Penny stocks are an asset class that can deliver a large reward for a small risk (monetarily speaking). But the question of how to make money with penny stocks is more complicated. The phrase "you get what you pay for" comes to mind. 

Many investors see a low-priced stock and think more about making money fast from penny stocks instead of considering if the stock is worth their investment. As the meme stock movement showed us, penny stock trading can feel like gambling when a community of investors is involved. 

But you can study these companies' revenue, earnings and cash flow. You may even wonder about penny stocks that pay dividends. Here are some strategies that you can take to mitigate those risks when investing in penny stocks.

Finding the Best Penny Stocks to Buy

Before we learn how to find penny stocks, it's important to understand how the definition of a penny stock has changed. Forty years ago, a penny stock meant a stock that traded for under one dollar. As the name says, they were stocks that investors could buy for pennies on the dollar. And for some investors, that definition still applies. 

However, the Securities and Exchange Commission (SEC) defines a penny stock as one that trades for less than $5 a share. Some investors take an even more liberal definition of a penny stock to include any stock that trades under $10. Generally speaking, a penny stock is any stock that trades for $5 or less per share. MarketBeat lists those that trade under $1, under 50 cents and under 10 cents. 

Many stock screeners allow investors to find penny stocks. MarketBeat has a stock screener that's available to All-Access members. MarketBeat also provides free tools that quickly enable you to find stocks priced under $5 and a real-time list of the most active penny stocks. Here are some additional steps to show how you can invest in penny stocks.

Find a Suitable Broker

If you want to trade penny stocks, you need to have a broker that allows you to trade penny stocks and to trade those stocks without high spreads and commissions. Some brokerages, such as Robinhood, enable you to trade penny stocks, but it may only allow you to trade some penny stocks. In many cases, stocks trading at low volume may not be included.  

Know Your Risk Tolerance

Some of the major exchanges (i.e., NASDAQ, NYSE) list the best penny stocks. The reason is that to be listed on one of the major exchanges, a company must file with the SEC and meet its minimum filing requirements. This takes away some, but not all, of the speculative nature of these stocks. 

It's their speculative nature that makes these stocks appealing to many investors. However, "let the buyer beware" is very applicable when you look beyond the major exchanges to find a penny stock.

Penny stocks are primarily listed in the Pink Sheets and the Over-the-Counter Bulletin Board (OTCBB). There's a significant difference between these two groups of stocks. 

The pink sheets are a compilation of daily publications by the National Quotation Bureau. The companies listed on the pink sheets do not have to file with the SEC and do not need to meet minimum filing requirements, such as submitting a recent financial report. Investing in pink sheet stocks carries the most risk. 

OTC stocks are not listed on major exchanges but must meet some minimum requirements. However, you're still likely to have less information about these stocks than you will with an exchange-traded penny stock. When it comes to deciding where to invest your money, information is power.

Perform Your Due Diligence

Investing in the latest "hot stock or industry" may be tempting. The penny stock industry is littered with companies that advertise the potential to make money in oil, gas, gold and other precious metals. However, if information about a company is not readily available, or if it seems reluctant to provide that information, it's a sign to look for another investment.

Another good mantra to remember with penny stocks is to focus on companies where you may have some interest or expertise. After all, if you are a programmer, you will be much more likely to separate a tech guru's hype from real innovation.

Education is everything when it comes to investing in any stock, particularly penny stocks. There are literally hundreds of penny stocks. If you don't feel comfortable with the information you have, move on to another stock. 

Join a Stock Community

Joining a stock community differs from looking at what a blue checkmark says on Twitter. There are many groups of investors, such as StockTwits or Reddit, where you can find like-minded investors who may provide insight into a popular penny stock that you didn't have before. 

Remember the meme stock movement of 2021? Many of these investors found each other on these forums. But this should also be a reminder that it's easy to fall into a groupthink mentality. You should always visit these groups knowing how a specific stock or trade fits with your individual investment objectives. 

Ways to Make Money on Penny Stocks

Penny stocks offer a high return for a relatively minimal investment. A simple example shows you how to make profit from penny stocks.

An investor who bought shares of a stock that was trading for 50 cents would only need the stock to rise to 75 cents to realize a 50% profit. That turns a $500 investment into $750. 

But making money with penny stocks is different from knowing how to make money fast with penny stocks. That's harder to answer. Many people who dabble in penny stocks are speculators, even gamblers. They are attracted to the potential reward of these stocks and driven by technical signals more than fundamental analysis.

However, despite the inherent risk, you can follow some basic steps to make money in penny stocks while reducing your risk.

Limit Exposure 

Some investors love buying many shares for a low price, increasing their potential reward. Imagine buying the next Amazon.com Inc. (NASDAQ: AMZN) for pennies on the dollar. 

But the reality of penny stocks frequently does not live up to the hype. There is a saying that penny stocks trade as penny stocks for a reason. For every penny stock that becomes the next Amazon, a dozen or more never grow, or the company goes bankrupt. 

The takeaway is that you should only invest with money you can afford to lose. Most experts say your exposure to penny stocks should be 5% to 10% of your portfolio. As a best practice, these experts suggest you limit your exposure to any individual penny stock to 1% or 2% of your portfolio.

Think of Penny Stocks as Short-Term Investments

You should approach penny stocks with a different mindset than you do your long-term investments. Buying penny stocks requires you to think more like a trader than an investor. If you make a sizable profit off of a penny stock, you should look to sell and invest that money into your long-term investments. 

This doesn't mean you have to exit your position entirely. But large-cap dividend stocks reward you for holding their stock. While some penny stocks pay dividends, they are few and far between. So taking profits from these stocks will help you avoid losses and keep your exposure to penny stocks comfortable.

When looking at penny stocks like a trader, you should also look for specific price action. For example, when a penny stock is near a new high or low or when a stock is gapping (that means it's making a large movement — usually at least 5% — in either direction). 

Buy Penny Stocks that Have High Liquidity

Liquidity in investing terms means that there is enough volume of shares changing hands every day. Remember, every trade has to have a buyer and a seller. If you're trying to buy or sell a significant number of shares that nobody is willing to buy, you could end up having a trade fail to execute at the price you want. 

One way to check liquidity is to look at the average daily trading volume. Since it's possible to own many shares, it's important to pick stocks that allow you to sell a large number of these shares if necessary. In some cases, if the stock volume is only 1,500 shares a day and you own over 15,000, there won't be enough buyers to get out of a position quickly.

Avoid Penny Stocks that Come with Special Fees or Restrictions

Since you will be looking to trade these stocks rather quickly, make sure the trading platform you use will not charge special fees or put in volume restrictions. You need to be able to trade these stocks just like any other common stock. Most platforms will allow this for stocks traded on a major exchange, but it's always good to check.

Trade on “Paper” First

An old-school tip that can help you decide if a stock is worth your risk, particularly for beginners, is to consider paper trading. Paper trading is a straightforward concept where you invest an imaginary amount of money and then track your trades without exposing actual money. It helps you see how quickly a stock moves and how much volume changes hands. Many investment platforms make it easy to track your watch list.

Tips for Evaluating Penny Stocks

Many good stock screening services are available to help you find potential penny stock companies. This should not be the extent of your research, but it could help you create a quick short list in an industry that you can then individually research. Considering there are literally hundreds of penny stock companies, having a tool that can help you uncover potential candidates can help focus your efforts.

Another tool to use when evaluating penny stocks is your trading platform. Most brokers, including Robinhood and Webull, offer at least basic educational tools that can give you a template for trading penny stocks step by step. 

Review the following features when selecting a penny stock platform:

• Charting tools
• Financial data
• Research and analyst reports
• Order types

In the end, how to know whether penny stocks are worth it is based on the same research you would perform for any stock. What is its revenue and earnings outlook? When will it be profitable? Does it have a competitive advantage? How wide is its moat, if it has one? 

Technical traders will want to look at the price movement and volume. You'll want to see how volatile the stock is and where it is in relation to its moving averages. 

How to Minimize Risk when Trading Penny Stocks

First and foremost, take your emotions out of your trading. With that said, all penny stock companies have some level of risk. The primary risk comes down to the company's finances. Here are some questions to ask to minimize your risk of trading penny stocks:

What is the company's debt-to-income ratio (i.e., does it have liquidity)? 

Many penny stock companies rely on debt to finance their operations. But if that leverage is excessive, it could put the company at risk of bankruptcy. They also generally have a small market cap, meaning their outstanding shares' value is low. 

Does it have growing revenue and earnings?

Many penny stock companies are not profitable. But if they also have no revenue, there is extra risk. 

Does it have a competitive advantage in the marketplace and/or a moat that keeps competitors away?

Almost by definition, a company whose stock trades as a penny stock will fall short on the first two points. And on the last one, they may have a product that promises a competitive benefit, but for whatever reason, it may not be seeded in the market yet.

Good examples of this are biotech companies. These companies may be working on potential breakthrough drugs and therapeutics. However, these companies are subject to strict regulations and must go through a series of clinical trials before turning a profit or even beginning to deliver revenue.

Is there potential for fraud?

You may learn about a company from a newsletter that promises meteoric gains. These newsletters can appear very credible. However, if you read the disclaimers, you'll find that the company was paying the newsletter editor for their endorsement in many cases. This should be a gigantic red flag for you. If a company was a legitimately good investment, it wouldn't need to pay to get an endorsement.

Making Money with Penny Stocks Comes Down to Common Sense

While no investment is without risks, penny stocks are risky investments. It can be difficult to understand the real value of a penny stock company. Is this a company that has a realistic opportunity to get a product to market at scale? Is this an established company that is going through a difficult time?

At the depth of the financial crisis in 2009, several companies had drifted down to the level of penny stocks. Sometimes, you can find one of these companies and snap them up as they go through a rough cycle. On the other end, you may be looking at startup companies that are looking for investment capital with the promise of a high return on your investment. In some cases, unfortunately, the promise is more hype than hope and you can quickly lose your entire investment.

To invest in penny stocks, you should remember that if it seems too good to be true, it usually is. However, does that mean you should stay away from penny stocks? Not necessarily. If you limit your exposure to penny stocks, apply the same principles you would apply to your other investments, and have both the time and the ability to move quickly in and out of your trades, there can be the potential to make money.

FAQs

You may still have some questions about trading and/or investing in penny stocks. Here are answers to some frequently asked questions about penny stocks.

Are penny stocks profitable?

They can be. As the meme stock movement showed, a company's stock price is a reflection of supply and demand, not profitability. There are companies trading below $5 per share with steady profits. If the profits are projected to grow over time, that could be a sign that the stock is worth your investment.  

How much money can you make off penny stocks?

The better question is, how much money can you lose off penny stocks? You can lose your entire investment. However, on the positive side, the upside is also hard to quantify. It's better to base the size of your investment on how much you can afford to lose. 

How do beginners invest in penny stocks?

Beginners should stick to penny stocks trading on a major exchange (there are hundreds) and avoid trading over-the-counter penny stocks or stocks on the pink sheets.