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How Do You Make Money with Penny Stocks?

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New investors often see stocks with low prices and think they're bargains. After all, a stock worth $1 per share only has to gain $1 to double your money, while one worth $100 per share has to gain $100 to double your money. While the math is true, the math is misleading. The secret of making money in the stock market is patience. See, for example, Peter Lynch's One Up on Wall Street or John Bogle's The Little Book of Common Sense Investing for more details.

If you believe the ads plastered all over the Internet, people are making money with penny stocks, also known as microcap and smallcaps. Unfortunately, you're not likely to get rich if you buy penny stocks. You're more likely to lose money.

These cheap stocks aren't worth it. Penny stocks aren't like normal stocks. They're not listed on any major stock exchange. Even if you have a good online broker, you may have to jump through hoops to buy them, even signing a waiver with your broker.

What are Good Penny Stocks?

A good penny stock is a not-quite-impossible bargain of a company that can turn things around. The business must:

  1. Actually make money (a company that loses money isn't worth your investment).
  2. Have enough assets—or generate enough cash—to pay off its creditors without going out of business.
  3. Execute on its strategic plan to get re-listed on a major exchange.

All three factors are necessary to reduce the risk of investing. Great penny stocks may truly exist, but the odds are against them.

Finding Penny Stocks to Buy

One of the worst parts about buying penny stocks is that obscurity works against you. You want to find a stock that's undervalued. It needs to have a positive value: good financials and an improving outlook. It also needs to fly under the radar of most investors: it must be overlooked.

Before you can buy a stock, other people must be willing to sell it to you at that bargain price. If the company's really going to turn around, why wouldn't they just hold onto it until it gets more attention? Maybe you can luck out and find someone willing to sell a lot of shares at a fire sale price. That's also luck.

Worse yet, now that you've found that bargain basement price and you've actually bought that great penny stock, you're going to have to try to sell it somehow. Maybe you can hold onto it until it's popular again, but it's unpopular for a reason. People aren't looking at it. People don't want to buy it. How are you going to unload it?

Your best hope is to hold it until the company completely turns around and gets back on a normal stock market listing again. That can happen—but the risks are high.

How to Make Money with Penny Stocks

There are three obvious ways to invest in penny stocks. None of them are easy; none of them are guaranteed to make money fast. It's less risky and a lot easier to build wealth with value investing, but you must be patient: first to find good opportunities and then to wait for the results.

Pump and Dump

The most popular way to profit from a penny stock is to buy it cheap, convince other people that it's worth more than you paid for it, then sell it at the inflated price. This is hugely unethical and likely illegal. It's also difficult to make work.

You've probably received spam email telling you about this great hot tip promising "the top penny stocks 2016". The price is about to explode! You'd better buy it now to lock in your profit! Think about that for a second.

Any stock that increases in value does so for at least one reason. Perhaps the underlying business has improved. Perhaps the company's about to be acquired. Perhaps there's going to be a huge order that only that company can fill. If that's the case (and if your anonymous correspondent knows why the price is about to go up), ask yourself two questions. First, why would anyone encourage more people to buy the stock? More buyers means the price will go up. Second, how does that person know the price will go up? (At least without falling afoul of insider trading laws.)

It's a safe bet that your anonymous friend bought shares at 25 cents and wants to get a lot of people to buy shares at 50 cents and is trying to pump up excitement for the stock to attract more buyers. Nothing about the business has changed; it's still worth 25 cents per share. Your friend doesn't want to help you. Your friend won't teach you how to invest in penny stocks and make money. Your friend is looking for suckers to buy the stocks they want to sell.

Get Lucky

An ethical investor would prefer to to buy the stock of a valuable company, then hold onto it until the price reaches a good sales point. Unfortunately, you can't predict luck. There's no simple way to find a list of all of the good, cheap stocks to invest in. Not all good stocks are cheap and by no means are all cheap stocks good: a company financially battered and bruised could easily go out of business and sell off everything to creditors, ultimately paying you a fraction of what you put into the stock.

Struggling companies can turn around, but a struggling company is struggling with a low stock price for a reason. You can put in the research to figure out why. At least in Las Vegas or Atlantic City, you know what the odds of winning are before you put down your money. Penny stocks offer no such guarantee. (Unlike a casino, you won't end up owing money in the stock market unless you chase more exotic investments like futures, options, and derivatives.)

Find a Turnaround Company

Once in a while, a company will go through a horrible bankruptcy and end up restructuring (or getting bought out) at a great discount. Perhaps it can get out from under huge amounts of debt or it has a lot of inventory or capital equipment or real estate or patents or other valuable assets that are worth something to an acquirer.

Maybe it just needs some extra love and attention to get the business back in order.

These investments are rare and risky. It's not easy to predict when an airline will turn around or when a Canadian plutonium mine will find a new vein—but it can happen.

If you're careful and do your value analysis, sometimes you can find diamonds in the rough: companies with a turnaround potential. Sometimes the market is irrational and undervalues a business. It's unfair, but it happens and it represents a real opportunity.

This is rare, and most penny stocks are terrible opportunities.

Are Penny Stocks Worth Buying?

Even if a stock has a great price, and if it seems like 25 cents per share should be easy to double or triple your investment, be calm and careful. Do your research. You won't get rich by spending all of your available time looking for penny stocks to buy, but you can make good money by sticking to value investing to find great stocks at good prices, not risky ones at cheap prices.

Stick with what you can buy and sell fairly. Let scammers find other scammers.