So you want to become the next Wolf of Wall Street? Well, you’ve come to the right place! Before you can start trading penny stocks, you need to learn the basics before reaping the rewards. Penny stocks have a bad reputation and are regarded by some as the gutter of Wall Street! Talk to any financial adviser about them and they’ll laugh.
New traders starting off get attracted to these stocks because of the massive potential gains! It’s possible to make over 50-100% in a single day due to their volatility. On the other hand, blue chip stocks such as Google and Apple move up or down by less than 1% every trading day. 95% of penny shares are scams but once you understand how they work, develop a strategy to take advantage of the manipulation.
What are Penny Stocks?
Penny stocks are classified by the SEC as any stock below $5 per share and have a market cap between $50-$300 million. You will find that most trade over-the-counter on the OTC Bulletin Board (OTCBB). 95% of these pink sheet stocks aren’t real businesses. These companies trade for pennies and only exist so shareholders can dump worthless shares on suckers.
New investors hope to strike it rich by buying millions of shares in these tiny companies, trading for 1/10 of a cent. 99.9% of the time this stupid strategy fails. I strongly advise you to stay away from the OTC market due to the lack of regulation. OTC stocks struggle to survive, they don’t need to report financial earnings and generate little or no volume. It’s safer to only trade companies that meet requirements to get listed on the Nasdaq and NYSE.
Getting Started with Penny Stocks
You’ll be surprised how easy it is to get started with penny stocks. To reduce your chances of failure, start off by paper trading first. 90% of new traders are too eager and blow up their accounts within a few months. Learning to trade is like any skill, it takes time to learn. Rather than risking real money straight away, paper trading allows you to become more comfortable with the basics of the stock market. This is a vital component that will be the foundation to your success. You will gradually develop your own style and test out strategies in a safe environment.
Are you a long-term investor or maybe you prefer day trading/swing trading? Paper trading should last at least three months, then the real fun can begin! FYI, Marketwatch.com is the best place to open a virtual account and compete in competitions.
Setting Up a Brokerage Account
In recent times the barriers to stock trading have fallen dramatically. Almost anyone can sign up for a broker and start buying stocks within days. The only problem, finding suitable penny stock brokers is a challenging task. There are countless factors involved in selecting a good broker that won’t overcharge on commissions and offer fast executions but speed is important when entering and exiting trades. The ideal broker for penny stock traders also charges a flat commission rate, no volume restrictions, low account minimums and quality customer service.
Some brokers have no minimums deposits to attract new customers while others charge no fees. Robinhood and TradeZero charge no fee, the only problem is both of them offer terrible executions. Both brokers make money by routing their order flow through various market makers which put customers at a disadvantage. Remember there is no such thing as a free lunch on Wall Street. In my opinion, Etrade and Charles Schwab are the best options as they have low account minimums, cheap commissions and solid executions.
Another thing new traders don’t know about is the Pattern Day Trader rule enforced by the SEC. The PDT rule sucks for those with small account sizes. For accounts under $25,000, you are only able to make 4 day trades within the same 5 business day time-frame. To avoid the PDT rule most traders end up using an offshore broker which is risky and there are also tax implications to consider when using an offshore account. There are ways to get around the regulation but it’s better to save up enough money to use the best brokers.
Pump and Dumps
Not surprisingly, a lot of beginners get introduced into penny stocks from pump and dump schemes. Stock promoters purposely target novice traders who are more likely to buy shares in a crappy penny stock. This can be seen in movies like the Wolf of Wall Street and Boiler Room. Jordan Belfort made millions through pump and dump scams.
His firm, Stratton Oakmont would accumulate millions of shares in a tiny company with the intention of selling them at an inflated price. Back during the 1990’s they aggressively promoted penny shares through cold calling, using unethical sales techniques to attract buyers, advertising stocks trading for pennies as the next Microsoft. Later Stratton Oakmont would sell for a massive profit and customers suffered huge losses. In the end, Jordan Belfort was responsible for defrauding customers out of $200 million in total.
Nowadays, penny stock promoters use the internet to promote companies. With the advancement of social media, it’s much easier to reach a large audience. Promoters create websites to rank high on Google for specific search phrases and pay for ads on different search engines. Any time someone searches “hot stock tips” they will come across their website and sign up to their email list. Another tactic is advertising on Facebook to specifically target people likely to fall prey to scams.
Luckily the SEC has upped their game and is punishing promoters for illegal stock manipulation. The SEC is now monitoring the web for pump and dumps so the tactics mentioned are no longer as effective. Examples of some notorious promoters include Jonathan Lebed and John Babikian. These con artists defrauded millions from poor unsuspecting people. Always perform your own due diligence and never listen to “hot stock” tips.
Penny stock day traders need to learn technical analysis, so they can correctly time their entries and exits. Technical analysis is the study of historical chart patterns to predict the future direction of a stock’s price. It’s important to note technical analysis isn’t reliable for micro caps that are thinly traded. The greater the volume, the more trustworthy chart patterns become. Day traders such as Tim Grittani trade purely using technical analysis and ignore the fundamentals because they don’t matter in the short-run. Trade the ticker, not the company, is his motto!
Here are five basic terms you should know:
- Support Levels
- Resistance Levels
- Moving Averages
- RSI (Relative Strength Index )
- MACD (Moving Average Convergence Divergence)
Below is a helpful video from Peter Leeds. He explains the basics of candlestick charts, chart patterns and the best technical indicators to follow.
Penny Stock Strategies That Work
Shorting is one of the most popular strategies for volatile stocks in the $2-$10 range. Timothy Sykes popularized short selling over-hyped penny stocks and has made millions in the process. It involves placing a bet that a certain stock will decline in price. What confuses people is your selling a position in a stock you don’t own and buy it back later for a lower price. You’re borrowing shares from a broker who has shares available to short. If the stock drops, the profit is the difference between the price at time you borrowed and the price at which it was subsequently purchased. The problem is most brokerages don’t have the necessary tools to short sell stocks under $5 and therefore won’t allow investors to do so.
The optimal time to short sell is when a company explodes based on a catalyst and then waits like a sniper for momentum to slow down. This strategy is dangerous unless you have strong risk management. Technically your losses are unlimited. If you short 1000 shares at $4 and the price rises to $20, you lose $20,000! That’s more than 100% and end up owing money to your brokerage. Knowing when to short sell is difficult, stocks can act irrational longer than you can remain solvent. A lot of investors shorted the housing bubble too early and lost millions. Others waited for the right time and reaped the rewards.
Momentum Day Trading
Momentum traders make a living by finding penny stocks that are moving 20-30% in a day. They profit by taking either a long or short position hoping the momentum will continue in its current direction. Stocks that only move sideways are useless for these types of traders! To find volatile stocks use a stock screener such as Trade Ideas to gather a list. Using the correct criteria, you can whittle the list down from 5,000 to 10 stocks to watch. Building a watch-list is effective as you can focus your attention on just 10 charts instead of 100’s.
Criteria for momentum plays:
- Low float: the number of shares available to the public has to be under 100 million. Ultra low floats have around 15 million shares available. The lower the float, the less volume it takes for a stock to dramatically increase or decrease.
- Daily charts above the moving averages with no short-term resistance.
- High relative volume at least twice the daily average. The relative volume indicator is displayed as a ratio, example 4.5 means it is trading 4.5 times its normal volume.
- A positive or negative catalyst that will affect share price.
As with every strategy, the goal of momentum trading is finding high probability setups where you can control risk. This strategy is more popular in low priced stocks because of the rise of algorithmic trading. Algorithmic traders avoid small caps because the difference between the spread is too high. Their loss is your gain!
Long Term Investing
Investing in penny stocks for the long term requires using fundamental analysis to assess the attractiveness of a company. This is the same approach Warren Buffett uses but applied to the penny stock market. Investing early into small caps can be very lucrative but requires a lot of patience. You may end up buying and holding your position for a few years. While most long-term investments may not perform as expected others will become billion dollar businesses. Take Monster Energy as an example, it was once below one dollar in the mid-1990s. Back then the company was known as Hansen Natural. Right now their share price is $60 with a market cap of $31.4 billion! While investing in the next 1000% gainer is unrealistic there’s no reason why you can’t make 50-100% by investing in an undervalued company.
To achieve these impressive gains, you have to start generating ideas and researching companies. Over 95% of stocks under $5 are absolute garbage so you’ll need to dig through the remaining 5% to find the hidden gems.
Criteria to find the best small caps:
- Experienced management team with an impressive track record.
- Strong balance sheet – very little debt or long-term liabilities.
- Strong cash flow – it’s important the business can self-fund growth through revenue without needing to dilute shares.
- Operate in a hot sector – cyber security and artificial intelligence are prime examples.
- High barriers to entry in the industry – own a patented technology or have a sustainable competitive advantage.
- Consistent earnings that are growing each quarter. Watch out for companies using magic accounting to make financial results appear stronger.
Beware of Fraudsters
The penny stock industry is full of charlatans selling trading education to beginners. These self-proclaimed guru’s make thousands every month selling overpriced courses. They never reveal their track record and have no business teaching others how to trade. Some will show profits for certain trades but will never show their brokerage statements. Even 20 year old kids on social media are claiming to be experts. William Karaman and Austin Page are all good examples.
These young kids understand there is easy money to make by selling education instead of trading. They can teach the basics of penny stocks and sound as though they are knowledgeable. On social media, they post images of their stacks of cash or their rented Lamborghini. Painting this false image of success. “Use my simple strategies and buy your own exotic sports car.” It annoys me how people can’t see through their bullshit.
With so many scam artists online, it’s difficult for beginners to learn without getting ripped off. Finding an experienced mentor with a solid track record and successful students is crucial. While not everyone likes Timothy Sykes, he has multiple success stories. Some of his most successful subscribers include Tim Grittani, Steven Dux, Michael Goode, Roland Wolf and Connor Bruggemann. An alternative option is using YouTube and Investopedia to educate yourself. There are hundreds of videos and free websites that teach the foundations of stock trading but beware of marketers creating videos purely to advertise their services. In addition to YouTube videos, Penny Stocks for Dummies by Peter Leeds is another great learning resource.
While penny stocks are risky there still is potential to make huge profits providing you follow a suitable strategy. The path to profitability can be a long road, learning to trade is a frustrating task that can take years to master. Get yourself a mentor and set yourself up for success. This requires investing heavily into education that will pay off in the long run.
James Kelly is my name and penny stocks are my game! Former day trader turned long-term investor with a decade of experience in the market. Over the years, I’ve joined dozens of trading services and I aim to provide honest reviews to help traders make better decisions!