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For many beginner investors dipping their toes into stock investing, the first stop is penny stocks. As the name suggests, penny stocks are those companies that trade with a low share price , often less than $1. It's understandable to see why rookie investors get hooked by the dream of buying into a company for only few cents and then selling for a substantial profit when the price trades back in the multi-dollar levels. The extremely low share prices allow an investor to hold thousands of shares for a relatively small amount of invested capital. With that scale, the gain of just a few cents per share can translate into big percentage returns (the reverse is also true, of course).

Of course, such stocks are generally considered to be highly speculative and high risk because of their lack of liquidity, large bid-ask spreads, small market capitalization and limited following and disclosure. If you feel like you are ready to start trading penny stocks then continue reading. (For more on this topic, see: The Lowdown on Penny Stocks.)

Opening an Account

There are many factors to consider when opening an account, such as ease of transferring funds, fees and customer service. Brokers specialize in different areas, so take your time to shop around for one that will meet your needs. For penny stock investors, one aspect to pay particular attention to is the fee structure. Some brokers charge commissions based on a per-share basis. This structure is usually set at a certain rate for the first set number of shares, and then another rate for each additional share. This structure is better suited for investors who are buying a relatively low number of shares and may not be the best structure for penny stock traders. It may prove more useful to shop around for a broker that offers a relatively low flat rate per trade regardless of how many shares are traded. The lower the flat rate, the less impact fees and commissions have on the final return. (For more on this topic, see: Opening Your First Brokerage Account.)

Where to Look for Penny Stocks

Major stock exchanges, such as NYSE and Nasdaq, have special listing requirements. For example, according to Nadaq rule 5550(a), failure to have a minimum bid price of at least $1 per share for primary equities will result in being delisted. As a result, traders interested in trading penny stocks turn to the Over-The-Counter Market (OTC). The OTC Markets Group organizes securities into tiered marketplaces that reflect the integrity of the operations, level of disclosure and degree of investor engagement. (For related reading, see: The Dirt on De-listed Stocks.)

Narrowing Down Trading Candidates

Now that you understand where to trade penny stocks, the next step is to determine what stock to trade. One popular method is to use stock screening tools, such as the one found on the OTC Markets website or Finviz. Screening for stocks with a price under $1 is the easiest way to narrow down the trading universe. From here, you can filter the list down further depending on your strategy and risk tolerance. For example, perhaps you are only interested in penny stocks that conduct business within the technology sector. In this case, you’d make the necessary adjustments and then run the filter. (For more on this topic, see: How Investors Can Screen for Stock Ideas).

If you're a beginner at using stock screeners, check out: Finviz.com Stock Screener: An Introduction. Once you get the hang of using Finviz’s stock screener, your list, based on the filter above, should look something like this:

No.

Ticker

Company

Sector

Price($)

1

ADAT

Authentidate Holding Corp.

Technology

0.72

2

ANAD

Anadigics, Inc.

Technology

0.84

3

API

Advanced Photonix, Inc.

Technology

0.52

4

BLIN

Bridgeline Digital, Inc.

Technology

0.75

5

DAEG

Daegis Inc.

Technology

0.98

6

ETAK

Elephant Talk Communications Corp.

Technology

0.94

7

GIGM

GigaMedia Ltd.

Technology

0.98

8

GRVY

Gravity Co., Ltd

Technology

0.79

9

IKAN

Ikanos Communications, Inc.

Technology

0.34

10

LEDS

SemiLEDs Corp.

Technology

0.78

11

MCZ

Mad Catz Interactive Inc.

Technology

0.56

12

NIHD

NII Holdings Inc.

Technology

0.11

13

OIBR

Oi SA

Technology

0.72

14

OIBR-C

Oi SA

Technology

0.75

15

TIGR

TigerLogic Corp.

Technology

0.93

Source: Finviz.com | As of Sept. 7, 2014

Understanding the Risk

When it comes to trading penny stocks it's extremely important to understand the risk. In most cases, these companies are small-cap stocks and are susceptible to major volatility. Whenever money is put at risk in an attempt to make a gain there is risk of substantial loss. This is particularly true when it comes to investing in penny stocks, so tread with caution. Since most institutional investors, such as mutual funds, index funds and money managers, have rules set up that prevent them from trading penny stocks, they generally lack a following in the investment community. Therefore, liquidity is a serious concern and should not be ignored. It's not uncommon for retail investors to get stuck in a position or for it to take several days or weeks in order for there to be enough supply or demand in order to enter or exit a position without serious price fluctuations. (For more, see: An Introduction to Small Cap Stocks.)

The Bottom Line

Investing in penny stocks can be extremely risky and it definitely not for everyone. If you feel like you understand the risks and are ready to proceed then the first step is to find a broker, fund an account and then find a suitable trading candidate. Stock screeners are probably your best bet in narrowing down the universe of stocks so that you can find one that meets your trading style and risk tolerance. (For more, see: Penny Stocks Explained.)

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