Penny stocks certainly provide an exciting way to invest and make money – but it’s very risky and you have to know what you’re doing before you get started.
In this article, I’m going to cover the basics of how to trade penny stocks and interweave some more advanced resources for you to check out once you’re ready. Let’s first start with the basics.
Penny stock basics
Penny stocks can be super-complex, so in this section, I’m going to outline some of the basics you need to be aware of.
What are penny stocks?
Penny stocks are stocks that trade for less than $5 per share. They tend to tie to smaller companies, companies that have a limited history, or companies that have a poor financial history.
In many cases (but not always, as I’ll show you below), they aren’t traded on the major market exchanges such as the New York Stock Exchange or the NASDAQ, either, since those marketplaces have minimum requirements for stocks that trade there.
For example, the NASDAQ will spin-off any stock that is trading for under $1. Instead, penny stocks usually trade on the over-the-counter (OTC) market through the OTC Bulletin Board (OTCBB), which is a separate market that allows you to trade stocks like these.
OTC Penny Stocks vs. NYSE/NASDAQ Penny Stocks
I want to make a quick note on OTC penny stocks as compared to penny stocks that trade on major markets – since there’s a significant difference in the level of risk you’re taking on. In order for a penny stock to be listed on the NYSE, for example, its stock price has to be at least $1.00 and the company has to be completely transparent about their financials and other business dealings.
Everything else has to go to an OTC market (under $1.00 per share and little requirements on transparency). According to professional penny stock trader Ross Cameron, he does “not trade penny stocks trading over the counter mainly because of the lack of liquidity along with the lack of regulations in the OTC market,” and because these stocks “are far more susceptible to manipulation which makes them dangerous to trade.”
How much money do you need to invest in penny stocks?
Since penny stocks trade for so cheap, you don’t need a lot to get started. That said, you do want to have enough of a cushion in case you see some early losses. With penny stocks, you’ll be day-trading (meaning, opening, and closing positions within the same day), and it happens fast. So, you’ll want to make sure you’re covered for any ups and downs.
That being said, I think having at least $500 to $1,000 to start (at a minimum) should be enough to at least get your feet wet.
Can you make money with penny stocks?
You absolutely can make money with penny stocks, as has been proven by many people – Tim Sykes and Ross Cameron, who I referenced above, are two that come to mind. Both of these guys have made a living off of day-trading and trading penny stocks. While it’s super risky, they’ve come up with their own methods for making a consistent profit (and have taught others to do the same).
Now, the converse of this is that you can lose money – and lose it fast. Especially if you have no clue what you’re doing. While I don’t often equate buying and selling stocks to gambling, trading penny stocks gets awfully close if you have no idea how to do it.
So while I’m going to cover the basics for you in this article, it’s absolutely critical that you remember to never risk more money than you’re comfortable losing, and make sure you take the time to practice and try strategies that work for you.
Opening up a trading account
Now that you have a better idea of what penny stocks are and how they work, you’ll need to find a trading account that works with penny stocks. As I said above, most penny stocks do not trade on stock exchanges like the New York Stock Exchange.
But before you start trading on OTC markets, you need to learn the basics, which is why you should consider opening a trading account with an online brokerage to start. Then, after you get more comfortable with trading penny stocks, you can move to a more advanced broker that specializes in these types of stocks.
There are two different platforms that I’d recommend right now for trading penny stocks – and all for different reasons and uses.
If you’re someone who wants the most advanced platform with an abundance of tools and resources, I would go with E*TRADE.
E*TRADE also has some excellent charting options to get you started in looking at candlestick charts (though not as robust as a true charting software).
If you like to trade on the go and want to use your phone, try Robinhood.
Their platform is both app and desktop based and it’s easy to trade stocks. Where it lacks in charting, it makes up for in breaking news, cost (trades are free to make), and ease of trades. In fact, it takes just a few taps to complete a trade).Advertiser Disclosure – This advertisement contains information and materials provided by Robinhood Financial LLC and its affiliates (“Robinhood”) and MoneyUnder30, a third party not affiliated with Robinhood. All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. Securities offered through Robinhood Financial LLC and Robinhood Securities LLC, which are members of FINRA and SIPC. MoneyUnder30 is not a member of FINRA or SIPC.”
Setting up your trading platform
Okay, so you’ve chosen a broker and hopefully opened and funded an account – or at least you’re starting to. The next thing you need to do is set up your trading platform. This includes some extra physical equipment and some additional software.
Another disclaimer: I am going to share with you what seasoned penny stock traders use, but know that when you’re just getting started, you don’t have to invest in all of this stuff – as I really want to stress learning the basics.
You can certainly buy it and get set up right away to “feel official” and to even get practice making more sound day trading decisions, but remember that you won’t need to use the full capability of your trading platform until you’re risking more money and know more about what you’re doing.
That said, there are a few things you should consider getting:
- An extra monitor or two. While this might remind you of the movie Limitless, it’s far from that. You only need some extra real estate because you’ll need to have so many screens open at once.
- A stock screener. You’ll need good software that allows you to screen stocks to cater to your penny stock strategy. You can go basic and just use Yahoo! Finance, but if you want to really screen specifics, you’ll want a more advanced software. StocksToTrade is popular, but I’ve also seen many people using Trade Ideas. Note that these are expensive software but might help you in the long-run.
- Charting software. You’ll need a robust charting software that helps you do both fundamental and technical analysis (more on this below). Trade Ideas is excellent for this, as are TC2000, TradingView, and TrendSpider.
#2 and #3 can be had through a good online broker like E*TRADE, who has some of the best and most advanced investing tools and resources I’ve seen, but know that they won’t be quite as advanced as the paid tools I’ve listed above. So you could start with something like E*TRADE and work your way up to more advanced tools.
Outside of software and equipment, you’re going to need a strategy and lots of self-discipline. Trading penny stocks is not a get-rich-quick scheme, despite what you may have read around the interwebs. I’m going to outline some basic strategies below, but you really need to do in-depth research on what kind of strategy works for you and your risk tolerance and temperament.
How do beginners invest in penny stocks?
Alright. I’ve gotten through the basics. Now it’s time to dive into how you can actually start investing in penny stocks.
First, know that only a small percentage of active penny stock traders are going to be profitable. There are many reasons for this, but two major reasons are:
- Having no idea what you’re doing.
- Trading with emotion instead of logic.
It took Ross Cameron more than a year and a half of failing before he started to recognize patterns, which is ultimately what he formulated into his strategy to become profitable.
Buying vs. short-selling
One really important thing to understand with penny stocks is the concept of buying versus short selling them. Buying a penny stock is when you purchase the equity with the expectation that it’s going to fluctuate upward in the price – usually during the same day.
Short-selling, on the other hand, is essentially borrowing shares of the stock with the hopes its price will decline and you’ll be able to return those shares back to the broker and keep a profit. This can get complicated, so let me try to explain it.
Say you’ve identified a penny stock that you think is going to drop in value during the day. Its current share price is $1.00 but you expect it to lose half its value and drop to $0.50 that day – for whatever reason.
So, you could “borrow” say, 10,000 shares, on margin from the broker. You’re now on the hook for 10,000 shares returned to the broker. Now, you’d sell those 10,000 shares for $1.00 each (minus any fees of course) and make $10,000.
Then, say the price of the stock drops to $0.50 later that day. You could then buy those same 10,000 shares back at $0.50 per share for a total of $5,000. You’d then “return” those shares back to the broker and pocket the difference ($5,000).
While this sounds exciting, it’s incredibly risky and should be reserved only for advanced day-traders with a lot of money set aside that they’re comfortable losing. This is where the parallel of gambling and day-trading penny stocks comes into play.
Overall, I recommend focusing on buying penny stocks and selling them when their value increases versus trying to short-sell them.
Supply & demand and tape reading
The “tape” is a summary of all the trades made that day – it shows the size, price, and time of each trade. In short, tape-reading is a strategy that penny stock traders use to analyze the major movers throughout the day because with more fluctuations comes more opportunity to cash in on a gain in the price of a stock.
When a trade is executed, it shows on what’s called a print – which has the number of shares that were bought or sold, the sales price per share, and the time of that particular trade. With most sales platforms, there’s a color on the bid and ask price that provides you with an indicator of where that stock may be headed.
In most cases, if a trade happens at the asking price, it’s in a green color, if it trades at the bid price it’s in red, and if it trades between the two, it’s white. While this may not mean anything, you can make some assumptions from the data.
If someone is buying a security at the asking price (green) for example, it may indicate a bullish position. Buying at the bid price (red) may indicate a bearish position. After seeing this happen multiple times in a row, it indicates a trend and might be an opportunity for a trade.
That’s just one way you can use the tape to your advantage. Other indicators include the speed at which shares are moving, the volumes of shares being traded, and held bids and offers – which is essentially when there’s a lot of activity on certain equity but the price isn’t fluctuating.
Short sale restrictions (SSR)
While I don’t generally recommend short-selling as a strategy, it’s helpful to know one of the more important rules around the process – SSR, or the short sale rule. If a stock has declined 10% or more from the previous day’s close, the SSR will go into effect and restrict any further trading of that stock until the end of the following trading day.
This rule applies to any stocks – regardless of where they trade – but has a significant impact on penny stock day traders. A stock that’s declined more than 10% in a single day would make for a ripe opportunity in day trading, but since it’s been so heavily-manipulated, the restriction was put in place about a decade ago.
Again – I strongly advise against short-selling, but if you’re thinking about learning the strategy and you want to try it, know that there will be major restrictions with the SSR that you’ll need to work around if you want to make a profit.
Technical & fundamental analysis
You’ll need to do both fundamental and technical analysis on the stocks you want to buy. Just because you’re not looking at a penny stock as a long-term position doesn’t mean you don’t need to analyze it like you would other stocks.
Fundamental analysis looks more at the company, the state of the economy, earnings, the financials of the company, and more related information that is specific to the company itself. This is a much bigger factor when you’re doing long-term/value investing and less so with penny stocks. Still, though, it helps to understand the basics of fundamental analysis.
Technical analysis, on the other hand, is looking at stock charts, trending data, and other technical factors by analyzing past, current, and expected future performance. It’s the core skill needed to trade penny stocks, so it’s really important that you fully understand technical analysis before diving into penny stock investing.
Scanning for stocks to trade
There are a ton of strategies out there for finding and trading penny stocks – but not all of them will work for you, which is why it’s so important to learn as much as you can and practice with a paper trading account (meaning, fake money) until you can really figure out what you’re doing. That said, there are a couple of general rules you can follow to narrow down some stocks that might be good to trade on.
First, you need to do premarket research – meaning, find stocks that fit your criteria before the market opens for the day. Ross Cameron, for example, uses his stock screener to look for stocks that are going up in volume quickly and still within his price parameters. This might be an indicator of an opportunity to buy.
Cameron also looks at “gappers” – which means there’s something happening with that company (like breaking news). A stock that’s “gapping” means it fits all other criteria but is priced below the point you’d expect it to be at.
So, look at things such as breaking news for the company, the float (which is essentially the number of shares available to trade on the open market that day), and the volume of shares trading (higher volume is usually a good indicator).
You’ll also need to understand chart patterns. Certain strategies rely on analyzing candlestick chart patterns to see where there might be an upward or downward trend in price and trading volume.
This type of trading is completely speculative, but if done correctly and with enough data, you can make some pretty strong assumptions. An example of this is a bull flag pattern – which defines a risk point and indicates it’s time to get out of a position.
Understanding order types
The two basic order types you need to understand are market orders and limit orders. In short, a limit order is when you set the price you’re willing to pay for a particular stock, whereas a market order is when you place an order for the best available price. Pretty simple, right?
Not so fast. With penny stocks, it’s a lot more complicated.
When you’re day trading penny stocks, things move incredibly fast. So if you place a market order, the price you pay by the time the order is executed might be a few cents higher than you wanted. And with penny stocks, that can mean the difference between a profit and a loss on that position.
So why not just make a limit order every time?
That’s easier said than done. Once you get into day trading penny stocks, you’ll see the velocity at which these stocks move up and down. So by the time you pick a price point and submit a limit order, that price may be no longer available, or much worse than you can do by timing the purchase right.
This is a problem with normal online brokers like E*TRADE that buy and sell on the secondary market – there’s always a delay in the execution of the trade. However, I think those platforms are the best for those new to penny stock trading, so this is more of something to be mindful of as you’re trading – you may have to be comfortable with a range of work on timing your orders appropriately.
Once you’ve advanced your skillset, you can move on to a different broker that trades on the primary market and will execute your trades instantaneously. But remember that there’s an inherent risk in that – so learn the ropes first.
Stock market dictionary
Rather than give you a laundry list of stock market terms, I am going to provide you with some resources to look up key terminology on your own.
- What’s the Difference? Market, Limit, and Other Stock Market Orders – This article discusses the key difference between market, limit, and other types of orders.
- Investing 101: How To Read A Stock Chart For Beginners – Learn the basics of reading stock charts and key terminology.
- Penny Stock Terminology – an excellent resource from Timothy Sykes.
How not to lose all of your money trading penny stocks
As I’ve already alluded to, trading penny stocks is risky and you can lose a lot (if not all) of your money. Here are two ways you can avoid losing everything.
Be comfortable with speculation
Unlike buy-and-hold investing (or value investing), investing in penny stocks has a lot less to do with the underlying company and more to do with news and how you expect the stock to behave.
With long-term investing, you should focus on finding stocks that are undervalued and represent a good, strong company that you expect to grow in the future. So, with value investing, you should think more about being a part-owner of the company.
Penny stocks on the other hand are more about cashing in on the (often erratic) behavior of the stock during that day. This might be reacting to the news, earnings, new product launches, competitors, etc. So it’s much less about the actual company and much more about identifying and acting on trends you see.
In short, this is speculation versus true investing. In order to be able to stomach the ups and downs of penny stock trading, you have to get comfortable with the idea of this. Also, because of the speculative nature of this type of trading, it’s prone to scams. Make sure you’re trading on a reputable platform.
Look at trading volumes!
You’ll rarely see me use an exclamation point, but this is so important. You might find a penny stock that fits perfectly with your strategy and it’s sitting at the right price, so you buy it. But after looking at the trading volumes, you can quickly see that nobody is really active in this particular position that day – meaning you may not be able to unload some – or all – of your shares. This puts you at a huge disadvantage and opens you up to more risk. So make sure there’s enough trading volume trending that day to be able to sell it the same day if you needed to.
Well there you go – the basics of penny stock trading. After you’ve digested this, I suggest getting a book or signing up for a class on how to learn more advanced techniques, then find a paper trading platform to practice trading before you start risking your own money. Once you master it though, penny stock investing can be incredibly lucrative.