Penny Stocks: What Are They and How Do You Make Money with Them?
Day trading penny stocks has skyrocketed in popularity in recent years, due to the low barrier to entry and the ability to turn small sums into large gains. Savvy investors who have learned how to make money with penny stocks have the potential to make quick profits, but the vast majority of penny stock investors will lose their shirts.
So, can you make money on penny stocks?
The short answer is yes, but it’s important to remember that trading penny stocks isn’t like trading your average stock. To learn how to make money with penny stocks, you’ll want to understand all the ins and outs before you dive in.
What Are Penny Stocks?
Penny stocks are called by many names, such as microcaps, small caps, stocks under $5, and more. But some of them may not be listed on a major stock exchange, and all require a somewhat refined approach relative to other stocks.
Most stocks are listed on NASDAQ, the New York Stock Exchange, and other major markets. Penny stocks, on the other hand, are often traded on the OTC, or Over the Counter, markets. This doesn’t factor into the trade, however, and most online brokers support this market.
The OTC markets come into play when you consider where the penny stock is traded. The OTC Bulletin Board, an electronic trading service operated by the Financial Industry Regulatory Authority, requires all companies to meet the minimum standards of keeping up-to-date financial statements. Penny stocks listed on publications like the Pink Sheets may not have met these requirements, giving you less information to base your trading decisions on and carrying a greater risk.
4 Tiers of Penny Stocks
- Tier 1 Penny Stocks: These are the stocks listed on major stock exchanges like NASDAQ and the New York Stock Exchange. They’re usually priced below $5 per share, although they can be a bit higher. They’re held to higher standards than OTC penny stocks because they have to provide financial information to the exchange, which means they’re less open to manipulation.
- Tier 2 Penny Stocks: These are traditional penny stocks that are typically between one cent and 99 cents.
- Tier 3 Penny Stocks: These are sub-penny stocks, which trade below one penny per share. Ultimately, these companies aren’t strong enough to have the stock priced at one penny per share. You’ll never find these stocks on the New York Stock Exchange or NASDAQ.
- Tier 4 Penny Stocks: These are triple zero stocks, which means they are priced between 0.0001 and 0.0009 cents per share. Oftentimes the “hot penny stock” alerts are on these stocks and primarily benefit those who bought the stocks first.
Penny Stocks or Cheap Exchange-Listed Stocks
Technically speaking, stocks listed on traditional exchanges aren’t penny stocks, regardless of how low their price is. If shares of a major company suddenly plummeted below a dollar, it wouldn’t automatically make them a penny stock. Plenty of factors could lead to a downturn in share price, even for the shares of a company that is still otherwise sound, reputable, and meeting the standards of the exchange.
As you’d expect, a company that has stock on the exchange offers a certain confidence to investors, since they’re not typically viewed as volatile. The NYSE and NASDAQ require a minimum market cap and share price to list, as well as annual listing fees. If a stock drops below the point where its capitalization or price per share is too low to meet these standards, the market has the option to delist the stock. If this happens, the stock moves to the OTC market. If you happen to own shares of a delisted company, you still own those shares, but they just won’t be worth as much.
How to Find the Best Penny Stocks
As mentioned above, trading penny stocks is risky. Many of these companies are fly-by-night and highly volatile, which puts traders in a position to lose big. However, you can still make money trading penny stocks if you trade smart and know what to look for.
What makes a penny stock a potential money-making stock? There are a few characteristics to look for:
- A company needs to make money. A company that loses money will always be a bad investment, no matter how low the share price is.
- A company needs substantial assets or cash. Strong businesses shouldn’t need to liquidate future viability to appease creditors, because they have enough cash to account for contingencies.
- A company must have a strategy in place. Penny stock companies don’t want to be penny stock companies, so the successful ones have a strategy in place to grow the business and get listed (or re-listed) on a major exchange. These goals should include rebuilding a long-term business and paying back investors.
These three characteristics help you determine a great penny stock to invest in and how to minimize your risk.
What You Need to Find Good Penny Stocks
Part of the challenge in determining how to make money trading penny stocks is finding them. Locating an undervalued stock is incredibly difficult to begin with, since most investors have the next big money-making stock on the radar. With penny stocks, you’ll also need to find the undervalued stock that has a positive value, strong financials, and a promising outlook.
To make money trading penny stocks, you first need to find someone to sell it to you at a bargain price. If a company turnaround is expected, a trader is going to hold onto shares to reap the rewards, which makes these shares more difficult for you to buy.
Once you’ve purchased the potentially lucrative penny stock, you also have to be sure you can turn around and sell it. You can always hold onto it and take a chance on it being hot in the future, but remember that you got it for a bargain because it’s not hot right now. No one is looking to buy it.
Considering all of this, the best hope of making money with penny stocks is finding the hidden gem, buying it at a bargain price, and holding on to it until the company rebuilds and gets back on a major market exchange again.
Using Scanners to Find Penny Stocks
To trade penny stocks successfully, you need to find the stocks that have the highest probability of going big. For many traders, scanners are the best way to do that.
Traders use stock screeners to narrow a huge list of available stocks to a small list with the characteristics they’re looking for. By applying a filter to the stock screener list, you’re left with only the stocks that fit your parameters. Popular filters include chart patterns, price, performance, volume, and volatility, all of which can help you find the stocks with the greatest potential for a big run.
Three specific parameters to find these stocks are:
- Breaking news. Look for stocks that are gapping up because of a news break that could be lucrative for the company. Avoid stocks that have publicity from a buyout or something similar, however, because that usually means a breakeven result or a loss for the shares.
- Float. The float is the number of shares actually available to trade, which is calculated by subtracting the closely held shares from insiders, employees and the company’s stock ownership plan. Ideally, you want the float to be below 100 million shares, but 50 million is even better. When a stock has fewer shares to trade, there’s more buying interest that could drive the price up.
- High relative volume. The relative volume is an indicator that tells traders how the current volume compares to the past trading volumes over a specified period of time, which gives you an idea of how “in-play” a particular stock is. The higher the relative volume, the more traders are watching and trading it, giving it plenty of liquidity for you to trade.
After you create your watchlist according to this criteria, you can wait for the market to open and see if there’s a breakout over pre-market highs for an entry point, or wait for a bullish flag pattern, which signals a move higher.
Reading Stock Chart Patterns to Find Penny Stocks
Like other types of stock market trading, there are two types of analysis in stocks: fundamental and technical. Fundamental analysis uses information about the company itself, such as management, debts, contracts, lawsuits, and revenues, while technical analysis uses patterns on a trading chart.
Fundamental analysis is the preferred method of most traders, though a combination of both analyses can prove more beneficial than using one over the other. Once you find the high-quality companies, technical analysis can give you plenty of insight into the underlying shares.
The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements on a scale of zero to 100. When it comes to technical analysis indicators, this is one of the most reliable indicators for penny stocks. Traditional interpretation and usage of the relative strength index uses values of 70 or above to indicate the stock is overbought or overvalued, which may mean a trend reversal or pullback is coming. A value of 30 or below is interpreted as indicating a stock that’s oversold or undervalued, which may signal a trend change or correct price reversal on the horizon.
Here are some of the most reliable patterns to look for:
- Bottoming-out patterns. Bottoming-out patterns are another reliable way of assessing penny stocks. This pattern emerges after a long, sustained slide in the share price. The trend goes downward over several months, then goes sideways for a few weeks. When this occurs in conjunction with a sudden increase in trading volume, the shares are expected to enter a sustained recovery in price. This is especially true if it occurs with an oversold condition.
- Price dips. Penny stocks are thinly traded, so they can have incredible price volatility due to the imbalance in buy and sell orders. This can lead to shares dipping significantly when the sellers outweigh the buyers. If a stock suddenly drops without any discernible reason and on a low trading volume, this is a price dip pattern. Price dips provide an opportunity, however, because they typically reverse. Taking advantage of price dips is all about being in the right place at the right time, keeping a buy order on a thinly-traded penny stock that’s well below the recent price, and getting some of these shares at a lower price.
- Top-out pattern. A top-out pattern has similar principles as the bottoming-out pattern, but in reverse. With this pattern, shares have been climbing for long periods of time, but appear to be leveling off or turning sideways. Sometimes this is just a short break before moving back up, but if it occurs with a penny stock, especially alongside a declining daily trading volume and overbought condition, others may be preparing to move in on it. Shareholders are looking to sell to capture the high prices, while buying ends, leading to tumbling share prices.
- Share consolidation. Share consolidation is when a base of shareholders turns over, and it’s a great sign for penny stock prices. Stockholders have high expectations for the shares they bought, so they intend to hold onto them. The frustrated shareholders are looking to get out, however, so there’s a transformation happening. The penny stock will trade sideways on a higher-than-average volume, which is a bullish indicator for the future of the shares. The stocks will reach a tipping point when there are no more sellers looking to get out and a small percentage of owners holding on, so the next move for the stock is high.
- Candlestick chart patterns. Candlestick chart patterns are unique in that they can show if a penny stock’s trend is about to reverse, or if prices may rise or fall in the short term. Candlestick chart patterns speak to investor psychology, which has an incredible impact on the state of the market. Generally, candlestick patterns are a great way to confirm the existence of other patterns.
- Gapping. Gapping is when a stock opens higher or lower than it traded the day before. If a share gaps higher, it’s a bullish indicator, and if it gaps lower, it’s a bearish indicator. This is a technical indicator that can be misleading, but it still has enough validity to belong in your arsenal of penny stock strategy.
- Going against trend. Going against the trend is one of the most reliable technical indicators with any type of stock shares, but it works incredibly well for penny stocks in particular, due to its ability to identify stocks that perform well under pressure. If the market as a whole has significant dips and a specific industry sees a drop, the shares that stay steady in price are the ones standing to gain when the market recovers. For example, if the shares you’re watching fall only slightly, stay steady, or even increase in price while the rest of the stocks are going downhill, that’s a bullish sign for that stock.
Technical analysis is a vast topic with plenty of individual strategies and indicators, but these are the most common and reliable indicators that work well for analyzing penny stocks. Just be sure to remember that they aren’t infallible and should be worked into a larger strategy.
Using Financial Ratios to Find Penny Stocks
Like chart patterns, financial ratios can be used in conjunction with other analyses to determine the right penny stocks to trade. With adequate financial disclosure, which shouldn’t be a problem with more reputable penny stock companies, the same analytical methods used for larger companies can be used to assess the worth of a penny stock.
A positive trend on the balance sheet and strong numbers are important because so much of a penny stock’s value is based on projected performance.
- Liquidity ratios. Liquidity ratios, which include the quick ratio, cash ratio, and current ratio, are the first ratios that you should consider in analyzing penny stocks. Penny stocks can’t always cover their short-term liabilities within a given time frame. Lower liquidity ratios are a good indication that a company is struggling to stay in business or grow.
- Leverage ratios. Leverage ratios are another important subset of ratios. These are similar to liquidity ratios in that they focus on a company’s ability to cover its debt, though this pertains to long-term debt and is broken down into debt ratios and interest coverage ratios. Debt ratios will shrink or expand, but expanding ratios should only occur if the company is trying to support future growth and development. Interest coverage ratios measure the debt load and the company’s ability to manage it, so higher interest coverage ratios are preferable.
- Performance ratios. Performance ratios include subsets like gross profit margin, net profit margin, and return on assets. These help quantify money made at each level of the income statement, which should reflect steady and sustainable growth in operating earnings.
- Valuation ratios. Valuation ratios measure the appeal of the stock at the current price. In the case of penny stocks, stock shares can be undervalued. Price-to-earnings ratio is the most common ratio for stocks, but it becomes meaningless if a company’s earnings are zero or negative. With penny stocks that fall into this category, the price-to-sales and price-to-cash flow ratios are more effective.
These financial ratios can be calculated and compared to the same ratios for previous periods or projected ratios, as well as ratios of direct competitors or the overall market to gauge the company’s value.
Minimize Risk with Penny Stock Trading
Do penny stocks really make money? Yes, but they can also lose a lot of money. Penny stocks are a risky investment, but there are some ways to lower the risk and put yourself in a position for money-making penny stock trading.
- Pick stocks from companies in the OTCQX tier of the OTC markets, because this tier has stricter financial standards for listed companies. These companies must comply with the U.S. securities laws and meet higher standards of operations compared to OTCQB and OTC Pink Markets.
- Avoid Pink Sheet stocks, which are prone to manipulation and fraud. The most reputable companies are not only more likely to give you a return, but they’re also a less risky investment.
- Avoid pump-and-dump scammers. Many OTC penny stocks will be promoted as the next big breakout, but the reality is that these large companies that provide a near-guarantee of success start with a high-priced IPO, not on the penny stock market.
- Avoid low-liquidity penny stocks. Most penny stocks have a volume of around thousands of shares a day, but penny stock companies with breaking news could have a high volume of millions of shares in a day. How do penny stocks make money for you? This is the time when you’re likely to cash in, and in the penny stock world, there’s some major event nearly every day.
- Don’t overtrade. Once you find the stocks you want, buy where you think other traders will enter, know when to sell penny stocks, take quick profits, and adjust the stops for small gains that add up over time. You may get lucky and have a big win on occasion, but most of your money will come from these smaller trades.
- Focus on trading and not investing. Trade penny stocks every day, and you’ll find that you’re making money from buying and selling penny stocks, rather than investing in the next big hit. Added up over weeks, months and years, you’ll find that you’re raking in cash.
- Understand the business. It’s important to understand the business you’re investing in before you buy stock in the business. Doing background research and monitoring the news and market for big events is a common practice for day traders. You should apply this same strategy to trading penny stocks.
- Diversify your penny stocks. While opinions vary on the number of penny stocks that you should own, you should be in at least three of four sectors of the economy that are healthy and growing.
- Only risk what you can afford to lose. There are no guarantees in investing, especially when you’re trading penny stocks. You should only trade with money that you can afford to lose if the worst-case scenario does happen.
With the risk and uncertainty of trading penny stocks, this option isn’t a great choice for everyone. However, if you can tolerate a little risk and think quickly on your feet, penny stock trading can be a great source of income with the potential for massive gains.
Now that you know a little about how to make money investing in penny stocks, you can educate yourself even more to become an expert.