Investing in micro-cap stocks (also known as microcap or penny stocks) can be difficult if you are in-experienced or for novices who have never ventured into this type of investing before. Majority of investors avoid micro-cap stocks but it is all about understanding the risks and being able to mitigate them. Many investors choose not to educate themselves and this is where you will gain an advantage.
Many micro-cap stocks are subject to all kinds of fraud and manipulation. This doesn’t mean you can’t be on the winning side. Money is to be made by going long and shorting these securities. Just make sure you are on the winning side whichever it is.
Here is how you can invest in penny stocks while understanding the risks and increasing your chances of big gains without losing your shorts, shirt, socks, and shoes.
Most (if not all) institutional (professional) investors neglect the micro-cap stock market arena for many reasons; however, some dip their toes in with high risk funds. “Micro-cap Stocks” (microcap or penny stocks) mean those stocks who typically have a market value between $50 million or $350 million, often trade less than $5 per share, and trade on minor exchanges like the OTC exchange (over-the-counter) rather than national exchanges like the NASDAQ. More frequently the share price is $0.10 – $3.00. Brokerages often have different definitions so this can vary.
A low share price doesn’t necessarily mean it is a poorly run company, in fact there are several profitable and growing micro-cap stocks. However, a low or more importantly, a declining low share price is indicative of a bad business. This could be a business on the verge of bankruptcy, engages in deceptive tactics, manipulation, and even fraud. As mentioned before, there are diamonds in the rough that may have fallen on hard times, start-up mode, or going through transition. These types of micro-cap companies have genuine potential and significant possibilities of growing, providing investors with outsized returns.
Is it smart to invest in penny stock and micro-cap stocks?
Often novices buy micro-cap stocks because of subconscious psychological factors that is a smaller increase in the share price can create larger returns and profits. Let’s ask this simple question: which companies share price is easier to double? Company A whose stock price is $0.25 (an increase of $0.25 needed to double) or Company B whose share price is $300 (an increase $300 needed to double). Many beginners think it is easier for Company A to double its share price because it is only $0.25 versus $300; however, this is flawed logic and rooted in psychology versus reality. In fact the answer is the share price doesn’t matter in terms of doubling, it has to do with the company’s prospect to increase the share price. If a company introduces a new product or gets approval for a drug, their prospects increase dramatically and so does the share price whether it is $0.25 or $300 (just look at Tesla).
There are many reasons why investors avoid micro-cap stocks. They are often associated with pump and dump schemes, fraud, listed on minor stock exchanges, limited to no reporting standards, and minimal oversight.
However, those reasons shouldn’t stop savvy investors because there are numerous reasons to invest in micro-cap stocks.
How to keep from losing your money
Now that you have a better understanding, do you still want to give it a go? Here is a practical guide on how to invest in micro-cap stocks.
1. CHOOSE A GOOD BROKER
Identify a broker that will allow you to trade micro-cap stocks. Some brokers have restrictions and restrict investing in these stocks due to the high risks. There are numerous to choose from and we have reviewed and rated the top brokers for micro-cap investing. There are also only a few top brokers for short selling micro-cap & penny stocks.
Brokers can charge a range of fees as well as minimum account values. Make sure to do your research and select wisely (or use our recommended brokers that we have done extensive research already). Switching brokers is doable but timely, difficult, and sometimes costly.
2. UNDERSTAND YOUR GOALS
Decide your microcap stock investing style, rules, and outcomes. There is no correct way, just make sure you have one and aren’t shooting from the hip. If you are using charts and indicators then you are using technical analysis to guide your investing decisions which is more speculative in nature. If you get an alert from a stock promotion newsletter, website, or email and buy stocks off based on that information it is highly speculative. Make sure to lock in your gains as soon as possible because it could be a pump and dump scheme.
Alternatively, investors tend to have a much longer-term outlook on the company. This means doing extensive research, understanding the business model, and not worrying about the share price but rather if it is undervalued or overvalued. Investors take the buy-and-hold strategy because they are holding for years even decades rather than a short-term speculative trade.
Lastly is shorting these stocks. This is more speculative as well but it depends on your approach. If you are basing it on technical analysis or the share price has risen quickly, it would be speculative. A short selling investor does research and can hold a short position for years.
3. PRACTICE WITH PAPER TRADING
If you have never invested in micro-cap stocks, make sure to practice, practice, practice! This can be done through paper trading so that you can learn the pitfalls, pump & dumps, how to buy & sell, and master your emotions. Here are some of the best free paper trading & stock market simulators
4. BEGIN WITH SMALL ALLOCATION
Now that you have practiced, it is time to actually start investing in micro-cap stocks. Be sure to start with a small amount, fraction, or allocation of your overall portfolio. This should be roughly 10% or less at a maximum. Be sure to adjust your allocations over time. Small amounts will allow you to grasp the emotional ups and downs of micro-cap investing without risking all of your money.
5. MICRO-CAP STOCK SCREENERS
Finding which micro-cap stocks to invest into isn’t easy as there are thousands of micro-cap companies. The best way is to use screening tools that allow you to screen for fundamentals like revenue growth, profitability, insider ownership, etc. and technicals like moving averages, volume, relative strength, etc. Specifically, make sure to use a micro-cap stock screener. Choosing what to screen for depends on your investing goal and style. Here are the best free micro-cap & penny stock screeners and the best free stock charts for micro-cap & penny stocks
6. DO EXTENSIVE RESEARCH
Whether you are a micro-cap stock speculator or investor make sure to do extensive research which may be difficult. You should be able to find a company’s financial filing information on the Securities and Exchange Commission. If there are no financials, this should be a red flag. Similarly, another red flag is if there is no website or one that hasn’t been updated in a long-time.
Oftentimes, management will promote, create false or misleading stories to bolster their stock so they can sell shares for profit or issue more shares on the open market to keep the business afloat. As part of your research, you should understand if the company has hired stock promoters.
7. UNDERSTAND STOCK VOLUME
Checking the volume of your micro-cap stock is critical because you could get trapped in an illiquid stock. You only earn money if you are able to sell your shares, otherwise it is just paper gains or profits. If a stock price surges, but you can’t sell your shares because of low volume, you won’t realize the benefit of the stock increase.
How you check a stock’s volume is simple. Many sites (or your broker) track the daily volume a stock trades. I usually use yahoo finance and use average volume vs the daily. Generally the higher volume, the easier it is to sell. If a stock volume trades 100 times a day and you own 1,000 shares, it will take you on average 10 days to sell all of your shares if you were the only seller.
8. TAKE SMALL POSITIONS
It is important to take small positions in micro-cap stocks and consider the volume. You do not want to own a large portion of the average volume; otherwise it will be difficult to exit your position at the prices you wish. If you are the only seller, you will have to accept lower prices for your shares and you will flush the market with more shares than buyers which can cause the stock price to crater. Stick to small, modest positions so you can sell in a reasonable time frame.
9. DIVERSIFY YOUR PORTFOLIO
Ensure that you diversify your portfolio. Don’t go all in micro-cap stocks nor a single company. Always spread your nest egg into more safe assets and longer-term investments like the S&P 500 index or other ETFs. If you want exposure to micro-cap stocks & diversification, you can invest in the iShares Russell Microcap Index (IWC) which is an ETF.
10. BEWARE OF FRAUD & SCAMS
Micro-cap stocks trade on OTC exchange which has the highest ratio of fraud than any other exchange. This is largely due to the fact that there is limited financial reporting required by the SEC and OTC exchange. Often the businesses aren’t updated, business model changes to the most recent fad (stem cells, marijuana, bitcoin, coronavirus, etc), and key information is missing.
Micro-cap stock frauds usually take the form of different types of schemes. The first is the pump and dump scheme. The company or a shareholder of the company hires a stock promoter to send out a newsletter or email hyping a story or prospect of the company to help create excitement and push the share price higher. Usually the newsletter story offers all kinds of promise, amazing prospects, and/or products to create investor excitement and buzz (“the pump”). When the share price goes up because more investor buy the story, insiders and/or the company sell lots of shares for a profit (“the dump”). Usually this causes the stock to come back to earth.
The second type of scheme is “short and distort”. This is where investors or short-sellers write negative narratives about a company to try to make the stock price fall. The negative hype can lead people to sell their positions causing the share price to collapse and short-sellers profit from the decline.
11. SHY AWAY FROM SURCHARGES & EXCESSIVE FEES
Typically when you buy micro-cap shares, you are buying a large amount of shares. If a stock price is $0.05 and you have $100 to invest, you’ll be buying 2,000 shares. Some brokers will charge you a surcharge for stocks under a certain price and another fee if you buy a large amount of shares. There is no need to choose a broker who charges these excessive fees. Make sure to find a broker that does not charge for volume or price limitations.
Weighing the benefits and risks of investing in micro-cap stocks
Now that you have a greater understanding of micro-cap investing, make sure to weigh the benefits and risks to determine whether it is something you want to invest your hard earned money in.
- Significant & explosive upside
- Not covered by analysts
- Sometime easier to talk with management
- Lower to non-existent expectations
- Manipulation and fraud
- Lower volume
- Limited reporting requirements
- Higher fees
- Research is more difficult
In summary, investing in penny or micro-cap stocks can be alluring and may seem like an easy way to make a ton of money quickly. However, most of the time it is too good to be true. Unless you educate yourself, you will be playing right into the hands of penny stock manipulators and operators. Use appropriate tools and be aware of the risks. If you are able to do these things, you will reduce your chances of losing money.
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