If you are planning on taking advantage of the extreme volatility which is commonly associated with penny stocks, it is important to first understand what these stocks are and how to find penny stocks to trade.
In this penny stocks guide today, we are going to discuss the risks involved in trading penny stocks, how to avoid scams associated with these stocks, and how to find penny stocks using screeners.
What is the meaning of penny stocks?
A penny stock is a term that describes shares of a common stock that trade for less than $5 on U.S. stock markets and less than £1 on United Kingdom stock markets.
The U.S. Securities and Exchange Commission (SEC), on the other hand, defines penny stocks as any stocks that are trading below $5 per share.
Generally, penny stocks are associated with tiny, usually new businesses, many of which don’t have the potential to offer the type of growth that most traders are seeking.
In most cases, penny stocks are listed over-the-counter on the OTC Bulletin Board (OTCBB) or in the Pink Sheets.
However, New York Stock Exchange (NYSE), the NASDAQ, and the American Stock Exchange (AMEX) too also hold a huge chunk of listed stocks that are traded below $5.
Risks involved in trading penny stocks
Like any security, penny stocks have both advantages and risks that you should consider.
Learning more about what sets them apart from other types of stocks and about how they work can help you decide whether to include them in your portfolio.
Penny stocks are riskier than traditional stocks since they don’t represent companies traded on formal exchanges such as the NASDAQ or the New York Stock Exchange (NYSE).
First, they are less transparent since they don’t have to abide by mandatory information-sharing obligations like quoted companies. In addition, these stocks are less liquid than more popular stocks.
Therefore, it might be more difficult to get in and out of a trade at your desired price.
Finally, penny stocks are highly volatile in nature, meaning that the price can gyrate wildly against your position.
How to find penny stocks
You might be wondering how traders find new trading opportunities when it comes to penny stocks and how anyone decides which stocks to buy or sell.
Well, the answer to both of these questions is often a stock screener.
A stock screener is a tool that traders and technical analysts use to identify shares that fit a certain set of criteria.
Screeners can be used to filter stocks by price, industry, the average number of shares that trade during a given session, and more.
Stock screeners are a crucial tool for inexperienced traders, particularly if you are getting ready to try day trading and you are unsure which stocks to buy and sell.
Which penny stocks you trade is going to be influenced by a number of factors, including how much capital you have available, your day trading strategy, and your level of experience.
Whether you are trying to find the best penny stocks for day trading, or you prefer other styles like investing, position trading, or swing trading, your criteria for how to find these stocks ought to be written down as part of a trading plan.
Here are some of the best ways to scan these stocks using technical indicators:
- Breaking news
News is one of the major driving forces behind most of the stocks that are traded on Wall Street. The market reacts either positively or negatively to breaking news, which creates predictable patterns and affects momentum.
Like other types of stocks, the prices of penny stocks tend to observe instant movement with impactful breaking news, events, and hype surrounding the company.
Sometimes a company announces an amazing new product or releases strong financial results and the stock skyrockets, while other times the CEO writes a short tweet, and the stock plunges.
For instance, if a penny stock company reports favorable details regarding the release of new services or products, the price of its shares could go up.
Therefore, when trading these stocks, be on the lookout for any positive news and quarterly financial reports, as well as reports speculating an increase in the value of their profits and shares.
- High relative volume
Day traders are always looking for penny stocks that have high volatility.
One of the best methods that traders and chartists use to find these stocks is by comparing trading volume at any time against a baseline to check if there is an unusual trading activity that could indicate an opportunity.
Relative volume is simply a ratio that compares trading volume in a present timeframe against average trading volume over a historical timeframe.
For example, this ratio can be used to compare current trading activity around penny stock X against past trading activity around penny stock X, instead of against an unrelated stock.
If a stock is climbing steadily upward with high relative volume, that is a good sign that the momentum will continue.
Conversely, declining low relative volume even as the price continues to increase might be a sign of an impending reversal and slowing momentum.
- Good technical setup
To be an effective penny stock trader, you also need to have a good technical setup.
Given the penny stock market is a sea of ever-changing conditions, a decent technical setup can help filter out all the irrelevant information on your chart.
A setup is basically a precise set of things that have to happen to indicate a trade could take place.
Every trade setup will be different; say for example you only trade in the first two hours after lunch, or breakouts from triangle patterns in the first hour after the trading day.
How you can avoid penny stock scams
As mentioned before, the risk factor is significant with stocks that trade for less than $5. Not only are penny stocks very illiquid, but they are also subject to some scams.
The most infamous and popular penny stock scam is “pump and dump.” Basically, a pump and dump is the illegal act of promoting a stock you own with misleading and false information to sell when its price skyrockets.
If a penny stock trades on pink sheet markets, company information will be extremely scarce, if it is available at all.
Pink sheet stocks don’t have to meet the standards that stocks listed on major exchanges have to meet.
This significantly raises the possibility of fraudulent activities including pump and dump scams.
Therefore, it is advisable to only trade penny stocks that are listed on formal exchanges like the NASDAQ or NYSE to avoid getting scammed.
As we have learned above, a penny stock is any share that changes hands at any value lower than $5. And despite the long history of fraud, many day traders are still drawn to these stocks.
Penny stocks allow trading in small amounts and may help to earn huge returns if you find the right one.
Nonetheless, these stocks are extremely volatile, and as a result, there may be cases where you may lose your entire capital.
Moreover, a lot of penny stock scams exist. That means they are not suitable for every trader. One has to do extensive research before deciding to day trade penny stocks.