Penny stocks are where a lot of new traders start their career. Tempting day traders with the prospect of significant financial gains and a low cost of entry.

Stories of stocks gaining of over 5,000% in just a short time add to their appeal, and advances in trading technologies make it easier than ever to jump into the market.

But what are they and can you get rich off penny stocks?

What are penny stocks?

According to the U.S. Securities and Exchange Commission, a penny stock is any stock that trades at or below $5 per share. These stocks are often traded in less regulated over-the-counter (OTC) or “pink sheets” markets, but also trade on listed exchanges like the NYSE and NASDAQ.

Penny stocks are generally floated by tiny companies that have low market capitalizations.

In most cases, these companies are usually in industries that are perceived by some market players as carrying strong growth potential such as precious-metals mining, medical marijuana, fuel-cell development, and biotechnology.

Why penny stocks are viewed as a way to get rich

Penny stocks are viewed as a way to get rich because they tend to have high percentage returns. You can’t deny it — the math on owning these stocks is psychologically attractive, particularly for inexperienced traders.

For example, imagine that you have $1,000.

If you decide to buy one stock with all $1,000. You are weighing two different choices – you can purchase 10 shares of a stock that is trading for $100 per share, or you can buy 1,000 shares of a penny stock trading for $1 per share.

If you purchase 10 shares of the stock that is priced at $100 and the price soars by $1 per share, you will have earned a profit of only $10.

If you choose the penny stock and the price jumps to $1 per share, you investment will have doubled.

This thinking is deceptively appealing and can wreck otherwise logical and sane individuals.

You look at the $100 stock and imagine your penny stock getting there. If it does, your 1,000 shares are worth $100,000.

This simple example makes the appeal of penny stocks quickly evident.

Risks involved with trading penny stocks

Although penny stocks offer trading opportunities, day traders have to realize that reaching their ambitious goals will require more effort and probably take much longer than initially anticipated.

In addition, penny stocks are considered to be more risky than larger stocks because of their lower levels of regulation and wild price fluctuations.

By buying penny stocks, you can own far more shares than you would otherwise be able to with regular stocks. In addition, penny stocks can double, triple, or gain more value quite quickly since they are lowly priced.

However, it is also possible for these stocks to suffer dramatic losses in a very short period.

Penny Stock Example

While the company that owns the $100 stock is unlikely to be pushed out of business anytime soon, the one that owns the $1 stock certainly could. If the larger stock falls by a dollar, that is only going to cost you $10 and keep holding it in hopes that it will rise again as time goes by.

If the penny stock you bought falls by a dollar, it is completely wiped out and you have lost all $1,000.

Penny stocks have less regulatory oversight compared to those traded on the formal exchanges, and their cheap prices mean that small price moves can quickly add up to massive percentage moves.

In addition, penny stocks are very thinly traded (illiquid). This means very few shares (low float) are traded/transacted daily compared to stocks of larger companies. This concept is called liquidity.

Most professional traders with big account sizes are also barred from trading these stocks since they are highly speculative.

Moreover, penny stocks are often prime hunting grounds for “pump and dump” schemes and scammers. Some scammers tout a stock, only to unload shares into a thinly traded market, profiting in the process but leaving other traders with losses.

Penny stocks are extremely risky, and this is an important thing that every day trader ought to keep in mind.

That is not to say these stocks can never be traded wisely, but you need to exercise caution when trading penny stocks.

Can penny stocks make you rich?

Although penny stocks have some great attributes, they are not right for everyone. These stocks truly can turn a small amount of capital into a huge sum of money pretty fast, but can just as quickly wipe that investment out.

It seems appealing that you can purchase shares of a company for a very small price, and if it just rockets to the same price as Amazon one day, you become filthy rich.

However, you need to remember that a cheap price mostly implies that the company comes with very high risk and a big chance it will not become profitable or exist in a few years.

Simply put, these stocks are cheap for a reason.

Set realistic expectations

Have you got realistic expectations when trading penny stocks or are you shooting for unrealistic profit targets?

As a day trader, your job is not to build a lasting relationship with these stocks; it is simply to trade them for a profit by setting realistic expectations. Remember that day trading involves buying and selling stocks or financial securities all within the same day.

In other words, you will close out all positions by the end of the day.

Therefore, it is important to set realistic expectations and choose the right penny stocks. Several factors can influence your choice of choice of penny stocks, noteworthy among them quarterly earnings reports, media announcements, press releases, FDA approvals, and more.

The key thing to keep in mind about penny stocks trading is that it’s all about selecting the right ones and having realistic expectations.

Utilizing fundamental and technical analysis tools, using stocks scanners, and scanning press releases for valuable news can also help.

In addition, look out for important patterns including the likes of: double bottom patterns, Fibonacci retracements, flat top breakouts, bull flag breakouts, golden cross patterns, and flag chart patterns.

You can find these patterns in our Technical Analysis Guide.

Bottom Line

Penny stocks may seem cheap compared to stocks of popular companies like Apple (NASDAQ: AAPL) or Tesla (NASDAQ: TSLA), but often they are much more expensive, despite their cheaper price tag.

They are among the most volatile stocks in the market, so you may pay a much higher price than you initially anticipated, including potentially losing all of your money.

So, make informed trades and read as much as possible before day trading these stocks.

Most importantly, you have to set realistic expectations about you potential trading returns, and keep in mind that each unit of profit is accompanied by a unit of risk.