Penny stocks are one of the most misunderstood assets for the new day trader.
It seems appealing that you can buy a stock so cheap, and if it just increases to the same price as Apple one day, you become a billionaire.
However, many new traders have a hard time understanding the difference between investing and shopping. When you are looking to purchase something consumable, a cheaper price is a good thing for a shopper.
However, as an investor, a cheap price suggests the company comes with very high risk and a large probability it will not exist in a few years. Basically, penny stocks are cheap for a reason.
Penny stocks are defined as any company with a share price under $5 US.
So let’s take a deeper dive at penny stocks, and why they are the worst day trading asset.
How to Buy Penny Stocks
Buying penny stocks is very easy. The process is identical to buying any other stock or ETF. First, you need to open a brokerage account, which will vary depending on where you live. A broker houses your money and connects you to the electronic marketplace. In exchange, you pay the broker commission for this service.
Second, you have to decide on what charting software to use. Most brokers offer their own charting and trading tools. The trick is finding the one that works for you in one integrated solution. You can also have a separate charting platform that is not tied to your brokerage, but you cannot trade directly through the charts in this case.
One great software and broker for penny stocks trading is “Lightspeed”, which provides a cheap commission and fairly good fills in low float stocks.
Now that you have a brokerage account setup, you fill out a trade order ticket according to your desired price level and strategy.
However, if you are looking to day trade then penny stocks are the worst idea.
Penny Stocks on Robinhood
Most penny stock investors and traders are amateurs and just starting out. More on why penny stocks are a terrible strategy for anyone in the next section.
But first, let’s take a look at Robinhood for penny stock trading.
Is Robinhood a good penny stock broker?
You may have heard that Robinhood offers commission free trading. But you also know that no business can exist without making a profit. So what is actually “FREE” and is it worth it?
Yes, it is true there are no commissions for penny stock trades, but there are regulatory fees that are added. So it is not completely free. Here is a complete trading fee schedule of Robinhood.
Let’s assume you want to purchase 10,000 shares of a penny stock company trading at $0.50 with Robinhood.
The transaction value is calculated by multiplying the share price times the quantity. This is called the ‘principal cost’.
In this case, it would cost you $5,000 USD ($0.50 x 10,000 shares). Robinhood charges you $22.10 per $1,000,000 of principal. It will cost you just 11 cents, calculated as: $5,000 divided by $1,000,000 and multiplied by $22.10.
But what happens when the stock market is plummeting and you cannot get in to make a trade to get rid of your losing investment? This happened recently, in 2020, when customers were locked out as the market plummeted over 30% in just days. Read about this story here.
Trading is like any other job, you need the right tools to be successful in this business. Unfortunately, for the more active investor and trader, you need a more powerful broker with more options.
Let’s take a look at the concept of day trading penny stocks, is it even a good idea?
Day Trading Penny Stocks
Day trading penny stocks is extremely dangerous for many reasons. In day trading, the goal is to buy and sell a stock within any given day and profit from the difference in price.
However, penny stocks are very thinly traded. There is very little quantity of shares that are exchanged on a daily basis when compared to bigger companies. This concept is called liquidity. In penny stocks, the term is also called a “low float stock”, indicating there are very few shares available for transacting.
In addition, most professional traders with big account sizes are forbidden to participate in penny stocks because they are highly speculative. This is what makes stocks very thinly traded, and a very predatory marketplace for the retail investor.
With very little money, you can move the stock price.
The Penny Stocks Pump and Dump Scam
Here is an example of just one way the retail investor gets taken advantage of in penny stocks.
A signal service company promises to email you profitable trade ideas, and even show you their account statement to prove it. They’re making money, you can too, you think to yourself.
Let’s imagine a fictitious company called “Pretty Penny Stocks” is planning to send a buy signal to their email list of 100,000 people for stock symbol ABC.
Before they send the email, the company buys 50,000 shares of ABC for themselves. Now that the service owns the company, they stand to make a huge profit if share prices increase.
The email goes out to 100,000 people advising them to buy ABC shares, it’s a great investment they say. Let’s assume just half of the list wants to buy 500 shares.
A grand total of 25 million shares are demanded by the company’s email list. What do you think happens when this many orders are chasing the stock price?
Because investors are eager to get into this great penny stock, they start paying more and the share prices rise even further. By the time everyone gets a chance to buy ABC stock, it’s up 50%.
Who do you think made the most money?
Pretty Penny Stocks, who owned the company before it started to increase in price. Who do you think sold the stock to greedy investors piling in? Pretty penny stocks.
By the time everyone is in, the stock stops moving higher and eventually everyone gets worried and starts selling. All these buyers rushing to get out slams the stock price lower, back to where it was before the email newsletter went out.
Pretty Penny Stocks posts a huge profit on their website, as you are left at home scratching your head why you lost so much money.
Welcome to the penny stock pump and dump scheme.
You need to know that no professional traders participate in these thinly traded markets. This is a retail bleed out market, and those taking a high stake gamble on a very risky company.
Penny Stock Shorting
One of the most risky trading strategies you can ever try is shorting penny stocks. I would advise avoiding any type of penny stock trading, and especially shorting low float stocks.
Short selling is when you sell a stock you do not own, hoping to buy it at a cheaper price to profit from the differnece.
But what happens if it doesn’t go down?
Let’s look at an example of this disaster which can lose all of your money and leave you owing hundreds of thousands more.
Imagine you think company ABC is going to drop down to $0.50 from $0.75. If this happens, and you short 10,000 stocks you can make a $2,500 profit.
So let’s go ahead and sell 10,000 shares of ABC. But the stock does not go down any further.
All of a sudden, the stock is halted for trading as Apple announces they are buying out the company at $15 a share USD. When the halt is lifted, ABC is trading exactly at $15 a share and trading is now open at this price.
What is your loss?
Let’s calculate it: $15 per share market minus your purchase price of $0.50. Now we multiply the $14.50 difference by your 10,000 share quantity.
You are sitting at a massive $145,000 loss.
But what if you only had $10,000 in your account?
You are left with a -$135,000 debit which you must cover, or you will be bankrupted personally by collections agencies. Your credit rating is screwed if you cannot pay.
The lesson here is that you are responsible for every penny of every trade you take. It takes one massive surprise like the one above to blow out your entire account and your life savings.
A similar scenario happened to a trader of KBIO stock. You can read the painful story here.
Day Trading Penny Stocks Reality
The truth is, you can become a successful day trader. However, you will not be day trading penny stocks, they are the absolute worst product.
Most professional traders use futures for day trading, as they provide high liquidity, low costs and a real opportunity to make good income with a small trading account.
The reason you haven’t heard about them yet, is because they work.
So let’s get started, let me teach you how to day trade futures the right way inside our community.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.