So youre ready to learn how to trade penny stocks?  You want us to teach you where to find the best stock picks?  Before we get to that, you must first understand what a penny stock actually is.

There is a lot more to penny stocks than just their definition.  A penny stock is any stock under $5.  Often they are under $1.  However that doesn’t really explain what they really are, and how they are different from the stocks you hear about in the news.

Penny stocks are high risk, high reward stocks that can jump double or even triple digit percentage gains in months, weeks, or even a single day. With a conventional large stock, an increase of twenty percent a year is considered a great return.

When dealing with penny stocks, something as small as becoming noticed by a few large investors could be enough to send double or triple its value.

Large cap stocks provide a false sense of security. It is a common misnomer that huge companies are always safe investments. Just look at Bank of America during the financial crisis, Caterpillar when the housing market crumbled, AIG, Fannie and Freddie, the list goes on.  Goodbye dear WaMu! All of these companies are multi-billion dollar businesses, with worldwide brand recognition. The point is, no matter how large or celebrated a stock might be, there are no guarantees.

A penny stock provides the chance to take on the market risk that every company embodies, with the possibility of much higher payoffs.

Of course, penny stocks aren’t immune to problems either.  Make no mistake, more penny stocks will crash than NYSE or NASDAQ stocks.  They certainly offer greater risk, but the risk to reward ratio can greatly favor investing in a penny stock versus a stock like Ford or Microsoft.

So what exactly are the risks and rewards to investing in penny stocks?

Well, as stated before, the gains can be extraordinary. Why? The simple answer is a lack of liquidity. These penny stocks don’t boast a huge roster of thousands of investors, mostly because they trade on secondary markets (OTC and Pink Sheets). Secondary markets are an alternative to the NYSE and NASDAQ exchanges, where small companies can list for a smaller fee (15K versus 250K) or where larger companies (Nestle, Deutsche Telekom, etc.) can go to avert a lot of the red tape associated with major exchange listings.

Being listed on these secondary markets usually doesn’t allow for analysts to cover these stocks, good, bad, or indifferent. This results in less institutional interest in penny stocks, and thus, limited liquidity.

Once a stock starts to stir up interest though, the result often such a large percentage gain because the amount of buyers and sellers is typically small in comparison to a large cap stock. For example, say someone wants to buy a share of Apple. There are so many sellers and buyers of Apple that the buyer will most likely get to purchase that share at the market price. But for someone who wants to buy a penny stock, there are less sellers. That allows the sellers to set a higher price.  A hot stock will have a lot of buyers, and far less sellers.  A lot of demand, not a lot of supply.

Also, there is a psychological factor that comes into play. Jumping from ten to twenty cents does not seem like that big of a deal, but in percentage terms its just as big as a $100 stock shooting to $200. This can result in increased gains, because it is much harder for investors to bid a stock up from $100 than it is from 10 cents.

There are risks to investing in penny stocks, but these can all be managed with the discipline and knowledge on when to buy and sell. Locking in profits on a large spike in price is the one way experienced penny stock traders usually manage the risk. Getting too greedy could result in a loss of any profits.

Even if you don’t sell at the top, setting stop losses will reduce any large hits to your profits. This measure will allow you to automatically sell at a certain price, before it starts to drop too much.  Most experienced penny stock traders will never hold a position without a firm stop loss order in place.

Just remember, they can go down as fast as they went up.

In the end, penny stocks are high risk / high reward endeavors. Gains that NYSE or NASDAQ traded stocks might achieve in a decade could be experienced in days with a penny stock.

How do people find these hot penny stocks? There are literally endless ways to research individual equities, and thousands of stocks to filter through.  You should give them all a try, and see what works best for you.  Our stock newsletter is also a great source for penny stock picks that are set to make immediate moves.  If you’d like to get our next penny stock pick, click here.

Good Luck and happy trading!