Beginner's Guide To Trading Penny Stocks: Part I

Penny stocks are an attractive jumping off point for people who have never traded before because they're cheap. You can purchase a large number of shares with only a little bit of money, which means you stand to gain an excellent return if that stock price rises. While these reasons are certainly valid, we need to explore a little deeper to really understand how a novice trader should be making their investments.

What exactly is a penny stock?

Holy crap. You can buy so much stock!

Browsing the internet will uncover several definitions. The term basically just refers to a cheap stock. Personally, I consider stocks less than $5 a share but greater than around 30 cents to be a penny stock. Stocks under 30 cents might be more appropriately termed sub-penny stocks which should be avoided by the novice trader. Penny stocks are also typically less well known so you might not consider a big name company trading under $5 dollars to be a true penny stock.

Stocks, including penny stocks, are traded over exchanges. You've probably heard of some of the major ones such as the NASDAQ. Each exchange has its own requirements that a company must meet for their stock to be traded on that exchange. Since exchanges like the NASDAQ have more strict regulations concerning what companies must disclose and report to investors and the SEC, you won't see many penny stocks trading there. Instead, most penny stocks appear on the Over-The-Counter (OTC) markets.

Characteristically, penny stocks are more illiquid than other stocks. Liquidity, in this case, refers to the stocks volume, which is just another way of saying how many of that stocks shares were traded. A stock with high volume is basically just trading a lot. In order to be liquid though, that volume must be consistent throughout the trading day. Liquidity is important because it determines how easily you can buy and sell that stock.

Never trade a stock with a chart like this

The chart above shows a penny stock with very low trading volume, meaning it is also very illiquid. You may run into charts like this because they often see large percentage changes which create a tempting illusion to new traders. A stock that is up 250% in a single day might make you salivate when considering how much money you can make if you had just bought in the morning. You start to see the illusion for what it is though when you consider all the factors. The biggest problem is that low volume, illiquid stocks, rarely show a clear trend. They may gain 50% or more from a single trade then 30 minutes later be down 100%. Basically, they're terribly unpredictable and you should just train yourself to recognize which stock charts to ignore.

A trend can be more easily seen here

This chart shows a stock trading with extremely high volume, making it liquid. As you can see, it's much easier to see a pattern which is really the key to successful trading. You can use the pattern of the trading to better predict how the stock may behave in the future and plan you're trades accordingly. We'll go into that more later though.

Beyond just looking at a chart, you can use the more quantitative analysis of a stock's dollar volume. Dollar volume shows the relationship between volume and stock price, which provides a more accurate picture of how liquid a stock is. For instance, a stock that trades 20 million shares in a single day might seem like a high volume stock with good liquidity, but if that stock is only valued at $0.0001 a share, it only traded $2000 dollars worth of stock which is pretty much nothing. Dollar volume is usually shown when looking at stock quotes but you can give yourself a rough idea of it by simply multiplying the days total volume by the stocks current stock price (although it would be more accurate to use the stocks average price for that day). A stock that trades a few hundred thousand dollars a day or more is generally going to be liquid enough to consider trading.


Which stocks do I buy?