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So, you have a few grand burning a hole in your pocket. Maybe you’ve managed to hold onto your job through this whole COVID-19 crisis and just received some government stimulus money. You want to take a shot at learning trading but there are too many options to decide on. Options? Forex? Crypto? What about…penny stocks?!
Penny stocks are the red-headed step-children of investment securities, you say. It’s true, penny stocks are the source of many a boiler room scheme, these low-priced, sketchy shares are pumped and dumped more often than the travel sized toothpaste containers back when people still traveled.
In fact, we warned you off investing in penny stocks on Robinhood. The vast majority of these companies are financially troubled and more likely to hit zero than rise above their penny stocks status (technically, a penny stock is any company trading below $5 per share).
However, just because a certain type of security makes for a crappy investment doesn’t mean you can’t trade it. (Read about the differences between investing and trading here). The stocks you find in the pink sheets or OTC markets are actually favored by traders who seek to profit from volatility.
In fact, many of the reasons that penny stocks make for bad investments also perversely make them potentially great for day trading. You’ll just want to ensure you use a broker with good day trading capabilities like IBKR or TD Ameritrade. Don’t attempt to do serious day trading on the Robinhood app.
Now let’s check out the top reasons why penny stocks could be a good place to cut your teeth as a novice trader.
1. No Wall Street Competition
Most penny stocks have very little institutional ownership and don’t interest Wall Street traders or analysts, who are often forbidden from participating in the shares. Because penny stocks are often issued by extremely small, financially precarious companies, large investors simply can’t enter and exit the stock without causing huge price movements. This means professional mutual fund and hedge fund managers, large banks and trading firms mostly have to avoid these shares by regulation.
As a beginner trader, this should be great news for you. You don’t have to worry about competing with genius quant fund managers with PhDs from MIT and Harvard. In fact, you are more likely to be competing with degenerate gamblers who have turned to the OTC markets as a respite from their favorite dog racing track being closed due to the coronavirus. I would much rather compete with this cohort than Goldman Sachs or Steve Eisman.
2. You Can Skip the Fundamentals
By restricting your gaze to stocks priced under $3 or so, you’re not only preserving flexibility for your small stock trading account, you’re also implicitly accepting the fact that the wares you are trading in are…suboptimal.
Penny stocks range from yesterday’s good idea to obsolete technology providers to downright frauds. If you don’t believe me, Google some of the “corporate HQ” addresses for these fine “companies” and you’ll often discover PO Boxes or residential addresses, because many of them don’t even have real offices.
While the reality that every penny stock is fatally flawed might bother an investor, this is actually great news for a beginner day trader. If you know what you are trading is trash, then fundamental analysis becomes much less relevant. In fact, the only fundamental news you need to be aware of with penny stocks is if a company you are trading issues a press release with a (surely bogus) claim, then you can expect some volatility as the stock is predictably pumped and then dumped.
By treating penny stocks as the steaming toxic waste they are, you also won’t be tempted to hold any one stock for too long, an often fatal flaw of penny stock investors who get blinded by a huge gain only to watch it evaporate just as quickly, often in the same day.
3. Repeatable Patterns to Learn
As penny stocks follow the tried and true pump and dump scheme, you can learn just a few basic patterns commonly found in technical analysis and apply them over and over again to develop a potentially profitable strategy.
Remember, unlike investors, traders are attempting to profit off of the volatility of the shares and not trying to find the next great company.
Penny stock traders generally look for breakouts to the upside and then short stocks that have exhausted their ridiculous moves and crash back to earth as the pump collapses. These moves and a few others, such as “morning panics” where a stock crashes at the opening only to recover back to its previous level can keep a busy penny stock trader going day after day.
4. Make money long and short on the same play
As you perfect recognizing and then acting on the same patterns that emerge in the penny stock space repeatedly, you’ll get to a point where you can potentially be profitable on the pump and dump of the same play in the same day. Some of the best penny stock trades involve catching the explosive ride up, waiting for the stock to fade as buyers become exhausted, selling your shares and then going short on the same stock and riding gains all the way back down.
While some traders may never be comfortable going short and you also have to be mindful of the Pattern Day Trader rule on small accounts under $25,000, successfully “double dipping” on a penny stock pump and dump scheme is a pretty attractive and potentially very profitable move that simply doesn’t happen in the same way with legitimate stocks in the S&P 500.
5. Volatile Moves Every Day
Almost every day you will see a penny stock move 50% up or down and sometimes 100% up or down. This is a big contrast to the major stock markets where you may encounter many days of sideways markets and even relatively volatile stocks such as Tesla will go through lengthy periods of moves of less than 1%.
The great thing about penny stocks, whether trading as OTC or on the NASDAQ, is that you will see enormous moves almost every day. That means every day there is an opportunity for you to ride a wave of euphoria or grief, up or down, or sometimes both.
But where do you find these stocks? A stock screener tool is your best bet. Check out Bar Chart or FinScreener, both of which carry OTC issues. You can then start building watchlists of big movers each day with associated high volume (look for stocks with at least 1 million in daily average volume). As your list expands, start studying the moves these stocks make and what patterns may have revealed the move ahead of time.
Remember, never fall in love with a penny stock. One stock could have a major move up, back down and then do nothing for years afterwards. The volume should be your guide.
6. Low-Priced Shares
This point is obvious but often misunderstood. The appeal for penny stocks having a low share price is that you can quickly build a large position and flip that position as it spikes. Trading in penny stocks means it’s easier to build positions in standard lots of 100, which can be helpful for quickly unloading shares once you’ve hit your target profit rate of return. And you do always want to unload them after a big gain. The next Amazon is not in hiding in the OTC bargain bin, trust us.
There is no point in loading up on thousands of shares just because you can and it makes you feel rich. This is a common way most dabblers in penny stocks go broke.
7. Stop Losses Are Your Friend
As the many interview subjects of Market Wizards make clear, cutting your losses quickly is among the most important key to a successful trading career. Because you are looking for patterns in penny stocks that will lead to explosive growth or drops (if you happen to be short), you can set relatively tight stop losses that should exit you quickly out of your position if your thesis proves misguided.
This should eventually leave you in a situation where your winners are big winners, while your losses, even if more numerous overall, are all of a small magnitude, leaving your account profitable overall.
What About Forex/Options/Tesla/Bitcoin?
Penny stocks certainly aren’t the only thing you can trade and certainly aren’t as cool as trading Tesla or Ethereum. We’ve considered many other asset classes and styles and came back with the following drawbacks for beginner traders with small accounts:
Forex – Trading foreign currency has a lot of appeal, including a 24 hour market, massive liquidity and limited commission fees. However, because it’s such a massive and liquid market, the competition is endless. Well-financed global banks and hedge funds are tightly focused on the currency markets in a way they never will be for penny stocks, and you also will be constantly monitoring economic news 24/7 as any time a central banker burps it will have implications for the currency markets. Most currency traders need a good grounding in both technical analysis and fundamental trading to be successful long-term in this space.
Options – Like forex, options receive a fair amount of interest from a variety of institutional investors and large trading houses. There are many appealing aspects to options trading for small account, including the ability to express long, short and neutral market positions (without actually having to own any shares) and the chance to earn huge gains with limited risk. Unfortunately the huge gains are statistically very unlikely from happening in a way that will allow you to build up a small account.
The variety of options strategies means you really have to study a lot to ensure you understand your risk profile. Certain options plays can leave you open to unlimited risk, while the appealing plays you see on Wall Street Bets where a lucky trader lays down a few hundred bucks to win tens of thousands are about as rare as winning the jackpot at the craps table in Vegas.
While buying options is cheaper than acquiring the equivalent in shares, options contracts can still be quite expensive, making it hard to diversify a small account with multiple options contracts.
Crypto – The volatility in crypto trading has some similarities to penny stocks and plenty of traders have made good profits in these markets. However, crypto shares many similarities to the forex markets, with added accusations of market manipulations and technical challenges of trading on the markets. With institutional traders increasingly interested in crypto and competition from HFT and other algorithmic participants, crypto may not be the most beginner friendly place to start your trading journey.
Popular stocks like Tesla – Name brand stocks are less appealing for trading than penny stocks for a number of reasons. They cost much more on a per-share basis, typically move much less, and are more driven by fundamental news that is being gobbled up by dozens of highly paid analysts who cover the stock. The odds that you will see something ahead of the crowd on Wall Street related to a major name brand stock is small. Finally, you’re also at the mercy of the broader market when trading a big stock; in most cases, a bad day for the broader market will impact the stock you are focused on, which is less true of penny stocks that seem to mostly have their own strange momentum.
Trading in a small account is tough. There are really very few good options for turning a $2,000 account into something much greater. However, we believe penny stocks offer one reasonable option for growing a small account with relatively few drawbacks.