Before Making Your Initial Investment, Consider This
Here’s where things get a little messy…
You can open lots of different types of trading accounts, each of which might require a different initial investment.
Again, the brokerage firm makes this decision, though you can always deposit more money than the firm requires.
Type of Trading Account
The most common and basic trading account is the cash account. It’s just what it sounds like — you can buy stocks based on the funds you have in your account. For example: If you have $1,000 in your brokerage account, you could theoretically by 100 shares of stock at $10 per share.
In most cases, cash accounts are the simplest and least expensive accounts to maintain. You’re not borrowing from your broker or shorting stocks, and you can’t place an order until the cash actually hits your account.
A margin account is a little different. You might want a margin account if you intend to short stocks, which involves borrowing shares from your broker when you predict a stock’s price is going to decrease.
Most margin accounts require higher initial investments because you’re allowed to trade on margin, which requires leverage. I’ll explain that more below.
Then you have retirement investment accounts, such as 401(k)s and IRAs. These accounts don’t allow you to short stocks or trade on margin. These types of accounts are beyond the scope of this article, but they’re often used for longer-term investments.
Some traders, including me, use high-net-worth brokerage accounts, as well. Some high-net-worth brokers require you to have an initial investment of between $500,000 and $1 million, while others demand more than $1 million.
Your individual trading strategy can also help you decide on your initial investment. Some traders are dip buyers, others look for earnings winners, and still others trade based on catalysts. It all depends on your risk tolerance and how you prefer to evaluate potential trades.
I do a lot of dip buying and short selling. For instance, if I recognize a pump-and-dump scheme, I might short the stock to take advantage of the inevitable crash. I pay very close attention to the penny stock patterns I’ve identified because I know they often repeat themselves.
Keep in mind that your trading strategy will evolve. As you gain more experience, you’ll find that you’re more comfortable basing your trades on certain types of information.
Furthermore, you’ll figure out how much money you’re willing to risk on every trade and how much money you want to keep in your trading account — the maintenance level.
Lot size refers to the number of shares offered for sale at a given time. In the stock market, the average lot size is 100 shares. If you buy 10 lots of a given stock, you’re purchasing 1,000 shares. If your purchase involves fewer than 100 shares, it’s an odd lot, while a lot of 100 shares is called a round lot.
The number of lots you buy determines your position. Since I trade penny stocks, I like to take as large a position as I can so I can profit more handsomely. For example, buying 5,000 shares — 500 lots — of a stock priced at $3.25 per share is far more profitable than buying just 1,000 shares.
It’s possible to increase your position size without raising your initial investment. If you trade with a margin account, you can often use leverage to multiply your position.
You borrow the money from your broker — at a price — so you increase both your potential profit and your potential loss.
Lots of traders love to trade with leverage. They’re able to risk less of their own money on a given play.
Be Careful With Leverage
While you can trade with leverage, that doesn’t necessarily mean you should. I don’t use leverage because it constitutes too much risk. Since it involves borrowing money, the potential for loss increases exponentially.
For example, say you want to invest in a local business. You believe in the business owner and the produces the company sells, but you only have $2,000 to invest. You go to your friend and ask to borrow $5,000 so you can invest $7,000 instead. You now get a bigger share of the business’s potential profits.
Remember, you have to pay back that $5,000 regardless of what happens to your investment. If the business folds in six months, you lose not only your own money, but your friend’s money, as well. At that point, you have to scramble to pay back your friend.
Brokerage firms aren’t nearly as lenient as a loved one. Your friend might allow you to make installment payments over months or years, but your broker will expect you to cover any losses immediately.
Initial Investment Example
Let’s say that you want to start trading penny stocks. I applaud your decision. You’ll have to open a brokerage account and make an initial investment. For example: let’s say you decide on $1,000.
Your goal is to grow your account balance via well-timed trades. Pennystocking allows you to trade extremely cheap, microcap stocks. As your trading account balance grows, you can invest more into the stock market.
A good rule of thumb: Risk no more than 2 percent of your total account balance on one play. That might seem like a miniscule position, but it gets bigger as you (hopefully) profit.
Before I leave you to your own devices on this, let’s look at how to calculate that initial investment.
We’ll go over that first thing in the next issue.
— Tim Sykes
Editor, Penny Stock Millionaires