Penny stocks draw a ton of intrigue from traders and investors alike.
Why?
Because they are the most exciting movers…..no other stocks have that level of spikeability if a home run opportunity is found! Contrary to what many believe though, it’s not as simple as just hitting a buy button.
As with anything in the stock market, there are no free lunches. The level of potential rewards is almost always matched by the level of risk, and penny stocks are no different.
That is why there are important steps and guidelines that one needs to follow with these smaller cap stocks.
Choosing a Broker
You may be thinking that selecting the right broker has nothing to do with one’s success with penny stocks.
The reality is that, having a reliable broker is critical because all of the trade executions go through them.
When we say reliability, what we are really referring to is execution speed.
Why is this important?
The more time that it takes for an order to get filled, the larger the potential difference between the price that one is trying to get executed at and the price that they actually receive.
This is known as slippage.
Slippage can be especially bad with penny stocks because they tend to be very volatile, so fast execution speeds are of extra importance.
High volatility is not the only reason for slippage to occur, as brokers are looking to make money on transactions which further adds on to the potential slippage.
There are also other factors to consider such as commission fees and platform interface…
Brokers have largely gone away with commission fee structures over the past few years, so its become a less prominent factor.
The best interface on the other hand, is a very subjective matter. Some brokers prioritize customizability of accessibility, while others have relatively clean interfaces but offer less features.
Picking a Trading Approach
Once you’ve opened an account with a broker and familiarized yourself with the platform, you have to make a choice about the style of trading you are looking to execute on.
You see, there are multiple approaches to buying stocks, that can be categorized broadly based on the length of the position one is willing to take.
The different categories and the corresponding position lengths are:
- Scalping- seconds to minutes
- Day Trading- less then a day
- Swing Trading- a few days to a few weeks
- Position Trading- a few weeks to a few months
- Investing- months to years
It is important to know what type of trading you are interested in, because the style will dictate what aspects of a penny stock you will need to pay attention to.
Generally speaking, the shorter term the focus, the more important technical analysis will be and the less important fundamental analysis will be.
Conversely, as the length of the position increases, technical analysis becomes more important while fundamental analysis becomes less important.
For instance…
If you were interested in a day trading approach, a lot of the focus is going to be on timing good entry and exits, for which technical analysis matters a great deal.
On the other hand, over such a short timespan, the company’s health has little to do with the intraday movement of the stock. Of course, fundamental catalysts can cause interest in the stock and drive up the price action quickly, but it takes a backseat to the technicals.
On the opposite side of the spectrum…
If you were interested in taking an investment approach, the fundamentals are what are going to be the main driving force in moving the stock. Technicals matter little over such long time horizons, because having good timing has very little effect on our potential profits.
Managing Risk
Its important to keep in mind that the stock market is ultimately a numbers game…..and a player in such a domain is only as good as their ability to control risk.
This risk needs to then be weighed to the potential reward, so that a strategy can be devised to balance the two to the best of one’s ability.
This will depend on the trading style, and the types of positions one is looking to take. In the case of penny stocks, both the risk and rewards levels tend to be very high…
One way that trader’s try to control the risk is focusing on shorter term tactics such as day trading and swing trading. In this way, buyers can try to take advantage of the upwards swings while trying to minimize the damage on the downside.
From an investing standpoint, penny stocks tend to be smaller, less mature companies with more potential upside then those of your average stock. The problem is…..the risk is significantly greater, with the majority these stocks eventually going to zero.
Choosing a Penny Stock
Now that we know what trading approach we are looking to employ, and have devised a concrete risk management strategy…..its finally time to pick a stock.
This can be a daunting task, as there are thousands of Penny Stocks out there, however the constraints that we set up over the last two steps will ultimately help narrow down our choices!
For example, penny stocks with good chart setups and looming catalysts will be more useful for a day or swing trading approach.
Conversely, a track record of strong company leadership and good balance sheets will be much more relevant for longer term trades, such as with position trading and investing approaches.
We can narrow the pool of candidates down even further once we start weighing the relevant factors for our preferred trading approach, and see what they tell us about the risk to reward potential for the given stock.
Finally…
You hopefully have a short list of stocks to choose from. Don’t get discouraged if you have a hard time putting all the pieces together just yet!
You will figure out through trial and error the approach that works best for you, and the risk/reward strategy that falls in line with your personality and trading style.