In the 2013 film The Wolf of Wall Street, newly-minted stockbroker Jordan Belfort is forced to turn to a boiler room brokerage for employment following the Black Monday market collapse.
While Belfort might have been the personification of fraud, penny stocks aren’t necessarily shady or illegal investments. Companies not listed on major exchanges face a different set of financial hurdles, but crafty traders can take advantage of penny stocks to make enormous profits.
Just be sure to understand the risks associated with this type of asset before you start trading them yourself.
What Are Penny Stocks?
Penny stocks are shares with a price under $1 that trade “over the counter” (OTC). Also known as pink sheets, penny stocks are by nature smaller, unstable companies that struggle to get funding in the capital markets.
Access to liquidity is hampered, so these shares are often besieged by volatility. And not all of that volatility is achieved through legal means.
Penny stocks usually don’t have much of a free float. Since share availability is limited and the price is so low, it doesn’t take a ton of capital to corner the market on a pink sheet stock. This makes penny stocks highly susceptible to pump and dump schemes.
Pump and Dump Scheme
During a pump and dump, a ‘market guru’ will buy up a large number of penny stock shares and then promote those shares to their followers. The ensuing volume creates a huge jump in share price, which is when the guru sells. The unwitting followers buy high and usually lose most of their investment when the penny stock crashes back to earth.
Remember, companies with cheap shares trading OTC are usually there for good reason. The major exchanges want nothing to do with stocks priced under $1. Most penny stocks are either poorly run companies or in debt so deep it’s backbreaking.
Plus regulation is light and these firms’ financial paper trail can be difficult to follow. These shares are meant for short-term trading, not long-term investing.
That is why we only trade listed penny stocks. These are cheap companies that have to meet certain regulation guidelines in order to be listed on a major exchange like the NASDAQ or NYSE.
What to Look For in a Broker for Day Trading Penny Stocks
- Share Availability – Not every broker will support OTC stock trading. Many of the newer free trading apps only support stocks from major exchanges where the share price must be over $1. Most large, traditional online brokers will have OTC and pink sheet stocks available.
- Execution Speed – Penny stocks are extremely volatile. Since prices are low and liquidity is scarce, a move of only a couple cents can be more than enough to sink your trade. Direct market access brokers not only provide swift trade execution, but more manageable spreads too. Of course, the fees are a tradeoff you’ll need to measure.
- Trading Fees – When shares only cost a few pennies, you’re going to need to buy a lot of them to make any real money. Because of this, the cheapest brokers for penny stocks will have a flat trading fee instead of a per-share trading fee. For example, let’s say one broker charges $5 per penny stock trade and other charges 0.004 cents per share. If you trade 5000 shares with the first broker, you’re only paying $5. But if you trade 5000 shares with the second broker, you’re paying $20 commission on the trade.
Best Brokers for Day Trading Penny Stocks
TD Ameritrade has all the tools needed for a penny stock trader. The Thinkorswim platform is powerful and robust, trades are executed in 0.08 seconds on average, and the platform charges a flat $6.95 fee on OTC stocks. They also have zero commission on stocks listed on major US exchanges, plus 65 cents for options contracts.
E*TRADE doesn’t get the recognition that TD Ameritrade does, but they have some features to rival them. Power E*TRADE has tools similar to Thinkorswim and the broker charges the same $6.95 flat commission on OTC stock trading. Additionally, clients who make 30 or more trades per quarter will have their commission dropped to $4.95. Short selling is banned though and clients can only place limit orders on pink sheet stocks.
TradeStation is a direct access broker where clients can trade securities listed on all major exchanges, plus pink sheets and OTC stocks. By routing their own orders, clients can get lightning fast trade execution and low spreads. US clients can get the TS Go or TS Select packages and enable commission-free trading on the first 10,000 shares.
However, direct order routing comes with a $0.005 per share fee. TradeStation allows more freedom to direct orders to ECNs, exchanges, or market makers, but commissions will add up.
Risks of Day Trading Penny Stocks
- Questionable Finances – Penny stocks listed on the OTC bulletin boards or pink sheets don’t have to submit as much financial data as companies list on major exchanges. Shady dealing is much easier to hide when trading as a penny stock and accurate financial data could be hard to find.
- Thinly Traded – Shares trading outside the major exchanges don’t see much volume, so prices can gyrate wildly if a large buy or sell order comes in. With penny stocks, a single firm or trader can purchase enough shares to manipulate price without much difficulty. Penny stocks will always be susceptible to pump and dump schemes.
- Highly Volatile – Low floats and low prices tend to create high volatility. In some cases, OTC stocks trade for less than a penny, which means a fraction of a cent price increase could result in a 100% gain or loss. Speed and accurate pricing are key when trading penny stocks.
- High Commissions – Most brokers have gone the commission-free route when it comes to equities on major exchanges, but penny stocks will still cost you. Direct market access brokers will have per-share commissions and routing fees, while traditional brokers often have a flat per-trade fee.
Trading penny stocks can be a profitable venture because it doesn’t take much volume or volatility to send a share price skyrocketing. A few quick trades could net profits well over double or triple your principal, but penny stocks are much riskier than shares traded on the major exchanges.
Commissions are high, exchanges are unregulated, and fraud in the space is rampant. Plus, even Indiana Jones would struggle tracking down useful financial numbers on these companies.
Dealing in penny stocks might look like an easy way to rack up big winners, however traders need to know the risks. Don’t try to trade these opaque securities unless you really know what you’re doing.