The Securities and Exchange Commission (SEC), the U.S. market regulator, defines penny stocks as securities trading under $5 per share. The market capitalization of penny stocks is relatively smaller compared to large-cap stocks. They’re cheap and can have a lot of volatility, especially low-float stocks. Therefore, investors consider penny stocks speculative. They can create significant gains (100% up) or losses (60% down) in a single day, many times more. In addition, many penny stocks are newer companies, which means they lack much of a track record. Other companies have been around a while and have a history of pumping and dumping.
Penny Stocks for Beginners: How They Work
Penny stocks can look attractive to beginners because of their low share prices. If you have a smaller account, buying hundreds or thousands of shares of a cheap stock can feel like you’re getting more for your money. That’s one of the first misconceptions to get past.
The number of shares you own doesn’t determine whether something is a good trade. A $2 stock can be considerably riskier than a $200 stock depending on its liquidity, share structure, company fundamentals, and how it’s trading.
Some penny stocks trade on major exchanges, while others trade over the counter (OTC). OTC securities don’t have to meet the same listing standards imposed by national exchanges, which can mean less information is available to traders and investors.
Liquidity is especially important. A stock can look great on a chart, but if very few shares are trading, you may have trouble getting into or out of the position at the price you expect. Wide bid-ask spreads and slippage can turn what looked like a good setup into a bad trade very quickly.
You’ll also see low-priced stocks make explosive moves when volume suddenly comes into them. That’s where float, volume, news, and momentum start working together. A low-float stock with a catalyst and unusually high volume can move extremely quickly.
Low price doesn’t mean low risk. Penny stocks can move quickly in either direction, and low-priced securities have historically been targets of manipulation and pump-and-dump schemes.
Before trading one, understand where it trades, how much volume it has, what is causing it to move, where the important levels are, and how much you’re willing to lose if the setup fails.
OTC and Pink Sheet Stocks
The riskiest penny stocks are Over-the-counter (OTC) stocks, also known as pink sheet stocks. The wildest swings happen with these stocks. Unfortunately, the least information is available about them because they’re not required to follow the strict financial exchange rules like their cousins, the penny stocks listed on the New York Stock Exchange (NYSE) and the Nasdaq.
The three main rules for NYSE penny stocks are:
- Fully transparent financials
- The price of the stock must remain above $1.00 per share
- Not in a bankruptcy filing
Looking at these three rules, you can easily understand why trading in OTC penny stocks is not recommended. Traders can easily manipulate OTC pennies.
They can hide their actual financial status. They are also much less regulated. And they usually have much lower liquidity, so your trades may be very slow to be filled. Volume is so important!
Even the NYSE and Nasdaq penny stocks can have some wild price swings. So don’t feel like you’re missing out on the roller coaster at the amusement park.
Stocks in the Tech, Biotech, and Fintech sectors, priced between $1 and $10, can see overnight news that will cause 50% drops or 100% gains, with a total loss possible if a company declares bankruptcy. Take our day trading course if you need more help.
Tiers of Penny Stocks
- Penny stocks $1-$5 – listed on a major exchange priced more than a dollar, usually under $5 per share but sometimes just over.
- Penny stocks trading between $0.01 and $0.99 – are often listed on a major exchange but must meet the listing requirements within a specified period or be de-listed. Tier 2 stocks may be traded in fractions of a penny.
- Penny stocks priced below $0.01 – do not meet minimum requirements, so they cannot be listed on a major exchange. Many online brokers will not even allow trading of Tier 3 or 4
- Penny stocks trading at 0.0009 or less – are called “trip zero” or “hot penny” stocks. Susceptible to pump and dump schemes with low volatility and manipulation.
Penny Stock Trading Strategies
- #1 Controlling your emotions while trading is more important than the technicals, even though technicals are very important
- Have a good penny stock scanner like Trade Ideas or Benzinga
- Scan for stocks holding HOD aftermarket and build a watch list of 3-5 stocks that are looking to break out on daily charts
- Scan the premarket the following morning for any penny stocks that have a news catalyst using Trade Ideas
- Check your watch list from the night before and see if there is any premarket volume and if the setups are there
- Narrow down your watch list to a handful of small-cap stocks looking to break premarket highs at open
- Watch for momentum and volume at open and look for bull flags and ascending triangles, as they are both popular patterns for penny stocks
- Have support and resistance mapped out before you trade
- Practice scalping breakouts in a paper account until you’re ready to trade with real money
Swing Trading
Since investing in penny stocks isn’t the best way to trade them, how about swing trading? When you’re swing trading, you hold at least overnight for up to a few weeks. Therefore, you’re not trying to make a long-term profit. While you can do that with penny stocks, you must ensure they will move.
People often get stuck in trades because the bid-ask spread is too large, and the volume is gone. These are still things to think about if you swing trade. Looking at the profit potential and support and resistance zones is important. Reading the charts is key!
What are the patterns? Is there enough profit potential? How about the history of the chart? Does it show a pump and dump? What about volume? These are all questions you must ask yourself with penny stocks.
High Risk Penny Stocks
When learning to get started in penny stocks, be aware that you need a high-risk tolerance. Penny stocks have the potential to be volatile. They are high-risk and high-reward. Taking precautions against the risk is smart. For example, having a predetermined stop loss protects you from losing too much. You can lose your entire investment on a penny stock. Implementing that stop loss keeps your losses to a minimum.
People view penny stocks as a vehicle to get rich quickly. Yes, they can have explosive moves. However, it would be best if you were realistic with your expectations. Penny stocks are typically small but growing companies with limited cash flow. In other words, they’re high-risk with low volume. You need the volatility volume brings.
Volatility means the price can change dramatically quickly. This can be good and bad because it could go against you. Hence, a stop loss is important when getting started in penny stocks.
Investing in Penny Stocks
There’s a difference between trading and investing in penny stocks. Investing involves buying and holding long term, whereas trading is buying and selling short term. Penny stocks are risky to buy and hold long-term, but they can be done safely if you get the right entry and have the patience to hold. So, instead of investing in penny stocks, day trading them is the best way to trade the sector. That way, you can take advantage of their volatility.
You don’t have to be afraid of penny stocks if you know how to trade them. However, finding good penny stocks and learning to trade them correctly can be profitable.
Fundamentals
If you decide to invest in penny stocks, you need to look at the fundamentals. How does it differ from the technical analysis?
The fundamentals measure the value of a stock by looking at its economic and financial factors. In other words, you’re going to look at anything that can affect the value of a stock. The goal is to see if the penny stock is overvalued. Of course, you don’t want to invest in a penny-stock company that’s already overvalued, especially if it’s already pennies on the dollar.
How’s the management? Bad management can kill a company. Who’s the CEO? Listen to their conference calls. Is the management unloading their shares? Is their business model sustainable? Again, this is something to consider for companies like biotech.
Can they hang around long term? Do they have a competitive advantage in the field they’re in? Is their product better than other companies in the field?
If you’re investing in penny stocks, these are the questions you must ask yourself. Of course, you don’t want to invest in penny stocks if these questions don’t have good answers.
Returns
When you trade the cheapest and most volatile stocks, you only need to invest a small amount to see a considerable return. However, the estimate of successful traders who are successful in trading is between 1% and 10%, with 90% losing money. Even the majority of fund managers can’t beat the market.
With that warning said, the goal for penny stock trading is to identify any small group of stocks positioned to make a big move each day.
There are usually three criteria used to identify either small-cap or penny stocks that have the potential to move:
- News catalyst
- Max float of 100m shares
- High Relative Volume (RVOL)
Well Known Companies
At certain times, a few well-known companies, including Monster Beverage Company ($MNST), traded as a penny stock. Monster Beverage Company ($MNST) did, in fact, trade for less than $1 per share in 1995. However, the monster is not a corporation that comes to mind when most people think about penny stocks.
Unbelievably, shares of Monster Beverage now trade at around $60, and the company has achieved a market cap of $32.55 billion. So, while hindsight is always 20/20, Monster Beverage Company turned out to be one of the good penny stocks to invest in.
How to Buy and Sell Penny Stocks
- Premarket – have a good stock scanner that scans the premarket for gapping stocks
- Filter – narrow stocks by a minimum of 100K premarket volume
- News – search for a company news catalyst using Google or Benzinga.
- Watch List– create a watch list of 3-5 penny stocks stocks
- Volume – watch for huge intraday one and 5-minute volume spikes at open
- Highs – watch if price action can break premarket highs
- Flags – look to take entries on bull flag breakouts
- Flat Tops – look to take entries on flat top breakouts
- Risk – limit your risk by trading smaller candlesticks
- Winners – let your winners run and keep your losses small
Penny Stock Scanners
Penny stock scanners are essential to use when day trading. Customized scanners that find stocks that meet specific parameters give you an edge because you’re only trading stocks that have the potential to make a big run. Scanning for the day’s high “MOMO” (momentum) is worthwhile. MOMO is a real-time stock scanner that streams the new daily high and low breakouts.
This lets you find stocks moving quickly with high volume, which is great for just after the market opening. MOMO is good if the stocks on your day trade watch list aren’t running.
Criteria for Penny Stocks
- News catalyst – the first step is to understand which stocks might be moving and search for news such as earnings announcements, governmental approvals, or partnership/sales/merger announcements.
- The maximum float of 100m is the number of shares available for trade. The lower the float below 100m and the closer the shares are to 50m, the better; this way, there is significant volatility in the price, and this fluctuation can be traded.
- High Relative volume – starting with the premarket, it is a good sign if a stock has high RVOL.
When combined, we have a gapping premarket from the news. The volatility is tied to the low float, and the liquidity is related to the high volume. These are good stocks to put on a watch list.
Once a watchlist is created, it is time to look at the market opening. Two things should be looked for:
- A further breakout over the premarket highs
- Look for bull flags or flat-top patterns
You have a winner if there’s a news catalyst RVOL of 50 or more. This happens nearly every day. Keep an eye out for these runners. If penny stocks only have a few thousand shares trading daily, give it a pass. Liquidity is key to getting in and out of your positions.
This shows stocks that have a gap in the market. Gaps often identify that news has come out about the stock. This also meets the volume and price requirements that are inputted.
Low Float
By definition, the float is the number of shares available to trade on the open market. And the lower, the better because these are the penny stocks that will move and move quickly because they’re less liquid. Be warned that the smaller the float, the more potential it has to go parabolic in either direction.
As a rule, stick with penny stocks with over 300,000 in volume, ideally over 1 million, to ensure the stock is liquid. Second, to trade low floaters, look for penny stocks with a float under 20 million. Penny stocks with floats over 20 million typically are not parabolic movers.
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Penny Stocks Volume
Any price movement up or down with relatively high volume in penny stocks is seen as a stronger, more relevant move than a similar move with weak volume. This is because volume verifies trends and precedes price. For example, a volume surge is a key to confirming a breakout with penny stocks. Conversely, if there’s no volume, it is not a breakout; it could be just a false rally. Thus, if you’re looking at a large price movement, look at the volume to see if it tells the same story.
If the volume starts to decrease in an upward trend, it’s usually a sign that the upward run is about to end. In other words, a reversal is coming. Not only do we use volume to confirm trends, but we also look at it to get the best price. So you will have a wide bid-ask spread if the volume isn’t there.
In the trading world, a wide bid-ask spread leads to what’s known as slippage. And the problem with slippage is that it makes getting the best price impossible. Shockingly, it could mean you must pay 5% to 15% extra just for the illiquidity. Over a year, this could add up if you’re not careful.
Relative Volume
The relative volume compares the current volume to the normal volume for the same time of day. So, for example, a stock trading five times its normal volume would have a relative volume of five.
As intraday traders, we want the RVOL at two or higher with a positive catalyst. Coupled with a low float (see below), this stock has the potential to run.
Generally speaking, the leading penny stock gainers on the day had a higher relative volume than its average volume.
Tier 3 and Tier 4 Penny Stocks
These penny stocks aren’t required to adhere to the same reporting requirements of their Nasdaq and NYSE cousins. They have higher volatility and lower volume.
They’re also susceptible to fraud, such as the “pump and dump.” This happens when the stock holder promotes the heck out of it on social media or chat rooms, calling it “the next Microsoft/Apple/Tesla/bitcoin” hoping to lure unexpecting investors into the stock. Then, they sell their shares for a profit shortly after, known as the dump. Sadly, this happens a lot in the industry.
Trading Plan
Again, think of penny stocks as gold or gem mining. You will be more successful if you pick up a lot of small nuggets rather than just looking for one big one. Look for the setups once a penny stock ticks the watchlist criteria (news, float, and volume). Then other traders will be coming in, too.
For risk management, it’s a good habit to sell half of your position once you have a profit. Then, set the stop loss at your entry point so that the worst you can do is break even.
Raise your stop loss as the price goes up. Set your target goal and stop loss before entering each trade. Don’t try to overthink when trading penny stocks. Instead, stick to your criteria and trade your plan.
Make sure you use a simulator before trading live with penny stocks. That’ll give you a chance to practice without risking any real money. Once you have confidence, start with penny stocks between $5 and 10 dollars. The volatility and risk will be less. In addition, you’ll start to understand supply and demand zones and how penny stocks work.
Frequently Asked Questions
Day traders hold onto penny stocks for seconds up to a few minutes. Then, they are in and out of trades on the same day. Traders map support and resistance levels on 1-minute and 5-minute intraday and daily charts. They have pre-determined profit targets and stop levels before entering into a trade.
Statistically, 90- 99% of penny stocks fail because they go to $0 or get delisted. They are typically pump-and-dumps that run temporarily for a few days off a news catalyst, then end up dumping. If you don’t get in at support and ride the momentum before the pump, you can be left holding the bag at the top when they fail.
Can you make money in penny stocks? Yes, you can make a lot of money but lose a lot if you aren't careful. It's important to manage your risk when trading them and be aware of stock pumpers.
Technically, you don't need much money to trade penny stocks. You can start with as little as $50. However, because these are volatile stocks, make sure you have proper risk management in place so you don't blow up your account and lose all your money on one trade.
