Trading Woes On Small Cap Stocks, How To Avoid Them

Spotting a Small cap stock can be a challenging task for anyone, even for the seasoned investor. Let alone, finding one that's promising enough so you allow yourself the extra risks associated with it.

While most stocks that we know, like Apple (NASDAQGS: AAPL) trade at prices over hundreds of dollars, some stocks that don't appear in the larger exchanges are priced at a level significantly below that. As defined by the Securities & Exchange Commission (SEC), low-priced stocks that are under $5 are generally referred to as penny stocks. These are stocks trading on the pink sheets or Over the Counter Bulletin Board (OTCBB).

For most people engage in buying Small cap stocks because of the lure of greater ownership and the potential for greater yields that comes with it. For simpler illustrations, having $100 can afford you only 4 shares of a stock priced at $25 each compared with 1000 shares for a stock valued at $0.10 a piece. Even more, isn't it easier to go from $0.75 to a $1 than $75 to go to $100?

Well-known and established companies like International Business Machines Corp (IBM) or Coke have stocks that are described as less-volatile. What that translates to is, while these blue chip companies have reliable growth patterns over the years, it takes longer for investors to realize a sizable return on their investments. On the other hand, Small cap stocks give high-risk players the opportunity they need to realize greater returns in less time. It is not unheard of for a Small cap stock to move upwards 20% in a single day.

Different things contribute to the high risk and often negative perception on penny stocks. Investors who have been burned and lost thousands of hard-earned money buying these stocks gripe about low-level liquidity, market manipulation and even scam as the main causes.

Why people would risk money over something they know very little about is beyond this article, but that's not to say that buying or trading small cap stocks is like throwing money out the window. Investors who have turned to small cap stock trading and became winners in it would tell you it's about calculated risk and finding the right companies.

These handful companies are those that stand in the early development stages but in time show rapid growth by launching strong brands or establishing key partnerships. It is simply not just about plain-old luck, but careful analysis and projection. Lady luck favors the prepared,
after all.

Now if and when you decide to leap into that high-risk, high-gain arena, it's best to be prepared. Here are some things to do before buying a penny stock:

1. Find out all the information you can about the stock you are buying. And here lies one of the potential problems with Small cap stocks scarcity of company information. Larger stock exchanges like NASDAQ and NYSE provide the public scores of information, quotes and research that help regulate market activity. Small cap stocks on the other hand, trade on the pink sheets or Over the Counter Bulletin Board. Companies listed on the OTCBB do not have listing requirements as those on the NASDAQ or NYSE and are generally regarded as risky markets. Companies listed on the larger exchanges have a proven track record of success backed by solid management that helps reassure investors.

2. Check the company's level of liquidity. Ask yourself or your broker, Is there a demand for the stock?, How long does it take to find a buyer? Liquidity can be thought of as the level of trading activity or much simpler the number of people trading or exchanging a particular stock. SEC warns of the low-level of liquidity and infrequently buying involved with penny stocks. The last thing you want is to end up with shares that cannot be sold.

3. Watch out for scams or fraudulent activities. Because getting information on Small cap stocks is difficult, they are often a target of fraudulent activities. Some microcap companies influence your decision to buy the stocks through paid media TV, radio, and email that will give padded press releases in favor of increasing the company's reputation. You happily purchase the stock, which by then have become more expensive owing to the buzz around it only to realize after a while that you're left with stocks you can't sell.

When you receive favorable news from paid promoters on a stock, go ahead with do your due diligence first. Your homework should include at least a background check on the company its assets and operations. You should know exactly or at least be able to explain how it makes money and how it will use your investment. A good source of information comes from the report companies file with the SEC.

All OTCBB companies have obligations to file periodic reports that contain important information to investors about its business and financial condition. Ask your investment adviser for the SEC reports or how to find them. If the company doesn't file with the SEC, you can in turn ask for the Rule 15c2-11 file containing important company information.

1. Be wary of high-pressure sales strategies. Do not go into an investment without proper investigation. Brokers who say they have inside information on what's to be a promising investment are red flags to watch out for. They are likely leading you to a pump and dump scheme. Most solid companies built their record over years of success and are rarely overnight successes. Report any suspicious selling to your state's securities regulator or to the SEC.

Small cap stocks are definitely not for the faint-hearted investor. It won't even register as an option for most experienced investors seeking stock diversification. Still, we can't ignore the fact that there are a decent number of companies out there trying to find their way into the major market exchanges. Given good economic leads and favorable industry conditions only time can tell.