Contrary to the general public’s perception of penny stocks, they’re not all that risky if you know what to look for and understand the key facets to trading them. Penny stocks are simply issues that trade below $5 per share, and you will find them on all exchanges from the majors down to the pink sheets.
When you leave the Nasdaq and NYSE for the over-the-counter or pink-sheet market, reporting requirements are reduced; you will have less information to go on. That’s one inherent risk in penny stocks, but with that higher degree of risk comes a higher potential gain.
With that in mind, let’s look at five keys to trading penny stocks.
1) Do Your Due Diligence
Like any investment, you’ll want to research and dig deep into the company. This might require reading its SEC filings and deciphering the news. Moreover, you might look into company fundamentals and technicals. Don’t take someone’s word for it; look at reputable sources for information in a penny stock that interests you and stay on the sidelines if you can’t find the details you are looking for.
2) Penny Stocks Could Be Momentum Plays
Penny stocks tend to be momentum plays off of some catalyst, such as earnings, corporate actions or company developments. In the event of a positive catalyst, penny stocks tend to move in the same direction for multiple trading sessions before reversing. Therefore, you might try to capitalize on the stock’s momentum, but be mindful of taking profits; don’t hang in for too long, as penny stocks tend to reverse sharply when traders decide to take profits.
3) Keep Your Expectations in Check
The attraction of penny stocks is their wild success stories. Everyone hopes to be an overnight success.
It doesn’t always work that way. Therefore, keep your expectations in check with penny stocks, take profits when you can and don’t hold on to a penny stock in hopes of the stock running higher. Penny stocks move quickly, and you don’t want to be the one left holding the hot potato when the catalyst music stops.
4) Manage Risk Properly
Since penny stocks move quickly, consider setting a hard stop on your positions. In other words, think about using a stop-loss limit order that executes if the stock falls to a certain price. This helps remove some of the emotions from trading penny stocks.
5) Don’t Put All Your Eggs in One Basket
As with all investments, you don’t want to put all your capital into one issue, because one negative catalyst could crush you. Look to build a diversified portfolio, allocating a small portion of your total portfolio to penny stocks and other assets that carry a high degree of risk.
Beyond these five basic keys, you will need to put in the time and work to build an experience base in trading penny stocks. But these basics will give a solid footing as you consider taking positions in penny stocks, so stay focused on doing things right.
Taylor Conway is the lead day trader at PennyPro.com. He is a short-term day trader of stocks and ETFs.