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Oct 03, 2012, 12.09 PM IST | Source: Moneycontrol.com

How to make money in penny stocks

One of the basic rules of buying stocks is to consider 'value'; not 'price'. But when the starting point itself is price, you are committing one of the fundamental investment mistakes.

Sanjay Matai

Author & Promoter, The Wealth Architects

Expertise : Mutual Funds ,Insurance

More about the Expert...

First a WARNING...A STRICT WARNING -- I would sincerely advise you all against investing in penny stocks.

One of the basic rules of buying stocks is to consider ‘value’; not ‘price’. But when the starting point itself is price, you are committing one of the fundamental investment mistakes.

Unfortunately, however, the gambling instinct in humans is very strong. So despite knowing the risks involved and all sorts of warnings, people do get attracted to penny stocks. The lure of hitting a jackpot is simply irresistible.

So I decided to present five simple rules when investing in penny stocks.

If you choose to ignore my warning, kindly at least remember these rules. Going by the risk-reward ratio, the odds in penny stocks are heavily staked against the common investor. While these rules will not guarantee 100% success with penny stocks, they will at least improve your odds.

1. Invest only a nominal amount in penny stocks
It is psychologically comforting to buy a stock of say Company X priced at Rs.15/share, rather than Company A’s stock priced at say Rs.750/share.

Second, it sounds more logical and feasible to assume X doubling to Rs.30 than say for A to double to Rs.1500.

And third, with small amounts of money (say Rs.15,000) you can buy more shares of X (1000) than A (only 20). So even a Re.1 gain will give a profit of Rs.1000 in X and only Rs.20 in A.

Therefore, low-priced shares appear to be relatively easier way of making money.

However, don't forget that if it is easy to make 100% (or even more) profits in X, it is equally easy to even lose 100%. History shows that Rs.15 can easily become Rs.7.50 and you lose 50% of your investment in no time. But it will be difficult for A to fall to Rs.375. (Moreover, being a good business, A will bounce back, while X may never.)

Hence, do not invest more than 3-5% of your corpus in penny stocks. Anything above 5% is committing hara-kiri.

2. Extensive involvement
One noteworthy problem with penny stocks is the lack of information — especially reliable information.

In the absence of credible facts about the company, its management, operational numbers etc., it becomes difficult to make an informed judgement. In such a scenario, choosing a penny stock is like looking for needle in a haystack.

You have to really hunt for the stocks that are ‘truly’ undervalued. With lakhs of investors, thousands of brokers and hundreds of analysts — whose daily bread & butter come from the stock market — it is very difficult for good scrip to remain cheap for a long time. Only a seasoned day-to-day investor is in a position to detect such stocks before they are discovered by the market.

You may have to study 20-30 companies (maybe even more) before you find something promising. Do not make any compromises here.

3. History of the trading volume
Let’s say you are lucky and X does go to Rs.30. Congratulations! You are sitting on 100% profits. But beware — when you go to sell, you may not find any (or sufficient number of) buyers.

Penny stocks are normally illiquid. A large part of the share-holding is owned by the promoters who may readily be willing to be sellers. But when it comes to buyers, you won’t find many of them.

The fact that you tend to buy more quantity since the price is cheap (as we earlier saw 1000 shares of X) compounds the problem. Selling even 100 such shares is difficult; so selling large quantities is virtually impossible.

As such, it would be prudent to study the trading volume very closely for last 6 months to 1 year to check whether it is consistently high. Uneven spurts in volume could be signs of manipulation and not high liquidity.

4. Easy to manipulate / biased recommendations
Unlike big stocks, penny stocks are more prone to manipulation. And, given that most of us buy merely on word-of-mouth recommendations (our fancy for hot-tips), the job of unscrupulous dealers become quite simple.

Do not get carried away by hyped-up media reports through newspapers, television shows, newsletters etc. Don’t go by casual remarks in the train or in the office or at the parties. You must do your own research…thoroughly.

Think twice — no thrice — as to why someone is recommending you an unknown stock if he is so sure of the company. Isn’t he likely to beg, borrow or steal to invest in that company rather than recommend it to you?

Thousands of investors have been duped in the past. Do you wish to be the next victim?

Do not — I repeat, do not — believe on any tips; especially with regards to penny stocks.

5. The myth of 'It can't go any lower'
There is usually a temptation to invest when the stock prices correct sharply and are suppose trading at 52-week low. We tend to believe that ‘it can’t go any lower’.

This is not true.

If the company is facing serious business problems; or the promoters have siphoned away the money; or the manipulators have already made their riches, the stock price may never recover again. You can then forget your investment in that stock. In fact, over a period of time the stock exchanges will de-list that company so you can’t even trade in that stock. 

Therefore, work with very strict stop-loss targets. Don't live in hope.

Investing in penny stock can be injurious to your financial health. So it may be best to keep away from them. However, if you are still a game for it, tread (and trade) with extreme caution. Please do take good care of your money.

Sanjay Matai is a personal finance advisor, author and online financial trainer. There’s a lot more free stuff to read on his website ( www.wealtharchitects.in ) or blog (thewealtharchitects.blogspot.in).

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