When many of us think of penny stocks, we immediately conjure up images of Martin Scorsese’s black comedy, ‘The Wolf of Wall Street’; charismatic stockbrokers living the high life and making money hand over fist.
They make it seem all too easy – fun, even.
In reality, penny stock trading is rife with scams and insider trading. Only the bravest and most seasoned of all traders dare to venture into this cutthroat world. It seems impossible to make any real profit.
Or is it?
In this guide, you’ll learn:
– What penny stocks are (with examples)
– Where & how to buy them
– Risks & benefits
– How to avoid penny stock fraud
– Trading patterns to use
Penny stocks are shares of a company that trade for $5 or less. The term used to refer to shares that were trading for less than $1, but the definition was expanded by the U.S. Securities and Exchange Commission (SEC). Penny stocks are generally regarded as being very risky investments as compared to established companies given their high risk of going bankrupt.
A good example of a penny stock is T2 Biosystems, which as you can see from the chart below is currently trading at $1.40, making it a penny stock. However, you bear in mind that most penny stocks do not start out as such, but they usually enter this category after their stock price suffers major losses. For example, T2 Biosystems once traded at an all-time high of $24.54 in 2014 but has since lost almost 95% of its peak value.
You can buy and sell penny stocks via a broker who has listed the stock as a tradeable instrument. Some brokers offer the stock directly, while others will allow you to buy and sell the stock as a CFD. Buying and selling a penny stock as a CFD does not make you an owner of the share since the CFD only tracks the underlying value of the stock.
To own the stock, you have to open an account with a broker who lists its actual shares and not its CFD.
Finding the best penny stocks to trade is a process that can be accomplished by following the simple steps outlined below.
1. Do some basic research
Penny stocks are risky investments and doing some basic research such as a Google search will help you eliminate stocks with no viable business. You’ll be surprised to find many penny stocks that have no legitimate business and have massive debts. You should avoid such stocks at all costs.
2. Focus on trading volatile stocks
While volatility might be a bad trait in blue-chip stock that rises slowly over several months and pay a dividend, it is a major asset when trading penny stocks. Volatile stocks can have major moves intraday such as a 50% gain and it is these stocks that you should trade as a day trader. Hence, the reason why you should stay away from non-volatile penny stocks that move slowly.
3. Look for high volume stocks
You should only trade penny stocks that have significant daily trading volume in order to avoid being stuck in a trade. We recommend stocks that have at least 200,000 daily traded volume. However, conservative traders could limit themselves to stocks with a daily traded volume above 500,000 shares.
4. Look for fundamental drivers
It is best to trade stocks that have a fundamental driver or catalyst such as a press release announcing drug trial results, positive financial results, or a new acquisition among others. Investors may react to positive news catalysts by bidding up the company’s stock price, while negative news could trigger a selloff, both of which present excellent trade opportunities.
5. Use a stock screener
Using a stock screener is one of the easiest ways to find the best penny stock that you can trade. You can use the screener to find stocks that meet all the above criteria including having a daily volume of over 200,000, trading at a certain price say above $1, and to identify the most volatile stocks.
These five tips should help you find the best penny stocks to trade on any given day while avoiding those stocks that have a high chance of resulting in losses.
As we've alluded to, there are some major risks attached to penny trading that you need to be aware of. Here are some of them:
The Pump and Dump Scheme
The pump and dump scheme is a classic scheme employed by most if not all penny stocks. The schemers, which is typically the company’s management, usually create interest in the company via different avenues such as a press release. They usually tout a new invention or a successful clinical trial for biotechnology stocks, which trigger a buying frenzy causing the company’s stock to rally. The company insiders then sell shares causing the price to tank as they pocket huge profits.
These are the polar opposite of pump and dumps as the scammers collude with short-sellers who borrow the company’s shares then quickly sell them in the market. The company’s share price will likely fall given the huge volume of shares on offer, then the short-seller will buy the shares at the lower price and return them to the owners.
Fraudulent Reverse Mergers
Reverse mergers are a tool used by many small companies to list on the stock exchange without having to pay the hefty fees associated with an IPO. However, fraudulent companies use the same strategy to get a listing on the stock exchange to fleece investors off their money before quickly going under. Doing some research should protect you from such scams.
Guru and Mining Scams
Guru scams are perpetrated through mass advertisements by people who claim to have uncovered the next big thing that will make investors money. These are usually elaborate scams that seem to have a lot of proof in the form of riches accumulated by the guru.
Mining scams work in much the same way as guru scams in that the perpetrators usually claim to have discovered some huge deposits of a precious metal such as gold. Investors who buy stocks in these scams usually end up losing their entire investors. Do not invest in such.
Such scams usually involve fraudsters listing the shares of a foreign company in the US claiming that they have access to opportunities in foreign countries. They usually end up selling shares of cheap foreign companies to unsuspecting US investors, then pocketing the difference and leaving investors holding cheap illiquid shares.
However, despite the negatives there are some benefits associated with trading penny stocks:
The best penny stock charts to trade are those where there are prior spikes as these indicate significant volatility. The ideal scenario is when those spikes occur at crucial support levels.
Let's take a look at our first example:
Here, you could have sold the two spikes outlined in this chart on the lower timeframe charts and made substantial profits on those particular days.
Here's another example:
The spike in this chart also presented an excellent shorting opportunity for aggressive traders who could have made a lot of profit on the move. The fact that the spikes in the two charts happened at critical support levels presented excellent trading opportunities.
The key to avoiding penny stock fraud is to do some research on any company that you want to trade or invest in before putting your money at risk. Remember nobody cares about your hard-earned money more than you, which is why you’ll hear the common phrase, ‘do your own due diligence.’
Researching a company will help you determine whether it is a fraud or not, especially if it is a penny stock since the number of scams in the penny stock market is staggering.
The following tips should guide you when trading penny stocks and significantly increase your chances of success.
1. Avoid penny stocks that trade on pink sheets
As an investor or trader, you need all the information you can get to make prudent decisions and pink sheets do not provide the necessary information on a company’s finances.
2. Avoid free penny stock recommendations from promoters and experts
Remember the pump and dump schemes we discussed above, fraudsters usually promote certain penny stocks to suck in unsuspecting investors before dumping their shares. To avoid this, stay away from those unsolicited penny stock recommendations.
3. Always use limit orders
Use limit orders when trading penny stocks instead of market orders, which can be easily manipulated by the brokers and dealers resulting in a bad entry. By using limit orders you guarantee that your order shall be filled at your preferred price or at a better price, not at a worse price.
4. Make use of a stop-loss
Ensure that you put a stop-loss order on all your trades in order to limit your losses if the trade goes against you. A stop-loss order will help protect your trading funds by getting you out of losing trades quickly while keeping you in winning trades for the duration of the move.
5. Use the right strategy
Trading penny stocks based on support and resistance is one of the simplest and most effective strategies that wok on penny stocks. We highly recommend this strategy to beginner traders given its simplicity. However, even experienced traders can benefit from using the strategy.
Penny stocks are usually very cheap because their valuation reflects the underlying value of the company’s business. In most cases, they do not have a marketable product, hence, generating little to no revenue. They are also typically saddled with significant debt and other liabilities, which they are struggling to repay, hence, they are regarded as speculative investments.
Penny stocks are regarded as extremely dangerous because they are typically on the verge of collapse given their massive liabilities, minimal assets and low to zero revenues. Therefore, the likelihood that you will lose your money when investing in a penny stock is quite high since they are always at risk of going bankrupt. They also have many unethical practices such as doing PR pump pieces, issuing new stock and dumping worthless stock on unsuspecting investors.
‘Pink sheets’ is a term that refers to the service used by stocks that trade over-the-counter (OTC). Pink sheet listings are mostly used by penny stocks companies that cannot afford the costs associated with listing on major exchanges such as the NYSE or the Nasdaq. Pink sheet listings are slightly different from OTCBB listing as the latter have to file their financial information with the Securities and Exchange Commission (SEC). The pink sheets service has since rebranded and is now known as OTC Markets Group. Companies that choose to list on pink sheets are usually much smaller than those that list on the OTCBB, which is operated by the Nasdaq, and they are not required to file their detailed financial records with the SEC. Hence, they are typically regarded as being very high risk and usually have low traded volume, which can be a major hindrance to traders.
Yes, you can make money trading penny stocks. However, you should be aware of the inherent risks associated with such stocks and should factor this into your trading plan. By following the various tips and strategies outlined in this article, you can increase your chances of trading penny stocks profitably.
You do not need a lot of money to trade penny stocks. You can trade penny stocks with as little as $500, with some brokers allowing you to trade them with as little as $100. However, the recommended amount for a small trading account is at least $2,000, which gives you more trading options. However, do not put a significant amount of money such as your life savings, or even your entire trading account balance on any one penny stock given the significant risk associated with such stocks. You could easily lose your entire investment.
No, it is not illegal to buy or invest in penny stocks unless the company is involved in illegal business activities. You should report any company that is involved in fraudulent activities to the relevant authorities.
Penny stocks primarily trade on the OTC Bulletin Board (OTCBB) operated by the Nasdaq, and on pink sheet listings, which are a broker-dealer-network. However, there are some penny stocks that trade on the Nasdaq and the NYSE, which are usually companies that have lost a good portion of their previous value.
You can trade penny stocks through most US brokers such as ChoiceTrade, Charles Schwabb, Scottrade and TDAmeritrade. These are some of the best brokers to trade penny stocks with because they offer flat-fee charges as opposed to share-based commissions, which could quickly eat into your profits.