There are many ways that people trade penny stocks, but 90% of the people lose money trading penny stocks or any other kind of stocks. The most common reason why these people failed is because they don’t take the time to learn how the market works. Instead, they rely on tips from gurus or friends. When they are told that a stock is hot, they jump right in without doing any research on their own.
To learn how to trade penny stocks, you must learn that trading is a business, not a habit. In any business, you need to learn how it operates before you can make any money, and you work hard so that it doesn’t fail. Same thing with penny stocks, you cannot be lazy and expect to get rich with one hot stock. You need to learn how penny stocks works before you can trade and make money. Before we go any further, you should understand that penny stock is not for everyone. There are risk involved just like a business where it requires initial capital and it may fail or even bankrupt. Therefore, you should only trade with the money that you can afford to lose.
Penny Stocks for Dummies
There are two main types of penny stocks, Over-The-Counter (OTC) penny stocks and penny stocks that are traded on regular stock exchanges like NASDAQ and NYSE. We will focus on penny stocks on NASDAQ and NYSE. OTC stocks are too risky in my opinion.
Let’s start with the basic about trading penny stocks. Trading is different than investing because basically we are speculating. To improve our odds of winning, we must follow some rules and strategies. Investing requires you to do research on company fundamentals, buy and hold for a long period of time whereas trading requires you to study technical analysis and chart patterns to predict how the stock will perform in the short term.
There is actually a book called Penny Stocks For Dummies which is an interesting read. If you are just starting out, you can check it out.
How to buy penny stocks
Let’s now learn what technical analysis and chart patterns are because that’s what we will use to trade penny stocks. Technical analysis is a way for traders to predict the short term movement of stock price based on historical patterns. It is the study of past market data, primarily price and volume. Over the years, traders develop many different technical indicators that are directly or indirectly derive from stock price and volume. They used these technical indicators to find trade setups. The reason technical analysis works is because of human minds and psychology don’t change and they always act the same when they experience greed and fear.
Let’s say a stock XYZ is trading in the range of $4 – $5 for the past couple of months. It is safe to assume that $4 is the support and $5 is the resistance. So the next time the stock is trading around $4, you would want to buy it and trying to sell it when the stock approaches $5. This is the simplest form of technical analysis.
Volume is the second most important indicator in technical analysis. Let’s say the XYZ stock in our previous example breaks out of $5 one day and trades at $5.1 or higher. When a stock breaks out, it is usually a good sign that it can go much higher. However, when the break out happens with low volume, there is a high chance of a false break out. That means that XYZ will soon fall back below $5 and continue to trade in the range of $4-$5. On the other hand, if the break out happens with strong volume, there is a good chance the stock will go higher and trades above $5. When that happens, the $5 level will become the new support.
Same logic applies if XYZ stock trades below $4. When the volume is low when the stock goes below $4, there is a good chance the stock will recover and trades above $4 again. However, if the volume is strong when it drop under $4, there is a good chance that the stock will continue to decline.
List of technical Indicators
There are many other technical indicators that are derived from the price and volume. I will list the most popular ones here.
Exponential Moving Average
Moving Average Convergence Divergence (MACD)
Money Flow Index (MFI)
Average Directional Index (ADX)
Commodity Channel Index (CCI)
On Balance Volume (OBV)
Percentage Price Oscillator (PPO)
Relative Strength Index (RSI)
I will not discuss these technical indicators and chart patterns in details here, but I will explain each one and how to use them in the future. Please don’t freak out as you don’t need to learn all these technical indicators to trade penny stocks. You only need to learn a few and stick with them. Technical analysis is only part of the equation to trade successfully. The other part is the mind set and discipline which in mind opinion is much more important than technical analysis itself.
You can read Technical Analysis of the Financial Markets to learn more. This book is like the bible of technical analysis.
Like I said, trading psychology and discipline are critical if you are planning to trade penny stocks for a living. You have to know that technical analysis only helps you make a prediction on stocks, but it is not a fortune teller. If it were, nobody will be working anymore as everyone will start trading. It can go wrong from time to time and you don’t want to rely primary on technical analysis to trade. It is a lesson that I learn after thousands of dollars loss in trading penny stocks. I learn it the hard way.
That’s when discipline comes in. You need to develop the discipline to follow your rules when trading with penny stocks. You must not let your ego get in the way when you trade. For example, it feels and looks good when you buy a penny stock and it goes up 100% in a few days. But what are the odds of that happening? You might argue that you see penny stocks double and triple in a short period all the time, and that’s the whole point of penny stocks, isn’t it? While it is true that a lot of penny stocks double and triple, what most people don’t realize is that these same penny stocks can go down 50% or even 100% a few days later. To make a 100% gain on one trade requires you to buy in the right time at the right place and sell at the right time. To do this consistently is just not possible. Instead, you can aim for smaller gains such as 5%-20% on each stock because it is much easier for a penny stock to go up 5% or 10%. You will need to have an exit plan before you buy a stock. You can set a target price and a stop loss strategy because there is a chance the trade might not end up like you wanted to.
Sometimes, the best strategy is to ride the trend when a stock is going your way. However, you must have the discipline to sell it if it falls back to your original target price.
For example, your target is 5% on a stock, and the stock is going up with strong volume and pass your target price. You decided to hold a little longer, and the stock keeps going and you are at a 10% profit. Then the stock starts pulling back and hit your original 5% level, you should sell it. Many beginners are kicking themselves now for not selling it for the 10% profit, so they wait and hope the stock will go back up to the 10% level. Often, the stock just keeps going down until they can’t hold it anymore, so they sell for a big loss. That’s how most beginners turn a winning trade into a losing one.
You must keep in mind that the goal of trading penny stocks is not to get rich overnight, but to get rich gradually by improving and learning. A lot of people get wash away because they are trying to make a 50% gain on every stock. They might get lucky sometimes, but eventually they will lose all or most of the money on a single trade.
Penny Stock Book
There are many good books written about swing trading and investing, but only a few good books on penny stocks. The one penny stock book that I recommended is Penny Stocks For Dummies
Penny Stocks For Dummies is a good introductory book to penny stock investing. You will learn how penny stocks works and how to invest in them for the long term. The dummies books are easy to read and are very beginner friendly, this penny stock book is no exception. You will learn how tiny shares are defined and how they’re different than large companies. Of course, you will learn how to find undiscovered quality penny stocks, ways to identify growth stocks, and learn the fundamentals of potential investments. You will also learn the tools that you need to make good investments.
If you are planning to trade penny stocks, check out the best trading books that I recommended in my previous post. These books are good trading books, and many trading strategies applies to penny stocks as well.