Penny Stocks Explained: The Essential Beginner’s Guide

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Updated: 23 October 2020

penny stocks guide

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 money or any real profit.

Or is it?

In this guide, you’ll learn the following about penny stocks:

  • What penny stocks are (with examples)
  • Where & how to buy penny stocks
  • Risks & benefits
  • How to avoid penny stock fraud
  • Trading patterns to use

What Are Penny Stocks?

Penny stocks are shares of a company that trades for $5 or less. The term refers 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 risky investments compared to established companies, given their high risk of going bankrupt.

Even though some of the companies with penny stocks are trading on large platforms like the New York Stock Exchange (NYSE), most of the trades happened over the counter (OTC) through OTC Bulletin Board (OTCBB) or privately-owned OTC Markets Group.

Example of a Penny Stock

An excellent 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 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.

penny stock example

Where Can You Sell And Buy Penny Stocks?

You can buy and sell penny shares via a broker who has listed the stock as a tradable 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 its underlying value.

To own the stock, you have to open an account with a broker who lists its actual shares and not its CFD.

How Do You Buy And Sell Penny Stocks?

  1. Firstly, you have to open an online trading or investment account with a reputable broker.
  2. Next, log into your trading or investment account and search for the penny stock that you want to buy or sell.
  3. Chose and order type, either a market or limit order, and open an order ticket
  4. Specify the number of shares you want to buy and your preferred price, then execute the trade.
  5. You should receive a notification with the details of your order including how it was filled

how to find the best penny stocks to trade

How To Find The Best Penny Shares To Trade

Finding the best penny stocks to watch and 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 know that many penny stocks 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 stocks that rises slowly over several months and pays 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 with significant daily trading volume 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 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 specific price, say above $1, and identifying 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 you losing money.

penny stock risks and rewards

Risks of Trading Penny Stocks

As we've alluded to, there are some major risks attached to penny shares trading you need to be aware of. Here are some of them:

1. The Pump and Dump Scheme

The pump and dump scheme is a classic scheme employed by most, if not all, penny stocks. The schemers, 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.

2. Short-Selling Scams

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.

3. Fraudulent Reverse Mergers

Reverse merger is a tool used by many small companies to list on the stock exchange without paying 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.

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4. 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 typically end up losing their entire investors.

Do not invest in such companies.

5. Offshore Scams

Such scams usually involve fraudsters listing a foreign company’s shares in the US, claiming that they can access foreign countries’ opportunities.

They usually end up selling shares of cheap foreign companies to unsuspecting US investors, then pocketing the difference and leaving investors holding low priced illiquid shares.

Now, Let’s Talk About The Benefits

However, despite the negatives, there are some benefits associated with trading penny stocks:

1. Cheap to Buy

The main advantage of trading penny stocks is that they are cheap to buy. Hence you can get started with a small investing account.

2. High Probability for Huge Profits

The probability of the stock making huge percentage gains is relatively high given their low stock prices and valuations.

3. Grow Trading Accounts Quickly

Penny stock investors also have a high chance of quickly growing their accounts if they take the necessary precautions.

So, here’s to sum up penny stock trading.

Risks & Benefits of Penny Stock Trading

Risks Benefits
The Pump and Dump Scheme Cheap to buy, therefore more comfortable to start with small trading account
Short-selling Scams High probability of making substantial percentage gains
Fraudulent reverse mergers High chance of growing trading accounts quickly
Guru and mining scams
Offshore scams

The Best Penny Shares Chart Patterns

The best penny stock charts to trade are those with 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:

penny shares price chart

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:

example of a penny stock chart

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.

Avoiding Penny Stock Fraud

The key to avoiding penny share fraud is doing some research on any company 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 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.

penny stock trading tips

5 Penny Stock Trading Tips

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, and fraudsters usually promote individual 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 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 shares based on support and resistance is one of the simplest and most effective strategies for penny stocks.

We highly recommend this strategy to beginner traders, given its simplicity. However, even experienced traders benefit from using the strategy.

Wrapping It Up

Congratulations, you made it to the end! By now, you should have a solid idea of what penny stocks are and what it’s like to trade them. Before you take a “leap of faith” in, test the water first, and see if trading penny stocks is your thing.

It’ll be much better if you could consult someone who has experience in trading this type of stock as well. Make sure you practise strict risk management. Good luck, and always trade safe!

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FAQs

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.