Last Updated on Dec 20, 2019 by James W

Penny stocks are such a cheap investment that it’s tempting to just dive right in. However, this isn’t a smart strategy for making money. Instead, you should start by researching these three essentials before you start trading penny stocks.

Market Regulations

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Before you trade any stocks, you need to understand how the special markets where most penny stocks are listed work. Over-the-counter (OTC) markets are different than markets like NASDAQ and the New York Stock Exchange. You can find some shares listed under $5 each on those highly regulated markets, but most of your trading will likely be done on OTC markets.

OTC markets have their own standards. Some, like the OTC Bulletin Board, have minimum standards that companies must meet to post their shares for sale there. Others, such as Pink Sheets, have lax requirements. Companies on those markets may not have to post accurate financial statements, which can make trading on less-regulated markets especially risky. So, before you execute a trade, check the market requirements that companies must meet in order to post their shares for sale.

The Unique Risks of Penny Stocks

Penny stocks are affordable, so the financial risk might be more manageable for you. Most people don’t need to deposit thousands into a cash account to get started with these shares. However, penny stocks are risky — just like any other type of investment. Understanding their unique risks is also key to learning how to make money with penny stocks.

For example, many companies that offer shares under $5 each are either new or unproven. You can offset this risk through due diligence in terms of researching a company’s financial history and business plan. Also, like any other type of investment, some companies use penny stocks as a means to scam investors. Watch for common strategies illicit businesses will use and beware the unique risks of penny stocks.

How to Value Shares

The affordability of penny stocks can also cause some confusion in terms of how valuable they really are. For example, you might think that holding hundreds or thousands of these shares will entitle you to huge profits if those shares gain lots of value. Maybe — it depends greatly on the company’s market cap, the total shares they have available, and other factors.

To make more accurate decisions about buying or selling penny stocks, you need to practice stock valuation. The main types of stock valuation are absolute valuation and relative valuation. The former looks at the core value of an investment, and the latter gages the shares’ value by comparing the company to similar businesses. Both are useful, but you may find yourself using one or another based on your trading strategy and what works for you personally.

Penny stocks are appealing for an obvious reason. But, just because they’re affordable doesn’t mean you should jump into trading without reservation. Remember to take your time researching and to learn all you can about market regulations, risks, and valuation methods. With this knowledge in hand, you can approach the market with a proven strategy and make trades that are more likely to be profitable.

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