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How to Trade Penny Stocks

Penny Stocks are hot right now and you can make a lot money trading penny stocks when you do it right. It is much easier for a $2 stock to go up to $4 than for a $200 stock to go up to $400. However, there are a lot of risk involved when you trade penny stocks as they are very volatile. A stock that you buy for $2, may go up to $4, but it can also go bankrupt.

To trade penny stocks successfully, you need to know the following facts and follow these rules.


We are Trading Penny Stocks, Not Investing

You need to always keep in mind that you are trading, not investing, so please do not fall in love with any stock. The fact is that most penny stocks are craps and a majority of these stocks will go bankrupt in the long term. Of course, there are exceptions. Many of the blue chips companies started out as penny stocks. However, for one penny stock to become a blue chip company, there are over one hundred penny stocks that went under. Penny stocks are cheap for a reason.

So if penny stocks are craps, why are we buying them?

We buy penny stocks because we don't buy them for the long term. We buy them and hold them for a very short period of time from one day to two or three weeks, and then sell them for a profit or a loss. This type of short term trading is called swing trading.


Most People Lose Money Trading Penny Stocks

This is a fact and you need to learn why. The answer is simple, most people buy penny stocks because they want to get rich quickly and with this mind set, you can never be successful trading penny stock or any type of stock. You need to learn that for every winner, there's always a loser on the side of the trade. If you want to be a winner of that trade, you need to be discipline and have a system that works for you. First of all, you need to trade only with the money that you can afford to lose. Don't ever put your money for emergency use into the stock market, and don't borrow money or take out a loan to trade stocks.  You do not want to trade with scary money and expect to make a lot of money in the short term. Penny stocks are risky, you might lose all your money. When you trade with scary money, you will never be able to make good trading decisions and 90% of time you will fail to make any money trading penny stocks.


Diversify and Stop Loss

You need to diversify your portfolio to reduce risk. I personally will never risk more than 10% of my account on any one single penny stock. Penny stocks are more volatile than regular stocks and therefore you need to set bigger stop losses, but it should never exceed 30%.


Trading Mindset

Trading penny stock is all about your mindset. Beginners always wanted to buy at the lowest price and try to sell at the highest price. It is not possible because nobody can predict the stock market with 100% accuracy. This is a fact, and you need to memorize it if you want to make money trading penny stocks. Here are a few typical trades where you can see the mindset differences between a beginner trader and a discipline trader.


Trade 1. A beginner enters a trade without any plan. He buys a stock and hopes it will go up. Let's say he buys a stock at $2, and the stock goes to $3 a share and he sells it for a 50% gain. That's a wonderful gain, isn't it? Then the stock keeps going up after he sold the stock, now he is in the regret mode and kicked himself thinking why he sold the stock so early. He is hurt emotionally. This type of thinking is very dangerous when you trade stocks. It will influence the way how you will trade in the future. So the next time he buys a stock, he is likely to have a hard time taking profit because he thinks the stock might keep going up only to watch the stock drops and erase all his gains.

Here's what a discipline trader would do in this scenery. He enters this trade with a plan. Let's he buys the stock at $2 based on some kind of trade setups which we will discuss in more detail later in this article. Before he buy the stock, he already has an exit plan in mind. Let's say his target price is $2.5, and he takes a 25% profit and exit the trade. He is emotionally detached to this stock. So even if the stock goes up to $4 a share the next day, it doesn't bother him.


Trade 2. A beginner buys a stock at $2 and it drops to $1.8, he thinks it will not drop any further, so he continues to hold. Then the stock drop to $1.6, and then $1.4 and $1. He can't take it anymore and sold it and take a 50% loss. Then within the next few days, the stock rose back to $2 a share and he cannot sleep for days and wished he had not sold the stock. Again, this type of thinking is very dangerous for his future trade. In the future, he will have problem getting out of losing trades.

Here's how a discipline trade would execute this trade. He buys the stock based on the same setup and has a stop loss of 20%. When the stock dropped to $1.6, he take a loss and sell the stock and move on. He doesn't care if the stock go back up to $2 or more the next day. He is emotionless.

If you want to trade penny stock for profit, you need to get your mindset right. 90% of penny stock traders lose money because they have the wrong mindset. They too emotionally attach to their money and trades.


Penny Stock Listed on NASDAQ

I only trade penny stocks that are listed on NASDAQ and sometimes AMEX. Stocks under $5 are considered penny stocks to me. I don't trade pink sheets and penny stocks that are listed on the OTC market. They are way too risky and easily manipulated by penny stock promoters and are not liquidate stocks.


Penny Stock Trading System

There is no secret in trading penny stocks and there are a lot of trading system that works. However, if you can't get your mindset right, none of the trading system will work for you. Okay, enough about trading mindset, let's get to the trading method that I use to trade penny stocks. To be able to use this system, you will need to learn how technical analysis works and how to read chart patterns. I use technical analysis to find trade setups and exit a trade based on my target price and trade setup. I will use my two recent trades to demonstrate how I trade penny stocks.

I bought the stock on 12/17/2013 at $1.91 and sold it on 1/10/2014 at $3.85 for a gain of 101%. Here are the reasoning behind my trade.

1. The stock gap up on 12/4/13 with extremely high volume which is a good indicator that the stock is in a strong trend. Then it gaps up again for 2 more days with greater volume. This was the time that I started watching this stock because I feel a possible triangle pattern is forming.

2. Triangle pattern is a very profitable setup when the trade goes your way as in this case. I jumped on this trade a little too early as you can see as soon as I bought the stock, it started to drop. However, I have my stop loss set a little below the support line or the base line of the triangle pattern which is about $1.45. The stop loss is 24% which is within my limit. The trading volume were very low on the down days compared to the gap up days which is a very good sign.

3. You will always need an exit plan whenever you enter a trade. The trade work out pretty well for me as it gap up again on 1/2/13 with strong volume and I decided to sell on 1/10/2014. Usually, my target price is 30%, but if the volume is really strong on the up days as in this case, I would let my profit run. Right after I sold the stock, it went up another 20% the next day, but I didn't let it bother me. Remember, you need to be emotionless so that you can trade better.


Here's another recent trade SEED.

1. I added the stock to my watchlist when it went up 45% on 1/3/14 with really high volume. Then on the next day, it gap up with even higher volume.

2. My plan was wait for the stock to drop so a possible triangle pattern could be form. As expected, the stock dropped the next day and then pulled back further for the next couple of days. Notice that the volume is much smaller during the pull back days which is a good sign. Then on 1/14/14, the stock had its first positive day since the pull back. It gapped up the next day 1/15/14 and that was the time when I entered my trade at $1.96.

3. The stock went up nicely for the next couple days, and then the stock went up over 18% on 1/17/14 with high volume. I thought the trend might keep going for a few days. Unfortunately, the stock went down on the next trading day 1/21/14. The volume was not huge, so I decided to hold another day. There was little trading volume on 1/22/14, so I decided to sell on that day at $2.32 for a gain of about 18%.


Penny Stock Trade Setups & Rules

Here are the a few rules that I follow to trade penny stocks.

Trading Volume  - trading volume is extremely important in penny stock trading. If there is no volume, it will be hard to find a buyer when you wanted to sell. The stock needs to have at least 1,000,000 in trading volume when it spikes to be added to my watchlist. I will wait for it to dip and then get on the trade when I see signs of recovery. However, if the stock dip with very strong volume, then I skip the trade.


Trade Positions - trading position is also an important factor to trade successfully. You will not want to risk more than 10% of your total trading account on any particular stock. If your trading account is really big, I recommend 5% or lower.


Discipline,  Discipline, Discipline - I will repeat one more time. It is the discipline that differentiates a winning penny stock trader and a losing penny stock trader. It is not the trading method, account size or anything else. You need to follow your rules at all time such as trading positions and stop loss and be emotionless when you enter or exit a trade. If you are just starting out, I recommend that you paper trade for a while and then start trading a small account. You will need to learn how to be discipline by trading small money as you don't want to let money influence your trading decisions. Trust me, it is harder than you think. Most people never learn to be discipline and that's how they lost money trading penny stocks.


You can use technical analysis to trade penny stocks, here are some of the best technical analysis books that you can read.

If you like to see a list of dollar stocks, check out the stocks under 1 page.