An investment in a penny stock should be looked at as more similar to buying a call option than a traditional investment.
I'm not talking about $5.00 stocks here, but those that trade for around a dollar or less. True penny stocks.
Many investors buy penny stocks hoping that the stock will rise by hundreds or even thousands of percentage points to generate a huge return. Usually, there’s is a great story behind the company that makes it very hard to resist.
The unfortunate news is that penny stock speculations often fall short of lofty growth expectations. And investors that got burned are hesitant to take such a huge risk again.
However, every now and then penny stock dreams do come true. This chart of oil explorer Centric Energy provides just one example.
Centric was bought out back in 2011, but not before the stock rallied from less than $0.10 to over $0.60, at least a 500% move.
The balance between "stupid" risk and huge potential is often a fine line. But let's face it – that's the attraction of penny stocks … and speculation in general. It’s the thrill of the unknown.
Here's an idea that will help keep you in check, but also allow you the fun of investing in penny stocks.
View a penny stock as similar to a call option, where the expiration date is up to the buyer to determine based on the company's development program. Recall that buying a call option gives you the right to buy something at a specific price before the option's expiration date.
Your "call option" gives you to the right to participate in any upside the stock enjoys – which could be huge, several hundred percent – if things go well. It could also be a more moderate gain in the range of 5% to 20% like many professional options traders target.
However, if things don't go well, your "option," or the value of your shares, could "expire" and become essentially worthless, just like expired out-of-the-money call options do.
One advantage you'll have is that, unlike a true call option, buying stock doesn't have a defined expiration date. How long the stock is around depends on variables that you should have a feel for by doing your due diligence on the company. It could become the next Centric Energy.
For a small sum of money, investors own the right to participate in any upside. Just like an option contract is usually relatively inexpensive, each “contract” on a penny stock that trades for, say $0.10 cents as Centric did in 2010, costs just $10.00.
You can literally buy thousands of shares in a few different penny stocks for a few hundred bucks. If you've done your homework and selected at least one winner, your potential gain should more than make up for any losers.
As with any option investing strategy, diversify and use proper position sizing to manage your risk.
In the resource world, penny stocks are more often than not Canadian-listed companies that trade in either Vancouver or Toronto, and on the pink sheets in the U.S.
There are also thousands of consumer and tech-related penny stocks that trade on U.S. markets since investors have such a huge appetite for these types of opportunities.
Personally, I prefer the resource stocks when it comes to penny stock “call option” investing, because it's possible to buy several different companies that are all poised to benefit from the same catalyst – usually a potential oil or gold discovery in a certain region of the world.
Tyler Laundon, MBA