How to play the fast-moving space for the best profits.
A penny stock is any company trading under $5 per share. That’s the minimum threshold price that an investment fund needs before they can buy shares. Under that price, it would be too difficult for a big fund to build a large position without moving the market.
That makes this part of the market a great place for smaller investors to trade. While it can provide traders with some great returns, it also can have its risks as well.
Knowing those risks can allow you to better navigate this market and increase your profitability by avoiding potential losses with your capital and allowing you the chance to make the best buys now.
Tip #1: Understand the role of volume.
When investing in traditional stocks, volume, or the number of shares trading daily, is generally a moot point. Whether you’re buying 1, 100, or 1,000 shares of a big, blue-chip name like Home Depot (HD), you’re likely not going to move the market that much. Bigger players will be buying thousands of shares at a time, and your order will get filled near the price where these bigger players are trading.
That impediment doesn’t exist in the world of penny stocks. Some may trade on just a few hundred shares a day. Some may have millions of shares per day. But if you’re looking to build a stake, you won’t want to buy into the company that just trades a few hundred shares per day.
Why? Because if you start buying that much, your buys alone may be enough to start pushing the price higher immediately. That may even cause you to push a stock outside your maximum buy price. While that may sound fine on paper—you’ll already have a profit on the shares you bought first after all—it’s actually quite dangerous. That’s because once you stop buying, there won’t be any support for shares to head higher and they may fall again.
Even worse, when it’s time to sell, you may have a few thousand shares against a daily volume of a few hundred. If you’re not trying to push the market for shares down too much, you’ll be limited to how much of your stake you can sell each day. That’s a huge impediment to trading, as it could take days to get out of a position. And if you really needed to sell, you could even cause a penny stock’s price to crash.
To get around this potential problem, start by focusing on penny stocks that trade at least 500,000 shares per day. And make sure you never accumulate a total number of shares larger than 20 percent of a stock’s daily volume.
Tip #2: Do your own homework, and understand the assignment.
The penny stock world is rife with fraud, and rightly so. Social media posts or marketing efforts can easily hype a penny stock and move it far higher well before you have a chance to get on board. A stock that’s rising thanks to a marketing campaign will likely stop rising—and will likely crash—as soon as the campaign gets the plug pulled and anyone who bought shares stops buying, or rushes to the exit to take profits.
If a company’s recent returns look too good to be true, this is probably why!
At the end of the day, while there is a company behind every penny stock, these low-priced firms are truly trading opportunities, not investment opportunities. You need to be willing to take the inevitable loss far more quickly than you would with a bigger, more established company. By separating your penny stock trading from your core investments, you can ensure that you don’t risk your overall portfolio, even if you do occasionally get swept up into a mini-mania over one of these companies.
Tip #3: Follow technical analysis.
Again, while there are underlying companies to analyze, a penny stock is typically for TRADING ONLY. And that means you’ll want to use the tools of technical analysis. Key patters include looking at the Relative Strength Index (RSI) of a company, which helps indicate whether shares are overbought or oversold in the short term.
Another key technical tool is that of moving averages. With moving averages, you can spot when companies are undervalued, as they’re trading under their 200-day moving average. Likewise, when a company surges over its 200-day moving average, it’s probably getting hyped up somewhere and it’s time to take profits.
One final tip: Never be afraid to book a loss quickly, and never fret over leaving some profits on the table using these tools… it’s a fast moving space, and what looks like a lost opportunity today may be a relief just a few days later.
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