Anyone can make a few bucks in stocks like Google (NASDAQ:GOOG) or Microsoft (NASDAQ:MSFT), but to really hit home runs, you need to turn to penny stock investing and look for the unloved, the undiscovered and the misunderstood stocks.
There is no shortage of companies priced under $3 per share, but to successfully take advantage of the abundance of opportunities, you need a penny stock investing plan.
Here are six rules to follow when investing in penny stocks:
Rule No. 1 — Always Use Limit Orders
By their nature, penny stocks are very thinly traded. As such, the deviation between the bid and the ask can be very large. Investors that use market orders can be manipulated by market makers looking to make a quick buck.
The use of limit orders prevents the market maker from buying or selling at any price. In other words, buy or sell penny stocks on your terms, not the market makers’ terms.
Rule No. 2 — Trade During Regular Hours
This rule goes hand-in-hand with limit orders. An absence of volume can result in after-hour trades that make little sense and most certainly do not represent an efficient match of buyer and seller.
I’ve seen after-hours trades executed at prices well above or below the closing price in the market. With penny stocks, even a few pennies’ difference can make or break a trade. My advice is to stick to regular trading hours to elicit the most efficient trade.
Rule No. 3 — Don’t Chase Performance
The biggest mistake I see investors make is to chase a trade. For whatever reason, some investors choose to buy only after a stock moves higher. When a stock takes off, these folks decide that the waters are safe to participate. Nothing could be further from the truth.
In many cases, by the time you decide the water is safe, the opportunity is gone. Losses then follow. This effect can be magnified with penny stocks that can move very quickly one way or the other. In order to avoid this investing mistake, stick to new recommendations and the buy limits that come with them.
Rule No. 4 — Keep Your Holdings Down to 20-30 Positions
This rule is a golden rule of any investing strategy and one that I believe in without question. Maximum gains can be achieved with a portfolio of 20-30 positions.
Build a portfolio with more than this number, and dilution of returns will be the result. Build a portfolio with less than this amount, and the likely outcome is to be performance that lags significantly. Even worse, buying too few stocks runs the risk of big losses.
With penny stocks, I know for certain 25% of the positions will be poor performers or losers. That might seem like a bunch, but keep in mind that leaves 75% of the portfolio generating significant gains.
What I can’t tell you with certainty is which stock will be in which category. Try to do that guessing on your own, and you are likely to get burned. Stay diversified if you want success.
Rule No. 5 — Buy and Sell for a Reason
This might be overstating the obvious, but it is surprising how many people buy stocks simply because they are moving. Investors need to understand exactly what it is that they are buying and why they are buying it.
It is OK to own a stock that already has increased in value as long as there is a good reason to do so. I call these reasons “triggers.” A stock without a trigger can never take off. Think of the rocket ship that needs a booster to leave Earth’s atmosphere. The same is true with penny stocks. Without that reason for moving higher, a stock is likely to wander in the wilderness.
Rule No. 6 — Expect an Average Holding Period of 90 Days
Penny stocks are volatile creatures. They can go up fast, and they can go down fast. In most cases, I am looking for big gains to come in 90 days or less. If that move does not occur, I move on to the next opportunity.
In some cases I might go back and forth on a single stock because of the volatility. There will be no rapid-fire day trading, mind you, but I will not hesitate to sell a stock if I think it will be going down in value and vice versa.