Penny stock investing is a high-risk investment strategy that targets extremely volatile, low-priced shares. These so called “penny stocks” have the potential to make explosive short-term moves, making them very popular with day traders.
However, while penny stock investing can be highly profitable under the right circumstances, it is important to understand the associated risks before jumping in.
In this post, we’ll take a closer look at what penny stock investing is, its pros and cons, as well as how to find penny stocks worth trading.
What are Penny Stocks?
According to the SEC, penny stocks are companies trading for less than $5 per share.
They are typically found on OTC (over-the-counter) markets such as the “Pink Sheets” market, although some trade on major exchanges like the NYSE or Nasdaq.
As well as their share price and trading system, penny stocks have a few other distinct characteristics:
- Low Market Cap (usually below $1bn)
- Low Volume
- Low Float/Closely Held by Insiders
Risks of Penny Stocks
There are 3 main risks when it comes to penny stocks:
Opaque
Penny stocks are notoriously opaque, making it very difficult to gather reliable information on them. This is primarily because OTC stocks don’t face the same SEC requirements as stocks on major exchanges.
For example, depending on what platform they trade on, most OTC stocks have no obligation to submit periodic financial reports. This makes it extremely difficult for investors to assess their prospects.
Liquidity
Since penny stocks aren’t on most investors’ radars, they tend to trade very infrequently. In addition, some penny stocks are closely held by insiders, which means there aren’t that many shares available for trading anyway.
This low liquidity makes it very difficult to find anyone to take the opposite side of your trade, meaning you may get stuck with shares you don’t want anymore. There’s nothing more frustrating than having a huge profit on paper, but not being able to realise it due to lack of liquidity.
Volatility
Another side-effect of low liquidity is high volatility. When there’s less volume to absorb orders, prices tend to fluctuate much more easily. In addition, the lack of information surrounding penny stocks makes them highly inefficient. For example, they can go unnoticed for long periods of time before making a big move after a news catalyst.
What to Look for in Penny Stocks
Once you’ve considered the risks of penny stocks and decided whether they’re suitable for you, you need to know what you’re looking for.
To a certain extent, this largely depends on your personal trading style. For instance, a long-term investor will be more concerned with fundamental analysis, whereas a day trader will focus more on technical analysis. In most cases, however, you need a combination of both.
Fundamental Analysis
Here are some important fundamental considerations for penny stocks:
- Accurate Financial Reports: The more transparent a company is about their financials, the less likely it is to be a scam.
- Low Float: Low float stocks have the potential to explode when volume picks up.
- No Dilution: If a company regularly issues new shares, this will dilute your ownership percentage and weigh on the share price.
- News Catalyst: Penny stocks need a catalyst to drive the share price, for example a big order, strong earnings, or a new partnership agreement.
Technical Analysis
Similarly, here are the key technical factors that penny stock traders look out for:
- Volume: Penny stocks are extremely illiquid, so you need to make sure there’s enough volume for you to get in and out of trades easily.
- High Relative Volume: High relative volume stocks tend to indicate where the action is in the market.
- Momentum: Penny stocks are strongly driven by momentum, which draws traders to stocks gapping up in the premarket, hitting new highs, or displaying certain chart patterns.
How to Find Penny Stocks Worth Day Trading
Ok, so now we know the characteristics we’re looking for in penny stocks, how do we find them?
To do this efficiently, you need a penny stock scanner Essentially, a penny stock scanner alerts you to penny stocks that meet pre-defined criteria in real-time.
Below, I will show you an example of a penny stock scan suited for day trading.
Since the goal of day trading is to get in and out of a trade on the same day, the scanning criteria revolves around technical analysis more than fundamental analysis.
Here is an example of some penny stock scanning criteria:
- $0.5 < Price < $10: Although the “cutoff” price for penny stocks is technically $5, I like to exclude any companies trading below $0.5 and extend the maximum to $10.
- Float < 50 million shares: As mentioned, low float stocks have the potential to surge on any volume spike. 50 million shares is considered a low-to-medium float, so anything below this will pick up these volatile stocks.
- Gap > 2%: Stocks that “gap up” possess the kind of momentum that day traders like. I like to see a gap of at least 2%
- Volume > 200,000 shares: This minimum volume threshold ensures that the stocks in my scan are liquid enough to trade.
My favourite platform for performing this scan is Trade Ideas (thesovereigninvestor.net/trade-ideas-review) due to its flexibility and speed. However, there are plenty of other stocks scanners out there capable of the same thing, such as Scanz
How to Day Trade Penny Stocks
Finding a potential list of stocks to trade is just the beginning. We now need to decide which ones to trade, and how to do it successfully.
This can be summarised with the following 5 steps:
- Research any news catalysts
- Determine points of support and resistance on charts, and chart patterns like bull flags or ascending triangles
- Enter trades at support levels or breakouts
- Sell at resistance levels or topping patterns
- Set stop losses to minimize risk
I advise not trading in the first 30 minutes of the day. Stocks move around all over the place in this time, so you’ll only get whipsawed and lose money.
Instead, spend this time studying charts and any news catalysts from your stock list.
In particular, look for stocks that have started the day strong and managed to hold onto their gains. If this is accompanied by a positive news catalyst, that’s an extra bonus.
Essentially, you want to see prices that have gone up and consolidated in a sideways pattern.
These consolidation patterns come in different shapes and sizes – triangles, flags, head & shoulders, and many more that I won’t go into now. Once you gain a bit of experience, these should become more obvious to you.
Once the share price breaks out of this sideways pattern, you should look to enter your trade. In many cases, penny stocks can witness triple-digit percentage moves in the space of a few hours after these breakouts.
To set an exit level, you need to look left on the chart to find a previous point of resistance – which is like a “ceiling” that prices cluster around and fail to move above. The important thing is to remain disciplined and sell when it reaches your target, rather than trying to second-guess things.
Summary
In summary, penny stock investing can be a highly profitable investment strategy when you know what you’re looking for.
The volatility of penny stocks brings the promise of high rewards, making them extremely popular with day traders.
However, with high rewards comes greater risk. Penny stocks are infamously opaque, illiquid, and prone to scams, which means they aren’t for the faint-hearted.
As such, investors are advised to approach penny stocks with extreme caution and only risk what they’re willing to lose when trading them.
