There are many risks with penny stocks even before you begin talking about the risks of day trading. Day trading combined with penny stocks is a very risky endeavor. If you’re considering taking that route, be sure you’re trading with money you can absolutely afford to lose, because most of the time, that’s exactly what will happen.
Also keep in mind that many of the leveraging strategies day traders use may not be available with penny stocks. For example, most brokers don’t allow you to short penny stocks or use options for trading them.
Thirdly, most brokers don’t allow stop-loss orders on penny stocks that trade OTC. You can get around thatby sticking to penny stocks that trade on the exchanges, and in fact, most veteran day traders stick to only listed penny stocks.
Final main point; penny stocks often have extraordinarily low trading volumes, which means that your order may not get filled, or it may get filled over several days.
If you understand the risks and limitations, day trading penny stocks can be exhilarating and occasionally very rewarding.
First, you want to screen out stocks with low volumes; most penny stock day traders look for a minimum of 250,000 daily average volume. Too low, and you may not be able to fill your orders. Second, since you may not be able to short penny stocks traded OTC, you want to identify those that have had an increase in net price of at least 5%, but no more than 10% or 15%. A 5% bump suggests the stock may be entering a breakout, but above 10% or so, you may be looking at a pump and dump scheme, and you don’t want to get caught in a runaway market. You should also check for tight bid-ask spreads.
You can’t really use fundamental analysis on penny stocks, so sticking with technical indicators like moving averages is a better way to go. A stock with a rising short-term moving average and bullish crossover, meaning the short-term has risen above the long-term moving average suggests upward momentum.
Look for breakouts and breakdowns to time your entry. A breakout is when prices break past resistance moving upward; a breakdown is when they move below a level of support. Breakouts and breakdowns are usually marked by volatility and heavy trading volumes, which confirm the trend.
Next, you need strategies to limit your losses. If you’re trading penny stocks on the exchange, you can use stop-loss orders. An effective strategy might look like this:
Stock XYZ is trading at $1.85, and you see a long-term support level at $1.75 that the stock has approached but never crossed in a particular period of time. So you put in an order to buy 1,000 shares just slightly above the support level, say $1.78. As soon as it’s filled, place a stop-loss order for those same 1,000 shares at a penny or two below the support level, say $1.73. That limits your potential loss to about 2%, which is a good threshold for day trading.
Hedging and averaging down is another strategy for day trading penny stocks. You can do this whether you’re buying or selling. The strategy involves entering multiple buy or sell orders at different prices. If you’re buying stock ABC, for example, you make one order for 2,000 shares at $0.50 and another for 2,000 shares at $0.44.
If the price falls enough that your first order is filled and continues to drop until your second order is also filled, you can now average your price to $0.47 a share and still make a profit at $0.48 a share.
If the price falls and your first order is filled, but then it starts to rise, your second order won’t be filled, but you may be able to sell your 2,000 shares at a profit.
If the price never falls low enough to fill your first order, you’re not out anything and you haven’t lost anything. And in fact, an unfilled order isn’t a sign of failure; it actually suggests you’re doing it right.
Remember, when you’re day trading, you’re not looking for 40% or 50% returns, you’re looking to make several small wins, 10% or 20%. Waiting for the “grand slams” with highly volatile penny stocks is a recipe for losing it all. Exit the trade as soon as you can lock in a solid gain.