With the low barrier to entry, minimal capital, and potentially huge profit margin, penny stocks are quickly becoming one of the most popular trading options. Unlike value investing, which requires buying positions in strong companies and holding them long term, penny stocks provide opportunities to ride the volatile ups and downs of the penny stock market, hitting major gains for good insights.

Successful investing is about conservative decisions, diversity, and risk management. Penny stocks aren’t “investing” in the traditional sense but rather a game — one that rewards the smart players who learn how to play all the variables.

Understanding Penny Stocks and Penny Trading

Image via Flickr by Katherine Ridgley

Penny stocks are stocks that trade for under $5 per share. Stocks that trade for under $1 used to be from small companies trying to establish themselves in the market, which made them speculative and often volatile investments for sharp investors and traders.

Now, stocks priced between $1 and $10 are considered speculative and volatile investments, sometimes experiencing a 50 percent drop or 100 percent rise overnight. Penny stocks are at a higher risk of manipulation as well, which is the act of artificially inflating or deflating the price of the stock or influencing the market for personal gain. Because of this, many investors and traders are wary of getting started in penny stocks, and it’s always important to prepare for the possibility of a total loss. That said, penny stocks have the potential for incredible profits if you know how to play them right.

Here are the types of penny stocks available to trade:

  • Tier 1 Penny Stocks: Tier 1 penny stocks are listed on the major exchanges, such as NASDAQ or NYSE, and are typically priced under $5 per share, but they can be slightly higher than that. These stocks are speculative but not as volatile because they are required by the exchanges to provide financial information. They’re also held to a higher standard than over-the-counter penny stocks and less likely to be manipulated. If you’re looking to invest in penny stocks, choosing Tier 1 stocks gives you the peace of mind of knowing the company won’t vanish overnight.
  • Tier 2 Penny Stocks: Traditional penny stocks, as the name suggests, are priced between 1 cent and 99 cents. They’re never under 1 cent, though stocks can be traded on fractions of a penny. Like Tier 1 stocks, they can be listed on NASDAQ or NYSE. These companies get a public letter stating that they need to meet the minimum listing requirements of the exchange to have their stock above $1. If they meet these requirements, the stock is listed, but if not, it’s delisted and moved to the over-the-counter market exchange. Stocks over $1 will never have a spread less than 1 cent, which means they can trade at 1.01 by 1.02, but never 1.015 by 1.017. If a stock trades below $1, they will trade down to fractions of a cent.
  • Tier 3 Penny Stocks: Sub-penny stocks are stocks that are below 1 cent per share, starting at .0099. These stocks won’t be listed on NASDAQ or NYSE, so they don’t have any minimum requirements to meet. In general, a company that isn’t strong enough to have its stock priced at 1 cent per share, at least, isn’t likely to give you the returns you’re looking for.
  • Tier 4 Penny Stocks: Trip zero stocks are priced with three zeros, so at .0001 and .0009 per share. Even an incremental increase in these stocks is a 100 percent move over the entry price of .0001, so they’re often manipulated. “Hot penny stocks” promotions are often sub-penny or trip zero stocks that are designed to benefit the original trader, rather than giving you any real edge.

How to Invest in Penny Stocks for Beginners

For many people, the idea of leveraging small amounts of money on cheap, volatile stocks into millions in returns is just a pipe dream. People succeed though, and they do it so consistently that it can’t be written off as dumb luck.

On the other hand, the allure of becoming an overnight millionaire has increased the popularity of penny stocks and caused many people to end up losing significant amounts of money. Roughly 10 percent of traders will become profitable, with the rest becoming a cautionary tale.

So, how do you make these odds work in your favor? The trick with penny stocks is recognizing the ones that will make big moves and finding them before that happens. Essentially, you have to predict the behavior of penny stocks to stay ahead of the market shift.

Successfully trading penny stocks depends on your ability to find the stocks with the highest chance of having a strong run. If you’re jumping on the investment that everyone’s talking about — the one that’s all over the news, sent to you in emails, or all over social media — you’re already late to the party. The hot stock is all over everyone’s radar, so the trade is already crowded, competitive, matured, and incredibly overpriced. When something goes from a current trend to a former trend, the shares of penny stocks in that industry collapse.

Similar to traditional investing, trading penny stocks work best when you start with what you know. People working in a specific industry, such as biotech or programming, are more likely to find out about upcoming trends in that industry. When you use that knowledge to inform your choices for penny stocks, you could be the one who finds the hidden gem before anyone else knows about it.

If you’re not in the type of industry that gives you insight into the market, you can still use your knowledge to select the right penny stocks. The industries you have a passion for offer opportunities as well, provided you know enough to catch on to new innovations that are poised to burst onto the scene.

Focus on the industries and passions you understand to gain an edge on the market. Research companies, read reports, check out new developments, then put that effort into the penny stock companies with the most potential.

Penny Stock Terminology

Before you learn how to buy penny stocks, let’s cover some of the common terminologies:

  • Pump and Dump: A pump and dump is when a stock is promoted to sell at higher prices, usually using deceptive language. A stock promoter will tell traders that a stock is expected to rise, and knowing that there will be an influx of buy orders, they’ll get in early and get out before the inevitable crash comes.
  • Reverse merger: A reverse merger is a cheap, quick way for companies to offer an initial public offering. It usually occurs between a penny stock company and a developmental company in order to hype up the newly-public stock price.
  • Margin: A margin is used to borrow shares from your broker in order to short sell stocks.
  • Leverage: Leveraging is borrowing capital from your broker that exceeds the money in your account. This comes with incredible risk since you could end up losing your own money and still owing money to the broker.
  • Short squeeze: A short squeeze is when a short seller tries to avoid losses by buying enough to cover their positions. If you’re betting that a stock will fall, you risk squeezing the stock as you buy and cover positions while the stock price rises against you and the other short sellers.
  • Hard to borrow: When you short sell, brokers need to find available shares for you to short. If there aren’t enough shares to short of a specific stock, the stock is known as “hard to borrow.”
  • Pre-borrows: Pre-borrows give you the option to reserve shares of hard-to-borrow stock in advance to short later on, which can help you gain an edge over other short sellers.

Analyzing Penny Stocks

Stocks are usually judged by the performance of the company, but this isn’t a complete strategy when dealing with penny stocks.

Fundamental analysis, or fundamentals, is based on the company’s actual business, such as its revenue, losses, profits, and projections, which can be used for valuation and investing. A company’s earnings-per-share, or EPS, is the profits divided by the total number of outstanding shares. The price-to-earnings ratio, or P/E ratio, is the stock’s price divided by its earnings, which is used to determine how expensive the stock is. All of these can influence penny stocks.

Technical analysis, or technicals, is another strategy in trading and investing. This method judges a stock on the price action and chart patterns, rather than information about the company itself. Technical analysis is often used in conjunction with fundamental analysis, but rarely on its own.

Why does this matter? Unlike traditional investing, penny stocks are all about the technicals. With lightning-fast trades and limited company information, fundamentals for penny stock companies aren’t much help. Technicals can give you insight into the movement of penny stocks, however, which is how you cash in.

One key element of technical analysis is a stock’s moving average, which is the average price of the stock during a specific time period. Basically, this cancels out the “noise” of market fluctuations to find the true trend over time. Shorter moving averages are better for short-term trading, such as penny stocks, because of the lag in prices.

A rising moving average indicates that the stock is in an uptrend, while a declining moving average indicates a downtrend. If a short-term moving average has a bullish crossover, meaning it crosses above a longer-term moving average, the upward momentum is confirmed. If the short-term moving average has a bearish crossover, meaning it crosses below a long-term moving average, the downward momentum is confirmed.

Here are some other elements of technical analysis:

  • A breakout is a price movement through an identified level of resistance, which is typically followed by increased volatility and heavy volume. This typically occurs when there’s an excess of supply that overwhelms the demand, impeding the upward movement, such as with breaking news and developments.
  • A breakdown is a price movement through an identified level of support, which is typically followed by sharp declines and heavy volume. Because this can signal a downtrend, this is a common time for the short sell.

Each of these elements can give you valuable insight into the performance and predictions of a penny stock.

Where to Buy Penny Stocks

As we mentioned, penny stocks can be manipulated. If you want to minimize your risk as much as possible, it’s best to find a source that’s reliable and trustworthy. In fact, gathering information from several sources gives you the best advantage. Conduct your analysis, make your trades, and learn from the results.

You can find many penny stocks yourself with a stock screener, which helps you identify potential investments. Most major financial sites offer free stock screeners that allow you to filter the results. If you want to find stocks trading at $4 or less in the biomedical industry, you can input those parameters to return only those results, which saves you time and effort in your planning process. The more you learn, the more you can push the envelope and take greater calculated risks for greater returns.

The Difference Between Penny Stock Investing and Penny Stock Trading

Penny stocks are unpredictable, volatile, and at risk of market manipulation. Investing is all about the long game, so truly investing in penny stocks isn’t feasible.

Investors look for diversified assets that are likely to have a modest upward trend over time. With penny stocks, you need to think short term, and you need to be tenacious enough to be one of the first ones in on the stock and one of the first ones selling out with a profit.

Penny stock companies typically don’t have the solid fundamentals of well-established companies, but they can announce a new development or partnership out of nowhere and have a spike. For this reason, shorting the stock is incredibly risky and ill-advised.

Investments That Can Influence Penny Stocks

There are several different investment types in traditional investing, all of which may have an influence on the performance of penny stocks.

  • Stocks are the best-known type of investment. Stocks are percentages of ownership in a company, not an investment in the company itself, and can fluctuate in value.
  • Commodities are physical substances, such as oil, gold, or other precious metals. The prices of commodities can influence penny stocks, though not by much.
  • Derivatives are futures and options, which derive their value from other investment types. They can influence penny stocks, but there’s not a direct correlation.
  • Real estate investment is a common choice for conservative investors to grow their wealth. Real estate investments can influence penny stocks in some ways, such as if a penny stock company owns a lot of real estate.

Even if you’re familiar with trading some or all of these, it’s important to remember that penny stocks are an animal all their own.

How to Day Trade Penny Stocks

Once you get the hang of the fluctuations in the penny stock market, day trading successfully isn’t out of reach. It will eventually become second nature for you to make the right moves and rake in the profits, as long as you avoid certain pitfalls that claim many penny stock amateurs.

Whether beginner or veteran, it’s always smart to avoid over-the-counter or pink-sheet-listed penny stocks. Companies that trade on these markets have fewer regulations, so they’re extremely vulnerable to fraud and manipulation. Stick with the major exchanges, like NASDAQ and NYSE, where the companies have to comply with strict requirements.

Avoid promotions as well. Catching the trend before it becomes a trend isn’t possible if you hear about it at the same time as everyone else. Hot penny stock promotions claiming to have the secret to the next Microsoft or Apple are usually trying to maximize their own profits on shares they own, not to mention that companies like these don’t start out in penny stocks. Big companies typically begin with IPOs, or initial public offerings, that are priced much higher than penny stocks. If you’re buying a penny stock share in hopes that it will blow up like that, you’re investing in one of the most speculative and high-risk options in the market.

Volume is another important aspect of successful penny trading. You want to avoid illiquid stocks, or stocks with few participants and low volume. Most penny stocks trade about a few thousand shares a day, which isn’t liquid enough to be in play, but breaking news for a company could cause a trade at millions of shares, which is the right time to trade. You should also keep your share size small so you can get out of your position faster, if necessary.

When it comes to returns, think small. Take a win of 20 or 30 percent and sell quickly. Don’t focus on finding thousands on a single trade, but look to trade penny stocks in volume to hit small returns that add up over weeks and months. This not only helps you make a true living, but it also keeps you from losing it all while you wait for the stock to have outlandish returns.

Finally, don’t bank on being the next “rags-to-riches” penny stock story. This is no place for romantics, so keep your head, stay skeptical, conduct your own research, and don’t be afraid to bail out of your position before the losses are too great.

Finding Penny Stock Brokers

Though most people think of brokers as the big-time brokers on Wall Street, there are many different types of brokers in investing and trading.

  • “Boiler room” brokers are brokers who use marketing techniques to take advantage of inexperienced investors. They have a powerful influence on penny stocks, however, and often try to manipulate them.
  • Online discount brokers can be found on online brokerage sites and handle electronic trading. These brokerage sites require very little money to sign up and are a great way to learn penny stock trading online.
  • Full-service brokers can be found at small and large firms, though they usually avoid penny stock trading. These are licensed brokers who don’t want the liability associated with trading risky penny stocks.

When you’re searching for the best penny stock broker, there are several things to consider. Brokers add a surcharge to stocks that are priced under a certain dollar amount, and this value can vary by broker. Because penny stock trades involve large numbers of shares that can ramp up surcharges, it’s especially important to find penny stock brokers with a flat commission.

Some penny stock brokers also have volume restrictions for trades. The best penny stock brokers will allow trades of unlimited shares without any additional fees, giving you the chance to maximize your possible profits, so there’s no reason to pay more for your large orders. Some brokers limit the number of shares you can trade in one day or in a single order, and since this type of trading is the foundation of penny stocks, you wouldn’t want to miss out on opportunities for fast, cheap trades.

Trading restrictions are another thing to look out for when finding a penny stock broker. Brokers who require you to trade penny stocks by phone order or limit the types of trades you can execute will impact your ability to trade successfully. Like any other stocks, you should be able to sell and buy penny stocks online without any hassle.

Get Started Trading Penny Stocks

When you get started trading penny stocks, wouldn’t it be nice to avoid the common pitfalls that affect beginners? Fortunately, if you’re interested in trading penny stocks, you can learn the ropes from the team at RagingBull. The experienced traders you can connect with through Raging Bull have been teaching beginners how to gain financial freedom by mastering penny trading. They’ve put together informative and interesting FREE materials that you can use to hit the ground running.

The best way to get started is with the FREE Raging Bull Bootcamp, which provides you with tips and tricks that seven top traders have used to beat the market and earn exciting returns.

If you’re the type of person that likes to find diamonds in the rough, you can use the Ultimate Penny Stock Playbook to learn how to find the next Amazon before the competition. With these resources, you can turn your small account into a future fortune.