How Top Investors Make Money Buying Penny Stocks

So you're ready to start investing but don't have tens of thousands of dollars to invest in shares of $Meta Platforms(FB.US)$ or $Twitter(TWTR.US)$. You may want to look at penny stocks. Before you dive right in, it's good to know some tricks of the trade.

It's also essential to understand the risks and how to avoid them as best as possible. Unlike the typical blue-chip companies like $Apple(AAPL.US)$ or $General Motors(GM.US)$, penny stocks allow people to buy more shares with less money to gain leverage based on small moves in price. If Apple stock jumps 5 cents, it doesn't mean much. But if one of the penny stocks under $1 makes that type of move, you're looking at a pop of 5% or more relatively quickly.

What Are Penny Stocks?

The term "Penny Stock" is defined as a stock that trades under $5 per share. Popular opinion might assume that these equities are only traded Over-the-Counter on the OTC market. However, there are hundreds of stocks under $5 traded on major exchanges like the New York Stock Exchange and the NASDAQ.

Penny Stocks Are Usually Smaller Company Stocks

Penny stocks are usually associated with smaller-sized companies, many of which could be considered start-ups.  Because of this, investors could have trouble finding stocks with high levels of liquidity.  This means that there is a lower trading volume for many penny stocks.

This can make for a tough time when it comes to selling stocks to take your profit.  Investors may also have difficulty finding a stock price that accurately reflects the current market for a stock. It's always important to keep this in mind before deciding to buy a penny stock.

On the other side of this coin, these small companies can become market leaders or, at least, formidable competitors. For instance, during the early days of the COVID pandemic, a small company called $Novavax(NVAX.US)$ was working on an influenza treatment candidate. They then flipped the switch on a potential coronavirus vaccine. Investors saw shares surge from under $5 to over $300.

Penny stocks can also include companies that've been beaten down. Thanks to the "Ape" movement, many of these were uncovered and brought to the masses. Most notably, $AMC Entertainment(AMC.US)$ and $GameStop(GME.US)$ were two that exploded from levels below $5 to over $480 in the case of GME stock. It's important to note that this isn't the norm, but it is possible under the right circumstances.

Finding The Best Penny Stocks To Buy

Now that you know what penny stocks are, it's time to start formulating your plan of attack. Since these stocks can be very risky investments and highly volatile, you need to trade smart. Know what to look for to see what makes a penny stock a potential moneymaker. Note that these are not guarantees, but they are good rules to keep in mind.

Characteristics Of Penny Stocks That Could Make You Money:

1. The Company Should Have Substantial Assets

Novice investors may come across skyrocketing penny stocks, but many of these can be "fly by night" schemes. These companies will typically have little to no assets or cash and boatloads of debt.  When it comes to making money with penny stocks, look for companies that have substantial assets. They will be more likely to have a real business plan in place and look to grow the company rather than pump shares into the market.

2. The Company Should Have A Plan

If you come across a penny stock with little or no news, very few financial documents, and a limited amount of information, beware. It's important to look for penny stocks whose companies have significant public information. This should outline the corporate strategy, growth plan, significant milestones, and more to show that this is a real company.

3. Beware of Overly Optimistic Projections [But Don't Ignore Them]

You don't see large-cap companies like Netflix or Disney "expecting to increase revenue by 40,000% next quarter." Likewise, beware of companies releasing news that is too good to be true.  Instead, utilize the two points above to help deduce the truth behind any corporate guidance.  If it sounds overly optimistic, it could very well be the case. This doesn't mean you can't use such headlines to your advantage.

Specifically for day traders, speculation on optimistic company updates can act as short-term catalysts for day-to-day moves in the stock market. Today, retail traders are becoming a larger piece of the pie and, as a result, have leaned on "playing the speculation" more than relying on fundamentals. Again, this is for day trading, specifically. If you're investing in penny stocks (or any stock), fundamentals should play a role in your long-term outlook.

6 Ways To Find Good Penny Stocks To Trade

If you want to trade penny stocks successfully, you need to find the best stocks with the highest probability of making a big move. Some traders will look for solid fundamentals, but most traders will rely on technical penny stock scanners to track irregularities in the market.

If you are building your penny stock scanner, you'll want to include at least one of these parameters:

1. Share Float

This refers to the total number of shares in the publicly traded float or market.  This includes everything in retail shareholder circulation. The figure is calculated by removing the shares held by insiders/employees from the overall outstanding shares. In general, the lower the float, the lower the number of shares that are trading at any given time. Higher levels of buying interest could drive prices up quickly.

2. Scan For Penny Stock News

Watch for companies that are making announcements.  Penny stock news can become an active catalyst to push stock prices higher on company optimism.

3. Penny Stock Volume Scan

Look for companies with higher relative trading volumes. Traditionally, the higher the relative volume, the more traders will be watching and trading specific penny stocks. This means plenty of liquidity to enter and exit a trade.

4. Short Squeeze Penny Stocks

Like low float penny stocks, stocks with higher short interest can also move quickly. Volatility plays a large role as a result. AMC stock and GME are clear examples of what can happen when stocks squeeze. The first thing to identify is stocks that many traders shorting.

What is shorting anyway?

When someone shorts a stock, they take a bet against it, and to profit from that bet, they'll borrow shares from their broker, sell those shares into the market, then when the stock drops far enough, they'll repurchase the shares at the lower price and return them to the broker. The profit is made in the difference in the price at which the shares were sold and repurchased. No matter what, the amount of borrowed shares needs to get returned.

So what's a short squeeze?

When there's a short squeeze, anyone shorting loses money. They are forced to buy back stock at higher prices to return their "loan" to the broker. This buying paired with short covering creates a unique situation where prices explode. This is more beneficial to short-term traders than investors. But if that's you, it's something to be aware of.

5. Penny Stocks With Unusual Options Volume

New traders might not know that even though penny stocks are already cheap, many have options to trade as well. Looking for stocks with unusual options activity can help shed light on sentiment. There aren't any guarantees that heavy Call volume means a stock will explode or heavy Put volume is a sign an implosion is coming. But, in most cases, unusual options activity has been used to understand what "smart money" is thinking about specific penny stocks. If you are new to options, check out our article, "Trading Options 101: A Beginner's Guide."

6. Penny Stocks With Insider Trading

Insider trading doesn't have to always be a "swear" word in the stock market. In fact, every investor can legally identify insider buying or selling by taking a few extra steps. Looking for things like Form 4s and Schedule 13s is a way to find insider and hedge fund trading activity in specific stocks. Like options volume, there's no guarantee that insider buying means a stock will rise and vice versa for insider selling. However, it has been used to gauge sentiment and, as a result, remains a catalyst for speculative trading.

You're Ready To Make Money With Penny Stocks

Having a good gauge of your risk tolerance and knowing the basics of penny stocks will put you at an excellent starting point to begin trading. If this sounds like the right choice for you, your next step is to find the best broker and make your first trade. Always keep your strategy and unique trading rules in mind to avoid taking significant losses and capitalize on big gains.