There’s a common perception that they are very risky, and there is some truth to this. The risk is not caused by the low price of the penny stocks. Many foreign exchanges typically price even their blue-chips in share prices which are less than a dollar. And because penny shares are not marginable in North American brokerage accounts – which means your broker won’t lend money against their value – they are actually less risky than stocks that trade for higher prices, as the most you can lose with pennies is your initial investment.

But there are some ways in which penny stocks are riskier than stocks that trade for higher prices if you’re not good at understanding the stock market. They tend to be smaller companies, and thus their management is not typically comparable in quality to that larger companies where the remuneration paid to executives can be much higher. Their smaller capitalizations make them more subject to insider manipulation. And they tend to be involved in riskier enterprises such as mining exploration.

In addition to the added risk, there are some other difficulties in trading penny stocks which you should consider. Institutional investors – such as mutual funds and pension funds – avoid them because they are too illiquid to buy in large quantities. This creates a problem for the retail investor as well. If you accumulate a large position in a penny stock you may find it very difficult to reduce your position. There simply may not be enough buyers who wish to buy your stock on any given day. In fact, some penny stocks are so illiquid that they do not trade every day. This illiquidity leads to another problem in trading them: the large bid-ask spreads. The bid-ask spread is the difference between the bid price and the asking price of a share.

In penny stocks it can sometimes be very large, with the difference representing a large percentage of the share’s value. With penny stocks it’s important not to put in market orders unless you’re confident that the spread is small, and that there is sufficient volume trading to fill your order. Otherwise, make it a practice only to use limit orders, and be patient. Volatility is another problem with penny stocks. For this reason you should generally avoid using stop-losses, particularly with very thinly traded issues, as you can easily be stopped out of a position simply by routine trading swings.

Penny stocks are risky, but they can also be rewarding. Returns of 100 percent, 500 percent, or even 1000 percent or more do happen. And since you can only lose a maximum of 100 percent on any single trade, you don’t need to pick a winner every time in order to make a significant return on your investment. Just be sure to limit the portion of your portfolio invested in penny stocks, and then pick a basket of them, rather than putting all of your money into a single name or two. Trading penny stocks can increase your investment returns, provided you trade them with caution, and are fully aware

Beginners

No one likes to say that they’ve just started in the stock market, but all of us started out at the beginning. Sometimes it’s the new guy who does well. (in my first three months, my portfolio grew 68%) and when you look to the experts, you will see that they’ve lost more money than you’ll ever see in your life time. They’re human too, but with an arrogance to them that sometimes bites them in the butt.

As a beginner you may want to just start with a “mock” portfolio and watch the stock market until you get more of an overview of how the stock markets work.

Amateurs

The amateurs are beginners with an attitude. They are the type that have been doing this for a short time and have had some positive results during that time. They look at what they’ve done in a few months and think that this whole stock market thing is easy. HA! They are also the first ones to think that they have it all figured out and they’ll be quitting their jobs in pursuit of trading stocks full-time. Once you have a good understanding of the stock market, your next step is to possibly stick with ETF’s (exchanged traded funds) or Mutual Funds. You can sit with an adviser to help make the choices that you need. Be aware though that these managers get paid by how much money you invest into their funds. The commission can range from .01%-5%, which can make all the difference in the world

Semi-pro

These are the type that got burned when they thought that they knew everything. They’ve done a lot of homework on how to reduce their losses, but they’re still not doing enough research into the companies that they want to invest. What they do is they trade in penny stocks (share value <$5). They feel that the risks are low since each stock is “only” $1.22. What they don’t know is that penny stocks are much more riskier than other stock (company) in the markets. Penny stocks are not a sure thing. Just because the share price is less than $5 doesn’t mean that it won’t go down more or even become bankrupt. When you play at this level, you must be aware of changes that will occur without warning and be prepared. If you feel that this is the way you want to go then make sure you check out each company in great detail.

Professionals

This last group is not the guys who work in Bear Sterns or Morgan Stanley (remember these are the type of guys who cause the housing and credit crisis from their immoral ways. A real professional doesn’t let his emotions get in the way of his trades. They do their due diligence and detailed research into each company they’re thinking about. They don’t just dump money into a stock because the herd is doing it. They take their time, they know that it’s a matter of patience and discipline. If you are at this level (or think you are), don’t sit back on your laurels. Just keep doing what professionals do…study and practice.

When you want to start buying stocks I suggest you look at ETF’s (Exchanged Traded Fund) and Mutual Funds. There are costs to each of them. You need to do your due diligence in looking for the right one. If your are starting out with less than $50,000, ETF’s and Mutual Funds are the way to go.

Buying penny stocks is what people who are uneducated in the stock market do. Don’t get me wrong, many people become very rich trading penny stocks. You hear it all the time, but what you don’t hear is that many more lose money playing it this way.

There are great companies that are on the rise in their industry, but not many. For every ten companies that are started, nine out those ten fail. Out of the ones that make it far enough to be traded on the OTCBB (over-the-counter bulletin board), at least 30% never make it past their initial public offering price.

You need to do research on the companies that you want to invest in. Learn to read financial statements, balance sheets and listen to conference calls on their earnings reports. Typically you need to do 5-8 hours of research for each company you are looking to invest in. After you buy into a company you will need to do at least one hour each week on each company. Do what I like to refer to as doing you due diligence, will end up saving you a lot of headaches later on.