How To Make Money Trading Penny Stocks

[Editor's note: This story was previously published in April 2018. It has since been updated and republished.]

First, let's get something straight. The definition of penny stocks is entirely subjective. What I think constitutes a risky penny stock, you might feel is a robust, thriving enterprise.

Therefore, before I answer the question of whether you can make money in penny stocks, I'm going to explain what I believe is the best definition of a penny stock. From there, I'll tackle the five rules investors should follow to be successful in trading penny stocks.

The Definition: Merriam-Webster defines penny stock as "a usually unlisted highly speculative stock usually selling for a dollar or less." Hence, the penny-stock moniker. Others are more liberal in their interpretation of what constitutes a penny stock.

The Successful Investor, an investment newsletter publisher I do some work for here in Canada, suggests the ceiling price can go as high as $5.

Here's what the SEC has to say about penny stocks:

"The term 'penny stock' generally refers to a security issued by a very small company that trades at less than $5 per share," states the SEC website. "Penny stocks generally are quoted over-the-counter, such as on theOTC Bulletin Board; penny stocks may, however, also trade on securities exchanges, including foreign securities exchanges."

So, I've got reputable sources from both the U.S. and Canada who accurately define what penny stocks are, including the price at which they trade.

At $5 or less, I do believe you can make money in stocks, but it helps if you follow these five simple rules.

For every success story like Monster Beverage (NASDAQ: MNST ), which traded below $5 as recently as 2006, there are hundreds of penny stock failures littered along the investment highway.

Treat penny stocks just as you would any other publicly traded investment, and your chances for success increase exponentially.

Tip #1: Buy Companies With Strong Balance Sheets

Source: Shutterstock

Like any equity investment, it's important that you establish the financial strength of the company.

When I look for stocks to invest in whether the share price is $5 or $500, I focus on companies with strong balance sheets. Although no debt is desirable when interest rates are rising, it's not very practical. This is especially true when it comes to penny stocks, many of which are still in the early stages of development.

Here are two rules:

1. Only invest in companies whose long-term debt (LTD) is 50% of shareholder equity or less. If a company has $1 million in debt, its shareholder equity should be at least $2 million.

2. Try to keep your penny-stock bets to those companies whose LTD is less than its market cap; the lower, the better.

Tip #2: Buy Profitable Companies

this man knows the secret to profitable options trading

Source: ©iStock.com/graphicnoi

As with any equity investment, it's important that you limit your investments to profitable businesses.

There are two schools of thought on this.

On the one hand, investing in publicly-traded companies, whether they're penny stocks or not, provides you with greater liquidity than private investments. Therefore, the ability to exit quicker justifies the higher risk many in this arena are willing to accept to generate outsize future gains.

On the other hand, private investments have longer holding periods built into them — often 3-5 years or more — which means investors aren't nearly as concerned about profitability as they are with growth.

It really comes down to your ability to handle uncertainty.

For me, I'm always looking for companies making money in the here and now. Anything less is called speculation, and while there's nothing wrong with this approach, it's not something novice investors ought to consider.

Tip #3: Understand the Business

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Like any equity investment, it's important that you understand the businesses you invest in.

There's a saying that if you can't explain what a company's business does in a sentence or two, you probably shouldn't be investing.

Imagine you're explaining the investment to your child who attends elementary school. It's easy to describe what Coca-Cola(NYSE: KO ) does: it makes soda pop. It's not nearly as simple to describe what business Bio-Techne(NASDAQ: TECH ) is in.

At least it's not for me.

Stick to what you know and understand. That's especially true with penny stocks with smaller market caps.

Tip #4: Diversify

Like any equity investment, it's important that you diversify your penny stocks.

How many penny stocks should you own? That's the million-dollar question, no matter how big or small the investment.

Some professional investors believe you've got to have a concentrated portfolio of your best ideas — say 10 to 20 — while others think you should spread your bets far wider over 100 stocks or more.

It's a subjective answer for sure.

What I do know is that you want to be in at least three or four sectors of the economy that generally are healthy and growing.

Since the risk/reward ratio of penny stocks can be significantly higher than that of large-cap stocks such as Coca-Cola, it's far more important to diversify your investments.

Tip #5: Risk What You Can Afford to Lose

9 High-Risk Stocks to Buy for Massive Rewards

Source: Shutterstock

Like any equity investment, it's important that you understand there are no guarantees and that you're risking the money you can afford to lose.

If your child's going off to university in a couple of years and the funds you've allocated for investing will pay his or her tuition, you might want to keep your funds parked in something more stable.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.