How to Play Penny Stocks

by John Hewitt ; Updated July 27, 2017

Penny stock trading is an extremely risky activity. Penny stocks (also known as microcap stocks) are equities valued below $5 that aren't traded on the major exchanges. Typically, they're very new companies with a short track record. Many of them have never turned a profit and never will. The lure of penny stocks is similar to that of a slot machine. They cost little to invest in and there's a tiny chance that they'll pay returns of over 1000%.

Step 1

Consider subscribing to a penny stock newsletter or multiple newsletters. These newsletters are often used to clue in investors to penny stocks that are poised to go through a breakout period. In many cases, the sheer fact that a penny stock is mentioned in a newsletter can send its price skyrocketing because the small market capitalization of such equities means that the price can be greatly affected by a relatively small number of investors.

Step 2

Set tight stop-loss and limit orders on any penny stock purchase or short sale that you make based on information from a newsletter, rumor, internet forum or news website. This is a highly risky strategy. The volatility of most penny stocks makes it challenging to set an effective stop loss order that won't also risk losing most of your investment. Choose your stop-loss and limit orders based on a shorter-term Average True Range (ATR) than normal for most stocks. ATR is the measurement of the volatility of a security over a period of time. For penny stocks, it's generally best to use an ATR of less than three days to determine stop and limit order positioning.

Step 3

Invest in multiple penny stocks with low correlations to one another's performances. For example, if you invest in two microcap gold mining stocks operating in the same country, you're greatly increasing your risk. To diversify and protect yourself from broad market movements in penny stocks, buy or short multiple penny stocks in unrelated market sectors.

Step 4

Look for penny stocks issued by companies that have existed for three years or longer. The newer that a penny stock is, the more likely that the company will become bankrupt and the shares become instantly worthless. Financial information reporting is less open and widely publicized among penny stocks compared to that of better-capitalized companies.

Tips

  • Penny stocks are vulnerable to what the SEC terms "pump and dump" schemes, also known as microcap stock fraud. In such schemes, newsletter authors are paid a bribe to tout the virtues of a particular penny stock (the "pump"). The readers of the newsletter then funnel money into the stock, sending the price skyward. Once this happens, the company owners and the newsletter authors sell their shares, triggering a collapse in the price (the dump). This process is illegal, but extraordinarily difficult to prosecute.

Warnings

  • Avoid investing in penny stocks unless you're prepared to lose most of the money you spend in it. The volatility of penny stocks makes them challenging to analyze using conventional technical and fundamental models.

About the Author

John Hewitt began freelancing in 2008, writing about subjects ranging from music to stock trading, the energy industry and business. His ghostwritten work has appeared all over the Web. He attended New York University, pursuing a bachelor's degree in history.

Photo Credits

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