Making Your Penny Stock Picks
Now that you know what to look for, it’s time to start making your penny stock picks
There are four things you’ll need to get started—your brokerage account, your research, your watchlist and your trading diary.
Your Brokerage Account
Brokers are basically your middlemen when you’re buying or trading stock. They run the account that you’ll log into to trade, and they’re the ones that are responsible for ensuring your shares are bought or sold after you place your orders.
You’ve probably heard about brokers like Charles Schwab or Scottrade before, but the thing you have to know is that not all brokers are created equal. A lot of people who want to get started with pennystocking will sign up with the first broker they see being advertised on TV without ever knowing that not only are all brokers different, even online brokers—the kind I use for penny stock trading—are different from other online brokers.
With that in mind, here are six things you need to know before signing up with a broker:
- Stock brokers have to be licensed. To work as a stock broker, you have to pass two exams given by the Financial Industry Regulatory Authority, Inc. (FINRA)—the Series 7 and Series 63 exams. These tests show that brokers know what they’re doing and that they know the laws governing the securities industries. If you come across a broker without these credentials, run fast in the other direction.
- Stock brokers have to make money. Every broker has a different fee structure—some charge per trade, while others set a flat rate—but all of them have a way to get paid. They might charge more if you execute your trades over the phone or need personal assistance, but even if you’re just placing trades online, expect to pay. This isn’t some free service they’re providing. Just be sure to compare prices to see which fee structure makes the most sense for how you’ll be trading.
- Stock brokers aren’t always good people. They share information with each other that isn’t easily accessible by the public. They take advantage of people—especially ignorant people who don’t know any better and have no business trading. They have bad reputations for a reason, but they’re unfortunately an unavoidable part of the process.
- Stock brokers will try to stick you with hidden fees. Wall Street is great at covering these up, but when you open your brokerage account, expect to be charged fees for everything from account maintenance to account inactivity, and from minimum balance requirement fees if you go below a certain amount to sales fees tied to certain securities, like mutual funds.
- There are many different types of brokers. Need a broker who won’t just execute you trades, but will also give you advice on everything from stock research to retirement planning and tax advice? That’s a full-service broker, but be aware that you’re going to be hit with high fees of as much as $100-200 dollars for a single trade. There are cheaper options, like mid-range brokers who charge $15-30 dollars a trade and discount brokers who charge $5-15 dollars a trade, but you’ll lose access to different perks the cheaper you go. If all you want to do is go with the cheapest option and execute the trades I describe in this guide, find a dirt-cheap discount broker and get to work.
Stock brokers typically have minimum account requirements. Like it or not, you’re not going to be able to open up a brokerage account with the $50 dollars your mom gave you on your last birthday. The lowest I’ve seen is a few hundred to $1,000 dollars, but it’s more common for account minimums to be set at $3,000 dollars, $5,000 dollars or even $10,000 dollars. But that’s just to open the account. If you want to do short stocks or trade futures contracts, some brokerages will require you to have even more in your account.
The bottom line is to read the fine print before signing on with any particular broker. Know what you’re getting into, what the requirements on you will be and what fees you’ll be charged. Even better, ask around for reviews of brokers. Don’t just make your decision based on price. Remember that you might need to get a hold of a support person in the event of an emergency. Missing out on a big play because you can’t reach your discount broker’s security team is going to cost you a lot more in the long run than shelling out for a more expensive broker with good customer service.
There’s one other thing you need to know about when it comes to brokers and that’s the pattern day trader (PDT) rule. Basically, the SEC says that, if you have less than $25,000 in your brokerage account, you’re limited to 3 round-trip trades a week.
It’s a huge hassle, and it’s a rule that I absolutely hate because it penalizes the people who need the flexibility the most. If you’re trying to turn a small portfolio into a big one, you need to be able to act when the right setups occur. If you’re tied up because you’ve already used up your one transaction for the week (and you don’t want to get into a buy or a short that you can’t get out of), you’re out of luck. The SEC put the rule in place to “protect” small investors from big losses, but if you ask me, the whole thing is downright un-American. Since when is it okay for the government to step in and say who can and cannot make a profit off the stock market?
Let me get off my soapbox now… There are ways around the PDT rule. You can set up multiple brokerage accounts so that you can make 3 trades out of each. Or, you can work with an offshores broker that doesn’t follow the rule (or one of the handful of US brokerages that doesn’t enforce it). Or—and this is my personal favorite—you can use the strategies I’m sharing in this guide to get your account above that $25,000 dollar limit so that you’re free to play with the big dogs and trade as much as you want.
Every so often, I release a list of my favorite brokers to my students—including the brokers I work with and whose policies I like best for pennystocking (including those that can help you get around the PDT rule). If you want to be notified when I send out my next list in the future, head over to my Preferred Broker page.
Earlier in this guide, when I was talking to you about how penny stock trading can be hard work, I touched on the need for constant research to plan out your potential plays. There are a number of different things you need to do as part of your research, but your ultimate goal is to create a watchlist of stocks that you’re keeping an eye as you look for the chart patterns described above.
One of the easiest ways to do penny stock research is to use a day trading or scanning program to look for stocks based on the specific parameters you define. For example, you could set up a screen with all of the following filters:
- A price under $10 dollars. Penny stocks are those trading at $5 dollars and below, but you can still find some pretty interesting deals if you expand your search to catch anything good under $10 dollars.
- ETFs, not funds. Unfortunately, many mutual funds have bylaws that don’t allow them to take a position in a low-priced stock, which makes them pretty much irrelevant for our needs. A good filter will ensure you only spend your research time on ETFs.
- A market cap between $10 million dollars and $500 million. This one is flexible based on your trading rules and preferences, but this is a pretty good starting place. If you’re getting too many hits on the lower end (or too many illiquid stocks), try bringing your bottom parameter up to $50 million dollars. If you aren’t getting enough, increase your upper limit to $250 million dollars or just leave your screen uncapped.
- Free cash flow greater than $0. Since penny stocks fluctuate so much, you’re better off evaluating quarterly numbers, rather than the trailing twelve month figures. Setting this screen to $0 will give you the widest possible net, though you can always bump it up based on the patterns you prefer to target.
- Revenue growth with robust profit margins. Screening based on revenue growth is a good way to find penny stocking opportunities, as companies can make money without actually growing. I wouldn’t recommend going as far as using an EPS measure, but if you look for a growing company with profit margins that cover its capital expenditures, that’s good enough.
- A PE TTM filter of 15 and below. I don’t always use PE ratio filters, and I don’t necessarily recommend that you do (although it can be a good way to determine if a stock you’re looking at is overvalued). Setting this parameter around 15 and below can help you narrow down your list if needed, but otherwise, I tend to set this filter so wide that it’s pretty much worthless.
- A reasonable PEG ratio. Generally, companies with a good free cash flow don’t have debt problems, but if it’s something you’re concerned about, you can weed out some stocks by filtering out those with extremely high PEG ratios. It really depends on the company, though, as some businesses do fine with high debt loads, while in other cases, it’s a big red flag.
- Scan of volume. Should be greater than 100,000 shares per ticker, per day—but not more than 20 million as I don’t like illiquid stocks or overly-active stocks.
Remember also that numbers don’t tell the whole story. Pair your scans with time spent reading press releases, following, digging into SEC filings, and just generally learning everything you can about the stock. If you know where to do your research and what promoters to follow for tips on potential pump and dumps, you may find good opportunities to watch that haven’t yet come up in your screening program.
The goal of all these different filters is to create a watchlist of your favorite 20-50 stocks, depending on how many you’re able to track. Once you have your watchlist, refresh it every month by re-running your scans and give it a quick check everyday to look for strange movements. Say you’ve got a cheap stock on your list that meets your free cash flow and growing revenue parameters. If you see that stock growing by 2% a day during your daily scans, that’s something you’ll want to keep an eye on.
Keep your watchlist up-to-date with new research, because this is the list you’ll come back to everyday to decide which plays you’re going to make. You can get as complicated as you want with your watchlist, but I recommend keeping things simple. Make a few notes on the company and how you expect its prices to move, and include any information you have on when you want to either get into or out of the stock. The more information you have, the better prepared you’ll be to take advantage of your favorite trading patterns when they occur.
Of course, if you don’t want to go to all the trouble of creating and maintaining your own watchlist, you could always sign up for my TIMAlerts. I send these emails out every day in real time letting my students know when I’m planning to make a move on a stock. Okay, that’s a sales pitch. Sorry for sticking that in here, but I’ve done so well with these stocks and my students have profited off these notifications as well. I really believe that they’re a great place to get started if you’re new to pennystocking.
Your Trading Diary
Last but not least, I highly recommend that you keep a trading diary, as this will help you better understand yourself and how patterns and opportunities change over time. I never used to write everything down, except on message boards—and message board writings aren’t usually very classy. But having a trading diary really helps you keep everything in perspective. I definitely could have made a lot more money if I’d started doing this earlier in my career.
As a trader, you’ve got to be able to adjust—to weed out your mistakes, to be real, and to review all of your business dealings (no matter how trivial). And you can’t do that if you don’t know where you’ve gone wrong in the first place.
So what you need to do is to set up a diary—it could be your Profit.ly account, or it could be something more private like a journal or notebook if you don’t want to publish your notes where everyone can see them. Then, after every trade, go back to that diary and write a few sentences on what went right, what went wrong, and what you want to do differently in the future. Do this for both your wins and your losses, as there’s plenty you can learn from both scenarios.
But don’t just write your thoughts down and then move on. Especially if you’ve come up with something you want to apply to future trades, you need to come back and read your diary entries from time to time so that you don’t forget about the changes you want to make. I used to think that people were crazy when they told me I needed a trading diary, but it’s made such a huge difference in my trading career that I recommend you get started with this tool from your very first trade.
Have all these different tools in place? That’s great—but there’s one final thing I want to share with you. I mentioned earlier in this guide that I have a set of trading rules I always stick to, and I recommend that you do the same. In the next chapter, I’m going to share some of them with you. My rules might not make sense for the kind of trader you want to be, but you should still read through them carefully. Use them as the framework for the list of rules you’ll create to protect yourself from the potential losses associated with undisciplined trading.