How to Trade Penny Stocks: What Potential Investors Need to Know

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While many investors are attracted to day trading penny stocks because of the minimal investment and potential large payouts, it’s also important to understand the risks involved before getting your feet wet. Penny stocks are classified by the U.S. Securities and Exchange Commission (SEC) as those trading under $5 per share. Approximately 18,000 publicly traded companies issue penny stocks. Because these companies are new and haven’t had time to establish a track record, they are considered speculative investments. That means they are not necessarily valuable, but they might be.

Another common definition of penny stocks is those issued by companies that have a total value of less than $50 million. Most penny stocks have a low daily share volume of just a few hundred shares or less. Because larger stocks rarely double or triple their value in short periods like penny stocks do, they don’t have the same potential to return 200 to 300 percent of your investment. Do your research about how to trade penny stocks to evaluate whether this is the right investment route for you.

Are Penny Stocks Right for You?

Image via Flickr by John Jones

If you are risk-averse, this likely isn’t the right investment vehicle for your personality. If you have the funds to play with and are OK with a little risk with the potential for reward, penny stock trading could be quite lucrative for you. Before getting started, seek a reputable mentor who is familiar with the industry and learn everything you can from that individual. The higher the caliber of the advice you receive in this field, the better your results will be.

To test how well you might be able to do as a penny stock trader, start out with paper trading. This allows you to keep track of imaginary stock trades and project your virtual performance without using real money. Try out different strategies and methods with paper trading before you put your actual funds at risk. Along the way, you’ll learn the jargon used in penny trading and possibly encounter a mentor who can show you the ropes.

Take one final step before paper trading, though: Document your desired objectives. Why are you getting involved in penny stocks? Do you see it as a fun hobby and aren’t concerned about profit, or do you want to make a certain amount of money in a specific amount of time? Without having an established goal, you won’t have any way of benchmarking your progress.

How Penny Stocks Work

The premise is simple: Buy an inexpensive stock for pennies on the dollar; then resell it once the price rises to make bank. For example, if you purchase 1,000 shares of a 5-cent stock for $50, and you are able to sell your shares after the price reaches 50 cents, you’ve made $500 — 10 times your initial investment. It’s important to understand, however, that opportunities of this magnitude are rare. Avoid getting caught in a bubble by those who promise riches that never materialize.

The Lingo

When you first start trading penny stocks, you’ll likely come across much unfamiliar jargon. Some of the most common terms you’ll need to understand include:

  • Averaging down, which occurs when you already own a penny stock and buy more shares of that same stock at a new, lower price.
  • Blue Chip stocks are conservative, low-risk investments, often held up as the opposite of penny stocks.
  • A bid is the price that a stock is currently selling for on the market.
  • Hedging is a strategy in which you purchase investments in opposing industries to cover your bases. For example, you could hedge by buying stock in both an automaker and a gas company. No matter what happens with gas prices, you’ll likely profit in one of those avenues.
  • A limit order is when you state the price you are willing to pay or accept when buying or selling a stock share.
  • Market capitalization is the number of shares a company has issued multiplied by the share price. This is a quick way to estimate the business’s value.
  • With a market order, you state that you want to buy or sell a specific stock at whatever price the market will currently bear (unlike a limit order, where you specify the price).
  • NASDAQ is the world’s largest online investment trading platform. You can trade penny stocks on the NASDAQ SmallCap exchange, limited to stocks that don’t qualify for the main market. Most of these are priced between $1 and $5.
  • A partial fill is when you are able to trade only a portion of the shares that you planned to trade.
  • A takeover is when one company buys all or most of the stock shares of another company. This event is often a catalyst for higher share prices.

Finding the Right Penny Stocks

To make money from penny stocks, it’s important to choose the best penny stocks to day trade. Look for investments with a solid 52-week high and a consistent pattern of increased earnings. Avoid choosing penny stocks just because they are written about in a free penny stock trading newsletter. Read the disclaimers carefully; often, the publishers are paid to promote a specific company, which in turn can artificially inflate the stock price.

Focus on high-volume penny stocks, defined as those trading at least 100,000 shares each day. Otherwise, you may get stuck with stocks you can’t sell. The same goes for stocks trading at less than 5 cents a share, which are generally less liquid than those trading at 50 cents per share or higher. For best results, look for the highest performing stocks with a volume of at least 250,000 shares each day and a consistent 52-week high.

You can also narrow your search by choosing penny stocks in a specific industry. This doesn’t necessarily have to be in the current hot industry. If you’re just hearing it about it, chances are everyone else already knows. And when it comes to penny stocks, changes happen quickly and the next big thing is already on its way out the door. Instead, seek success by buying stocks in the industry you’re most familiar with. If you’re a gadget lover, choose penny stocks from tech companies. Love hiking? Look for up and comers in the outdoor industry. You’ll have an advantage immediately over traders who are inexperienced in that realm.

Research Methods

As with other areas of investing, doing your research is the key to success in penny stock trading. However, this niche is also rife with bogus publications artificially pumping up the value of worthless penny stocks. You’ll need to be able to separate the wheat from the chaff when it comes to finding reliable resources.

Avoid relying on a single source. Instead, synthesize and critically evaluate the information from many trustworthy sources, so you can develop your own conclusions.

With stock screener software tools, you can set parameters and search for your own stocks that meet those criteria. This can be a good way to focus your research, since you can corroborate your own observation with reports from others to determine whether a penny stock is worth your investment. Many of these tools are free or cost just a few dollars.

How to Trade Penny Stocks

Trading penny stocks is as easy as logging on to your computer. You’ll need to know the name of the company, its ticker symbol, the exchange where it is trading, and the number (volume) of shares you want to buy. You’ll also need to decide whether to place a limit order or a market order. With a limit order, your trade will go through only if your specified price is met.

With a market order, your trade is guaranteed to go through, but the price is not guaranteed. Market orders are filled right away, while you must set a duration for limit orders. For penny stocks, it makes sense to set a “day order,” which means your order expires at the end of the day regardless of the number of shares traded. If your order extends to the next day, you’ll double your broker commission.

Multiply the number of shares times the cost per share to figure out how much your order will cost. While you can easily place an order with an online broker, you can also do so over the phone for a slightly higher cost. This is a good strategy for your first few trades, since you’ll have a live broker to answer any questions that arise.

Any orders you’ve made that haven’t yet been fulfilled are considered open orders. You can monitor these using your online brokerage account.

Choosing a Broker for Penny Stocks

The process of opening a brokerage account is similar to opening a bank account. You can choose either a discount or a full-service broker. The discount option is more appropriate for penny stocks because of its lower fees. Trades can cost as little as $5, and you’ll have access to an online account where you can view all your transactions and open orders. A full-service broker works one-on-one with his or her clients. This type of broker charges a much higher commission but also offers investment ideas and advice.

Once you know what type of broker you want to work with, research the following before opening an account:

  • What are their commission fees?
  • How fast can a trade be executed?
  • How reliable are your systems?
  • Are you accessible 24/7?

If you’ll primarily be trading penny stocks, look for a broker with features that are amenable to these types of investment. Look at whether they require a minimum balance, charge monthly fees, charge commissions on penny stocks that are as high as those for traditional stocks, and whether they handle trades from the penny stock markets.

Where to Trade Penny Stocks

Although some penny stocks are on the major exchanges, many are not. The NYSE American tends to be a good source for this type of investment. As mentioned above, the NASDAQ SmallCap exchange is a good place to get started with penny stocks. This is the safest market for penny stock traders because the companies traded here must comply with financial reporting requirements. It’s also covered by major financial publications and sources.

Other stocks that don’t meet the criteria for major markets are typically listed on either the OTC Bulletin Board (OTC-BB) or the Pink Sheets. OTC-BB is run by NASDAQ and consists of about 50 percent penny stocks trading at less than 50 cents a share. When a stock drops below $1 per share, it is usually removed from SmallCap and pops up on OTC-BB.

A private New York company called the National Quotation Bureau runs the Pink Sheets, which contain information about 3,000 stocks. They are printed on pink paper and sent to subscribers each day. Keep in mind that trading activity in this market is sporadic, and the companies traded here have no financial reporting requirements, and thus, no responsibility to the investors.

Toronto Stock Exchange (TSX) and Toronto Venture Exchange (TSX-V) are Canadian markets that provide a rich source for penny stocks, provided your broker allows Canadian trading. Companies on these exchanges tend to be small but reputable, easy to research, and subject to rigorous financial reporting requirements. Keep in mind that brokerage fees may be higher than with domestic trades.

Profit Strategies

If you want to learn to trade penny stocks, you need to develop a working strategy and stick to it in every situation. The first rule of thumb? Aim for a 20 to 30 percent return on each transaction. Traders influenced by overnight success stories often aim for a return of 1,000 percent or more when trading penny stocks and end up getting stuck with duds. Sell quickly and claim profit while you can.

Set mental stops to avoid losing more money than you can afford on penny stocks. While hard stop-losses can cause you to lose money because of the high bid-ask spread on these stocks, having your own threshold can keep your trading profitable. Many penny stock traders use a risk-reward ration to determine whether a trade is worthwhile. For example, if you’re trading a $5 stock, cut your losses at $1, so your risk-reward ratio is 5:1. Avoid trades with a risk-reward ratio of less than 3:1.

Limit your share size so it’s easier to get out of position if you need. A good rule of thumb is to trade no more than 10 percent of the daily volume of a specific penny stock.

The Role of Technical Analysis

Technical Analysis, or TA, is the process of analyzing stock charts to find patterns that can help you predict which penny stocks will be profitable. Although TA is not as reliable with penny stocks as it is with traditional, higher-priced stocks, it still has a place in your decision-making. Keep in mind that the higher the trading volume of a particular stock, the more reliable technical analysis will be. Some of the best TA methods for penny stocks include:

  • The bottoming out chart, characterized by a share price that trends downward for months before leveling out for several weeks. This is often associated with a significant, sustained price recovery, especially when paired with a sudden and dramatic increase in trading volume. This is particularly promising when the penny stock in question becomes oversold.
  • A topping out pattern, which is the reverse of a bottoming out pattern. Shares of the stock have been increasing for several months and have leveled off for a few weeks in a row. This typically indicates a good time to sell your penny stocks before prices begin to drop.
  • Price dips, a volatile chart with low sales volume in which prices dip in an absence of buyers only to rebound quickly, sometimes within minutes. Successfully riding these waves can allow penny traders to profit from the market volatility for this type of stock.
  • Share consolidation, which occurs when the trade volume significantly increases because many investors are looking to get out of that particular stock. Eventually, a tipping point occurs when many of the shareholders are new, and thus, less likely to sell. This pattern often precipitates a price climb.
  • Gapping, in which shares open with a higher or lower price than the previous day’s open. Shares that gap higher are typically a positive indicator, while shares that gap lower are a negative indicator. This allows you to time your penny share purchases and sales more easily.
  • Against the trend, which means the stock in question holds up in the face of a significant price decrease in the stock market as a whole and in the industry in particular. Look for stocks that fall less than 1 percent in price while the market is dropping by an average of 5 percent or more.

Even when these indicators are positive, make sure the trading volume of the stock is high enough to support successful technical analysis. In addition, TA should always be used in conjunction with fundamental analysis (FA), which looks at the specific characteristic of the company, the news reports, and the industry rather than simply reviewing the charts.

The Leeds Analysis

This analytical strategy was developed by industry experts specifically for use with penny stocks. It relies 80 percent on FA and 20 percent on TA to choose profitable investments in this category. With the Leeds Analysis, you’ll look at the following elements of a penny stock:

  • Trends in profits and earnings.
  • Trends in market volume, share, and size.
  • Barriers to entry, which means how difficult it is for competitors to enter that company’s industry.
  • Financial ratio trends, used to compare a business’s activity, liquidity, valuation, leverage, and performance.
  • Competitive strengths and weaknesses of the business in question.
  • The company’s balance sheet, which shows its assets compared to its debts.
  • The directions of the overall market.
  • Social and political trends that could affect the industry.
  • News releases issued both by the company and by others.
  • The status of the company’s partners, associates, and stakeholders.
  • Insider ownership of less than 35 percent.
  • Systemic market risk.
  • Nonsystemic company risk.
  • Penny stock competition.
  • Management and executive team.
  • Number of employees.
  • Intellectual property the company owns.
  • Pending legal actions against the company.
  • Shareholder turnover and consolidation.
  • Temporary and permanent dips and spikes in price.
  • Current trends and reversals.
  • Brand-value trends.
  • Brand awareness trends.
  • Product positioning.

If you can put in the research and work to analyze a penny stock company at this sophisticated level, you can increase your chances of profiting from this type of investment.

Pitfalls to Avoid

Although trading penny stocks is a perfectly legal and legitimate way to make money, they have a bad reputation because of the many scammers and other unscrupulous individuals who promote penny stocks, often using misleading language that is just shy of violating SEC regulations.

Don’t short sell penny stocks. When trading investments, you can sell shares before you purchase them at a higher price than you are buying them for, a strategy known as short selling. While this can be profitable with traditional trades, penny stocks are too volatile, and short selling can lead to financial loss of 50 percent or more.

Most penny stocks trade on the dark markets and the vast majority of those will lose money. Focus on reputable companies and reputable exchanges when trading penny stocks. If you’re not sure whether the claims made about a penny stock are legitimate, ask yourself: “Where did I hear about the company, and what was the source’s motivation for providing information about this penny stock?” If the resource does not offer a 100 percent unbiased guarantee, do not make a trade based on its information.

With the resources available at RagingBull, you can become a better trader for free in just seven days. Enter your email address on our site to request a free ebook. Joining our community of thousands of trainers and experts who have made millions of dollars by investing gives you the team support you need to excel in the stock market.