The Basics of Penny Stock Trading 

Penny stock trading can make our break traders. The difference between a smart trader and a naive one, is that penny stock traders who succeed cannot be misled by pump and dump schemes. 

What is a Penny Stock:

A penny stock is a stock sold for $5 or less per share. Penny stocking means traders trade these stops for profits, which means that they aren’t investing in strong companies with the intent of keeping the stocks. These traders are hopping on and off the bandwagon of penny stock prices at the right moments. The price is so low because the company is tiny and have little product. A higher price  per share is a sign that a company is succeeding, so it can be assumed that penny stock companies do not have the odds of succeeding in their favour. 

Penny stocks are often hyped up by promoters and press, which the company paid for. These promoters generate hype surrounding the company, and as a result the stock price increases due to the influx of shares being bought. Then once the promotion stops, the stock price falls rapidly. 

Most penny stock companies are not SEC compliant, i.e, they do not accurately present their finances to the public. Big companies such as Apple, or IBM are required to do so, but penny stock companies tend to not disclose their finances. While not all companies who are not complaint with SEC are penny stocks, it’s a good way to spot them. They reason they don’t disclose their  finances is that they’re not the best of companies and don’t want their shortcomings to be public knowledge, technically these companies don’t need to be making a product or any profits, penny stocking is more about hype that the overall integrity and success of a company. However, whether penny stock companies are going to succeed or not is not much concern for penny stock traders.

How to trade penny stocks

Set up a margin account:

All traders are required to have a brokerage account before they can access the market. As penny stock trading is similar to short selling, traders need to have a margin account. Margin accounts allow traders to borrow shares from their broker. Penny Stock Trading is done with the expectation that the stocks will decrease in value, just like how short sellers capitalise by buying back stocks for a lower price than what they sold them for because the market price fell. It’s not recommended to use leverage as it means borrowing capital that is more than the amount in your account, as there is never a 100% guarantee that the trade will go as planned, which means your open to the possibility of making a huge loss and owing the broker money. 

When it comes to short selling, not all brokers allow it because it requires them to find shares to short. When there aren’t any shares to short, the stock is “hard to borrow”, as most penny stocks are from small companies it’s often difficult to find shares to borrow with the intent to short sell. This is where pre-borrows come in handy as they allow traders to reserve shares in advance. 

Don’t trust anyone:

Penny stocks are often developmental companies which means that they’re skeptical about being transparent with the public, and will want to promote themselves as a rising star. Most penny stocks drop in price, and eventually fail altogether. Approximately 7 in 10 start-ups fail within the first six months to a year, so for them, it’s a game of hunt or be hunted. This is why traders should rely on their own research. 

Research doesn’t have to be a taxing activity. Traders can use a day trading or scanning program which finds stocks that fit into parameters defined by you. For example, implementing a filter which shows revenue growth with large profit margins, this can help spot penny stocks as they can earn money without expanding. 

The reason for all the filters and research is to create a watch-list, of approximately 20-25 stocks. The watchlist can be refreshed by re-running the filers and checking it everyday for abnormal fluctuations. For example, if you notice that a stock is growing a few perfect per day as you do the scans then it’s worth keeping tabs on. 

The next thing is to set up a trading diary; this can be a physical notebook, or written onto a account. The reason for a trading diary is that it becomes a clear way for traders to understand themselves and get a clearer picture of patterns and opportunities changing. It can help spot your own mistakes and rectify them before they cost you too much and helps maintain a good sense of perspective. After every trade regardless of if it was successful or not, write down what worked, what didn’t, and what you’d do differently, if you could change something in the diary. 

What to watch out for:

Penny stocks nearly always pump and dump. A pump and dump occurs when the promoter does their job well and the prices rise. Most traders will fall for them and lose money, believing that the prices will continue to rise. A smart seller will short sell these stocks as they are anticipating the inevitable crash. Promoters will usually send emails or leave tips on stock websites that a company is due to rise, which triggers an influx of people buying shares. When the company stops paying promotion, and the company insiders know when to jump ship, the price crashes, but not before they’ve sold their shares and profited heavily. Experienced traders can take advantage of these schemes and get in and out at the most opportune moments. 

Public companies sell shares to finance their endeavours, and reverse mergers are a way for penny stocks to IPO. It’s usually developmental companies and penny stocks that use this technique, as it’s how must penny stocks become penny stocks to get traded to the public. This happens quickly so the initial price can remain $5 or less, and benefit traders as it means there’s more stock to trade.