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How to Use Online Brokers for Trading Penny Stocks

Penny stocks and online brokers come from opposite ends of the trading spectrum. Penny stocks are a fairly old-fashioned concept that are bought and sold in over-the-counter markets, while online brokers represent the latest in trading technology. However, it is possible that the two can be used together effectively.

There will always be considerable pitfalls to trading penny stocks. But, the speed and cost-effectiveness of online trading can counter at least some of those pitfalls.

What are penny stocks?

"Penny stock" is a somewhat dated term. It was originally used to refer to stocks trading for less than $1 - i.e., stocks whose prices were measured in pennies rather than dollars. Eventually, due to inflation, the term came to apply to stocks trading for less than $5.

Not all stocks trading for under $5 are considered penny stocks. The term is generally applied only to stocks that are not listed on national exchanges, but rather trade over-the-counter. This is a fairly manual process of matching up buyers and sellers, and it greatly affects how the stocks trade.

Why are penny stocks considered so risky?

Here are some factors that contribute to the risk of penny stocks:

1. Thin trading means volatility

Because penny stocks are not freely traded but rather are only transacted when a buyer can be matched with a seller, prices can take big swings. If a stock has not traded in a while, the listed prices may not represent actual demand for the stock.

2. Commissions take a bigger bite

Commissions represent a higher percentage of smaller trades, and some brokers charge extra for trading penny stocks.

3. Mind the spread

There is often a big difference between what potential buyers are bidding for penny stocks and what sellers are asking. Your return from a stock can depend greatly on which side of the spread the actual trade price ends up being nearer.

4. Don't buy the hype

Thinly-traded stocks are more easily moved by hype, or even out-and-out fraud. Don't believe stories about how a certain little-followed stock is about to take off. Those stories are spread by people who buy these stocks hoping a little hype will get some suckers to buy at higher prices - and you don't want to be one of those suckers.

5. Under the radar can mean under-regulated

Because these stocks have a lower public profile than bigger companies and do not trade on national exchanges, they are likely to receive less regulatory scrutiny. This means "buyer beware" applies especially to these investments.

6. Avoid the "Q"

If a stock's "ticker" or trading symbol has a Q at the end of it, it means the company has filed for bankruptcy. Most investors should steer well clear of this type of damaged goods.

Who should trade in penny stocks?

Penny stocks are for people who understand the risks. This means recognizing the pitfalls described above, and it also means putting these investments in the right context.

For example, if you choose to speculate in penny stocks because of the potential for large short-term price movements, recognize that speculative investments should play a minor role in your overall portfolio. Penny stock investments should not be confused with the type of mainstream stock holdings that should play a role in a long-term retirement portfolio.

Another example of putting penny stocks in the right context is if you use them to buy overlooked companies that you believe are on the rise or ripe for a turnaround. This means doing fundamental research into these companies so that you understand their products, markets, competition and financial condition. It also means verifying that research through independent sources where possible, rather than just relying on promoters who have a vested interest in the stock.

How can online trading help?

If you choose to trade in penny stocks, online trading might help you do so more effectively for two reasons. One is that online brokers often have relatively cheap commission schedules. As noted previously, commissions can take a serious bite out of penny stock returns, but at least some best online brokers are less expensive than their traditional counterparts.

Also, the speed of online trading can help you execute buy and sell decisions in a timely manner, which is especially important in a market often marked by rapid price changes.

The bottom line is that trading in penny stocks is a highly speculative strategy that is not for the faint of heart. Online trading can help make the process a little more efficient, but it cannot eliminate all the risks associated with penny stocks.

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