According to Barron’s a penny stock is defined as:
A stock that typically sells for less than $1 per share, although it may rise to $10 per share after an initial public offering, usually due to heavy promotion. Penny stocks are typically issues by companies with a short or erratic history of revenues and earnings, and therefore such stocks are more volatile than those of large, well established firms traded on the New York or American Stock Exchanges. Most brokerage houses therefore have precautionary rules about trading in these stocks.
Barron’s Dictionary of Finance and Investment Terms, 3rd edition.
Despite the advantages of penny stocks, they can offer an opportunity to make money through day trading just like those that trade on major exchanges. Of course, you need to know how day trading works to leverage that opportunity.
But why would anyone choose to trade penny stocks in addition to, or instead of, the stocks on the exchanges?
Day trading penny stocks has several advantages, and the following four are the most important:
1. High Informational inefficiencies
When it comes to day trading, and indeed any form of investment, information is vital. It enables you to identify opportunities and the potential to make money as well as stop you from making critical investment mistakes. Indeed, professional day traders are always searching for information that gives them an edge at the marketplace.
Owing to how determined investors can be to know in advance about events that can affect stock prices, regulators like the US Security Exchange Commission (SEC) have stringent rules on how information regarding company performance and activities is shared. Indeed, releasing or using insider information to decide to buy or sell stocks is a financial crime in most countries.
With that said, information inefficiencies exist, and keen investors can legally exploit them to make a profit. For example, a company might file a merger with the regulator like SEC then take a few hours or even days before publishing a press release announcing it to the public.
A keen trader could see the filing on the regulator’s website and know that something significant is about to happen and therefore take appropriate investment steps. For example, buy more of the company stock if they believe the price is about to go up as a result.
It turns out, however, that the informational inefficiencies are higher in the penny stock companies than in the high-value stock companies. Often it is the result of poor information systems, lack of capacity or sheer incompetence. For a day trader, this is good news.
2. Fewer factors affect the price movement.
Often when deciding what to stock to buy or invest in, it is important to consider a lot of factors because, in the end, they affect the price movement of the stock. When buying stocks of the major market players, you have a lot more factors to consider than the companies behind penny stocks.
Many times some events affecting a company like Microsoft (MSFT) or Alphabet (GOOGL) can’t give you a clear understanding of how the stock price is going to react. For example, you might struggle to figure out how the investors are going to react when a multinational consumer goods brand like Procter & Gamble (PG) decides to sell one of its many products to a competitor. Would it inspire confidence or doubt about the company’s prospects?
Meanwhile, most penny stock companies have a single product in the market. Following news about that single product can easily help you be very accurate at predicting the future movement of the stock price.
3. You need a smaller capital to build a portfolio.
Many rules guide how stocks are bought and sold both on exchanges and over the counter. Some of these rules define how much capital you need to day trade particular stocks. For example, it is a lot complicated to buy a piece of a share (fractional shares). Also often there is a minimum amount of shares you can buy.
With major stocks, that means you need a significant amount of budget. For example, if a minimum amount of shares of a particular company you can buy is 100 and each costs $3000, then you need at least $300,000 to participate.
With penny stock, you may need to buy at least 100, but that ends up costing you a total of $50. What that means is that you can get in even with a small budget and you can also participate in many more plays even on the same day.
4. They are highly volatile.
When it comes to day trading, price volatility is good. The more volatile a stock is the more opportunities for trading it offers. Often the price of major stocks doesn’t move that much in a day. While that means stability for the company, it means fewer opportunities to make money for the day trader.
The position of the companies behind penny stocks is still unclear, and even the actual value of the stock is still a major question to many. Some might think a stock is overvalued while others hold the view that it is undervalued. Also, no one really knows whether the company will ever grow, and its product goes mainstream.
These factors make the price of their stock to be very volatile. This creates an opportunity for day traders to make money.
If you’re interested in making money, don’t forget to read these other great Savingadvice articles: