Day Trading Penny Stocks Strategy (Backtest)

Last Updated on August 28, 2022 by Oddmund Groette

The internet is flooded with courses on how to get rich day trading penny stocks. If the penny stock market attracts you, you might want to have a penny stock day trading strategy.

Day trading involves actively buying and selling securities within the same day, trying to capitalize on short-term changes in price. This strategy can be applied to penny stocks, which are described as stocks trading below $5.

In this post, we will take a look at how the day trading approach can be applied to trading penny stocks.

What is day trading?

Day trading is a style of trading whereby a trader buys and sells a financial instrument within the same trading day. The trade does this to avoid unmanageable risks and negative price gaps that occur between one day’s close and the next day’s price at the open. Day trading aims to exploit the inevitable up-and-down price movements that occur during a trading session and it is usually classified as speculation, in contrast with long-term investing where an investor buys and holds their investments for a long time.

Day trading, which has been common in Forex and futures trading, is also becoming popular in stock trading, and some people employ the method in trading penny stocks. This sophisticated style of trading requires meticulous market and news monitoring, as things move very fast. Those who succeed in day trading pay great attention to events that cause short-term market moves. They are typically very experienced and have a deep understanding of the markets, products, strategies, and risks. Many of them use leverage to increase the size of their stakes and thus their potential profits, but this can also increase the risk of losses substantially.

What is a penny stock?

A penny stock is a term that describes a stock that trades for less than $5 per share, although it used to be less than $1 in the past. Penny stocks are usually associated with small companies. Most penny stocks, especially stocks of small unknown companies, trade via over-the-counter (OTC) markets, such as the electronic OTC Bulletin Board (OTCBB) or Pink Sheets. However, some penny stocks trade on large exchanges like the New York Stock Exchange (NYSE) or Nasdaq Exchange.

Whether on the main exchanges or the OTC markets, penny stocks are not usually traded heavily. The lack of liquidity makes it difficult to sell stock since there may not be any buyers at that time, and as a result, there are usually wide bid-ask spreads or price quotes. Penny stocks are generally considered highly speculative and risky to trade.

Is it possible to day trade penny stocks?

Yes, you can day trade penny stocks. In fact, the only reasonable way to trade penny stocks is to day trade them, given the liquidity risks and the pumping schemes that go on there. It makes little sense to buy and hold penny stocks forever, thinking you’ve bought the next Apple or Microsoft Corporation (NASDAQ: MSFT). While a few penny stocks later turned into big companies, the chances of that happening with that particular penny stock you bought is very small. So, playing a long-term game in the penny stock market would leave you disappointed. However, the pattern day trading rule still applies to penny stocks.

What are the pattern day trading rules?

These are rules by the Financial Industry Regulatory Authority (FINRA), which day traders must keep to. The rules designate a pattern day trader as one who executes four or more “day trades” within five business days — provided that the number of day trades represents more than six percent of your total trades in the margin account for that same five business day period.

A pattern day trader is required to maintain minimum equity of $25,000 in their margin account on any day that the customer day trades, and they cannot exceed their day-trading buying power, which is generally up to four times the maintenance margin excess as of the close of trading the day before — they are only allowed up to 4x leverage.

Trading penny stocks with a small amount

Going by the pattern day trading rules, if you have less than $25,000 in your brokerage account, the pattern day trader rule can limit your day trades to three per week. While this may seem like a limiting factor to day trading penny stocks, it is not. You can still day trade penny stocks with a small account; you just have to trade only three times a week.

In fact, this might be a good thing; limiting your trades can actually make you a better trader, as it forces you to avoid overtrading and focus on the best setups for your strategy.

Why day trade penny stocks?

There are many reasons day trading penny stocks might be a good idea. First, there’s less competition, as hedge funds, professionals, and algorithms rarely play the penny stock market. So, you would be competing against a lot of uneducated traders.

Second, penny stocks are low priced, which means you can start day trading with a small account and still buy enough shares to make a profit in a short amount of time.

Third, penny stocks are volatile, which means they make big moves in a short amount of time — you don’t have to wait a few years for a stock to move a few dollars per share. A positive news release from a penny stock company can create hype and a big spike in both the price and the volume — an opportunity to make money.

Most successful penny stocks in history

Over the years, there have been many penny stocks that went on to do magic, even becoming some of the most valuable companies at the moment. Here are seven of the big stories:

  1. Apple Inc. (NASDAQ: AAPL): Currently the most valuable stock on the planet, with over a $2.4 trillion valuation, Apple was once a penny stock. Back in the early 2000s, AAPL traded for under 80 cents per share — a legit penny stock. As of this writing, AAPL shares trade for over $170, despite having a 2-for-1 split in 2005, a 7-for-1 split in 2005, and a 4-for-1 split in 2020.
  2. Amazon (NASDAQ: AMZN): Following its IPO in 1997, Amazon traded within the penny stock territory. It later graduated from its penny stock designation and went on a persistent bullish run. It last dipped below $100 in 2009.
  3. GameStop (NYSE: GME): GameStop was the big story of 2021. Before then, it was a penny stock, trading between $2s and $3s. Reddit retail traders figured out there’s strength in numbers, pushing GME into the $400s!
  4. Advanced Micro Devices (NASDAQ: AMD): AMD is one of the largest chip manufacturers in the world right now. But back in 2015, it was trading for under $2 per share. Now, it’s over $95 per share, making it one of the most successful penny stocks.
  5. Medifast Inc. (NYSE: MED): This is a nutrition and weight-loss company. As recently as 2008, MED traded as a penny stock. Last year? It hit $336 before losing almost half its value.
  6. Monster Beverage Corporation (NASDAQ: MNST): In the early 2000s, it traded for under 6 cents per share, but as of the time of this writing, it trades for over $90 per share. Over the years, the stock has returned over 142,761%.
  7. Castor Maritime (NASDAQ: CTRM): At the beginning of 2021, CTRM was trading under $2. But two big deals, at a time when the global supply chain was in the news, turned this shipping company stock’s fortunes around — it almost hit $20.

How to make money day trading penny stocks?

There are opportunities to make money day trading penny stocks. These stocks are cheap and have enough volatility to make some reasonable percentage profit in a day, and there may be less competition, as big players don’t often trade them. However, there are things you must do to stand a chance of making money. These are some of them:

  • You must have quantified strategies: This is the only way to know whether you have an edge in the market or not. Without an edge with statistically positive expectancy, there is no point in trading the market.
  • You must have a trading plan: This is where you specify your criteria for picking the penny stocks to trade. Also, your trading plan tells you when to be in the market and when to be out.

Risks associated with trading penny stocks

Penny stocks are very risky to trade for many reasons:

  • Many of the companies have unproven business models and end up worthless.
  • It’s very difficult to find consistently profitable penny stock strategies.
  • The stocks are illiquid and very volatile, which makes them an easy target for manipulation.
  • Many penny stocks trade on pink sheets, which are not well regulated and, therefore, open to scammers.

A common scam in penny stocks is the pump and dump scheme. This refers to a situation where a promoter acquires a position in a penny stock and then tries to artificially increase the share price by spreading false or misleading information about the company.

Day trading penny stocks strategy (backtest and example)

A backtest of a day trading penny stocks strategy is coming soon.

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