it is a good idea to stay away from stocks that do not have any financial or disclosure requirements. However, if you are interested in trading penny stocks, you should have a high-risk tolerance and you should do substantial research in deciding which penny stocks to buy.

Pump and Dump

If you are going to trade penny stocks, be careful to avoid the pump and dump scheme. There are a lot of penny stock scammers who deceive inexperienced investors by luring them to invest in these cheap stocks.

For example, a promoter will recommend a stock using exaggerated statements in an effort to boost the price of the stock. He will say good things about the stock to influence their listeners or readers to buy the stock because he has the stock himself.

The people who fall for the scheme will buy his recommendations and once they have bought in, the promoter will sell his positions after the hype has led to an increase in the stock price.

This would then drive down the price, resulting in big losses for anyone who bought these penny stocks as they could not sell their shares in time. This "pump and dump" scheme literally means pumping up the stock price and then dumping the shares after the price surges.

The opposite of the pump-and-dump scheme is the short-and-distort. This is where the scammer short-sells to make a profit.

He borrows shares and sells them immediately in the open market at a high price, hoping that the price will fall so he can buy the sold shares at a lower price.

He then returns these shares to his lenders and makes a profit. Penny stock scammers make sure the stock falls by spreading bad news about the company.

How Do You Buy Penny Stocks?

Penny stocks trade on major exchanges such as NASDAQ and NYSE. They also trade on OTC (over the counter) market.

Pink Sheets

Typically, penny stocks trade on the Pink Sheets or FINRA's OTC Bulletin Board (OTCBB). Pink sheets, also known as OTC market, are daily publications with bid and ask prices of OTC stocks.

They allow companies not listed on major stock exchanges, such as the NASDAQ or NYSE, to trade. Stocks that don't trade on major exchanges are said to trade over the counter. However, there are legitimate penny stocks. Some companies just aren't large enough to list on the NYSE or NASDAQ.

Generally, companies trade on the Pink Sheets because they are too small to be listed on a national exchange or they don't want to make their financial statements public.

Stocks on the Pink Sheets should be approached with extreme caution because they do not have any reporting requirements with the Securities and Exchange Commission (SEC) nor do they have to disclose any financial information to investors. It is difficult to analyze companies trading on the Pink Sheets because of the lack of information about them.

Likewise, it is also difficult to find information on stocks trading on the OTCBB to formulate a decision on whether or not the company is likely to survive. Often times, a company has been delisted from a major exchange because it cannot meet certain requirements and has to trade OTC.

There are no minimum standards that a company needs to meet in order to trade on the Pink Sheets or the OTCBB. Regardless of whether a penny stock is listed on the Pink Sheets or the OTCBB, it will be hard to find credible information on them.

How to Buy Penny Stocks

If you want to know how to trade penny stocks, you must do substantial research so you don't lose all your money.

10 Rules for Trading Penny Stocks

If you feel confident that you will not fall for any penny stock scam and you want to try your hand on trading them, you can use the below are tips for buying penny stocks:

1) Risk-Reward Assessment - before purchasing a penny stock, you need to make sure the stock truly has the potential to go up. You should also create a risk-reward assessment for the stock, even if you are not planning to invest much. How much risk are you willing to take for the amount of reward you're expecting?

2) Diversify - limit your holdings in the penny stock to a maximum of 1 or 2% of your overall portfolio. If you want to diversify and invest in more penny stocks, limit them to a maximum of 10% of your overall portfolio.

3) Stop Loss - set up a stop-loss order before buying the penny stock. Knowing what price to exit the trade if the market moves the opposite way will help you cut your losses.

4) Short Term Only - sell quickly and don't the penny stock for long-term. Penny stocks are made for short-term trades, not long-term buy-and-hold investments.

Because of this, it is important to know when to sell if you buy. If your stock has gone up a sizable amount such as 20 or 30% in a few days, it might be a good idea to take profit right away instead of waiting for larger profits that might never materialize.

Sell quickly if you make that kind of return. Some traders get too greedy and lose it all. Consider that the penny stock you purchased might be getting pumped, take your profit and move on.

5) Penny Stocks Volume - invest in a stock with adequate liquidity and trading volume, such as those that trade at least 100,000 shares a day. This way, if your stock does go up, you can actually sell it for a profit. Otherwise, if there are few buyers, the bid-ask spread will be large and it will be hard to sell your shares.

6) Ignore the Hype - ignore penny-stock success stories. Do not believe everything you read in emails and social media websites. A lot of the tips that you read from newsletters have a disclaimer at the bottom, where the writer is getting paid to pitch a stock.

7) Smaller Positions - don't trade large positions. Limit your share size in case you need to exit the trade faster. A good rule is to avoid trading more than 10% of the stock's daily volume.

8) Research - do your research and buy only the best ones. Not all penny stocks are created equal. There is a difference between a penny stock t hat is making a new high based on an earnings report and a stock making a new high because two newsletters pitched the stock.

Some penny stocks are fallen angels. For example, Citigroup traded below a dollar in March 2009.

9) Company Manager - check the company's management. Learn about the company's executives and directors and check to see if they had any notable successes or failures. Whether or not the company succeeds depends on the quality of the management.

10) Financial Statements

11) Avoid OTC Penny Stocks - avoid penny stocks trading on the OTC market because there are fewer regulations. Find the best penny stocks listed on NASDAQ and NYSE since those companies need to meet stricter requirements.

12) Discipline - don't fall in love with a stock. This rule applies to any stock, not just penny stocks. Look for the best patterns and setups to enter the trade.

If you are unsure about the pattern, skip it and find another one. There are plenty of other penny stocks. Don't be in a rush to enter a trade.

How Many Penny Stocks Are There?

There are over 10,000 penny stocks. However, some of them are so thinly traded that it is very difficult to exit a position. To find penny stocks to buy, you must do your own research and only invest in the best managed companies.

Read more to learn about swing trading strategies and Penny Stocks For Dummies.

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