How to make real money from penny stocks

New investors often think that cheap stocks—those with low share prices—are bargains. New investors sometimes fall into the trap of thinking that the lowest prices have the greatest potential to make them money. After all, a stock worth $1 per share only has to gain $1 to double your money, while one worth $100 per share has to gain $100 to double your money. (That math is true, but it's misleading. The secret of making money in the stock market is patience.) This math often leads investors to consider penny stocks (also called microcap or smallcap stocks).

What are penny stocks? They're generally stocks which sell for less than a dollar per share. (They're also generally sold on the over the counter exchange, OTC, rather than on the NYSE or NASDAQ.) Because they're so cheap, they seem appealing: $1000 can buy you a lot of shares, and a move of ten cents one way or another can make you a lot of money, percentage-wise. This seems like a secret way to get rich quick by investing!

Are penny stocks worth it? In a word, no. These smallcaps aren't that easy to buy. They're not listed on any major stock exchange. Even if you have a good online broker, you may have to jump through hoops to buy them (see How to Buy Penny Stocks). Yet any normal online broker will let you trade them, though you may need to sign some kind of waiver.

Then again, if you believe the ads plastered all over the Internet, people are making money—crazy money—with penny stocks every day. While it's true that that can happen, you're not likely to get rich if you buy penny stocks. You're more likely to lose money.

How To Make Money With Penny Stocks

There are three obvious ways how to make money from penny stocks. None of them are easy. (It's less risky and a lot easier to build wealth with value investing, but you'll have to be patient.)

Pump and Dump

Perhaps the most popular way to profit from a smallcap is to buy it cheap, convince other people that it's worth far more than you paid for it, then sell it at the inflated price. Unfortunately, this is hugely unethical and quite possibly illegal where you live. It's also difficult to make work.

You've probably received spam email telling you about this great hot tip about a really cheap penny stock to buy. The message promises you the moon. The price is about to explode! You'd better buy it now to lock in your profit! Step back and think about that for a second.

If the stock is really going to go up in value soon, it'll do so for a reason. Perhaps the underlying business has improved. Perhaps the company's about to be acquired. Perhaps there's going to be a huge order that only that company can fill. If that's the case (and if your anonymous correspondent knows why the price is about to go up), ask yourself two questions. First, why is that person encouraging you to buy now (thus driving up the price, because prices go up when there are more buyers than sellers) instead of buying more him or her self? Second, how does that person know the price will go up? (At least without falling afoul of insider trading laws.)

What's more likely is that your anonymous friend bought shares at 25 cents and wants to get a lot of people to buy shares at 50 cents and is trying to pump up excitement for the stock to attract more buyers. Nothing about the business has changed; it's still worth 25 cents per share. This appears to be how something like 900 Percent Stocks works. They're not interested in helping you. They don't want to teach you how to invest in penny stocks and make money. 900PercentStocks.com may just be a scam, with its clients more interested in finding suckers to make money from than than in helping you make money.

Get Lucky

It's far more ethical to buy a stock because it belongs to a valuable company and then hold onto it until the price reaches the point where you can sell it for a profit (or take a loss out of disgust). Unfortunately, you can't predict luck. There's no simple way to find a list of all of the good, cheap stocks to invest in. Not all good stocks are cheap and by no means are all cheap stocks good: a company financially battered and bruised could easily go out of business, selling off everything to creditors, and pay you a fraction of what you put into the stock.

Sure, the company could turn things around, but a company with a really low stock price has a really low stock price for a reason. You owe it to yourself to figure that out (unless you like the odds of gambling). At least in Las Vegas or Atlantic City, you know what the odds of winning are before you put down your money. Penny stocks offer no such guarantee. (Unlike a casino, you won't end up owing money in the stock market unless you chase more exotic investments like futures, options, and derivatives.)

Find a Turnaround Company

Once in a while, a company will go through a horrible bankruptcy and end up restructuring (or getting bought out) at a great value. Perhaps it can get out from under huge amounts of debt or it has a lot of inventory or capital equipment or real estate or patents or other valuable assets that are worth something to an acquirer.

Maybe it just needs some extra love and attention to get the business back in order.

These investments are extremely rare and still risky. It's not easy to predict when an airline will turn around or when a Canadian plutonium mine will find a new vein—but it can happen.

If you're careful and do your value analysis, sometimes you can find companies with the potential to turn themselves around and get listed on a top exchange again. Sometimes the market is irrational and undervalues a business. It's unfair, but it happens and it represents a real opportunity.

Unfortunately, most penny stocks do not represent this opportunity.

How Can You Tell if a Penny Stock is Worth Buying?

You can't just look at a stock price and see if it's a bargain. You have to figure out what the company is worth. A company that makes money is valuable, and a company that loses money isn't worth your investment. Of course there are secondary concerns, like the value of any other assets the company holds. Keep in mind that a company in financial trouble probably has creditors who have a claim on those assets that you as a stockholder can't ignore. Great penny stocks may truly exist, but the odds are against them.

How Can You Find Penny Stocks to Buy?

One of the worst parts about trying to buy penny stocks is that obscurity works against you. You want to find a stock that's undervalued. That means you can't have lots of people looking at it and valuing it fairly. It has to be a decent company with good financials and an improving outlook.

Before you can buy a stock, other people must be willing to sell it to you at that bargain price. If the company's really going to turn around, why wouldn't they just hold onto it until it gets more attention? Maybe you can luck out and find someone willing to sell a lot of shares at a fire sale price, but now you're relying on even more luck.

Worse yet, now that you've found that bargain basement price and you've actually bought that great penny stock, you're going to have to try to sell it somehow. Remember—it's unpopular for a reason. People aren't looking at it. People don't want to buy it. Now how are you going to unload it?

Your best hope is to hold it until the company completely turns around and gets back on a normal stock market listing again. That can happen—but the risks are high.

Are Penny Stocks Worth Investing In?

Even if a stock has a great price, and if it seems like 25 cents per share should be easy to double or triple your investment, be calm and careful. Do your research. You're probably not going to get rich on penny stocks, but you can make good money by sticking to value investing to find great stocks and good prices, not risky ones at cheap prices.