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How to Trade Penny Stocks
In this how to trade penny stocks article, I will share with you some strategies that I have used to make money from the stock market. There are two main trading strategies I use for penny stock trading, the pullback and the breakout strategy. I have already given the details of my pullback strategy in this penny stock guide and we will focus on the breakout strategy in this article.
To learn how to trade with the breakout strategy, let's first define what a breakout stock is.
What is a Breakout Penny Stocks?
A breakout stock is a stock that rallies from a consolidation area and makes a new 3 months high. For example, if a penny stock has been trading in the $1-$2 range in the past 2-3 months, and then it moves rallies above $2. This is what we called a breakout stock.
To trade breakout stocks, we must first understand support and resistance, which is a critical concept in technical analysis and one of the best chart patterns that every trader should learn.
In this example, $1 is the support, $2 is the resistance, and consolidation is the period where the stock moves back and forth between $1 and $2.
When a stock breaks out of resistance, it has the potential to double up in a matter of a few days.
The longer the consolidation period, the stronger the potential breakout. A consolidation period that lasts for 4 months is stronger than the one that lasts for only 1 month.
What is a False Breakout?
A false breakout happens when a stock breaks out of resistance only to fall back below the resistance level.
For instance, after the stock in our above example breakouts of $2, it then falls below $2 right after the breakout.
Volume is important when it comes to trading breakout stocks. If a stock breaks out with low volume, there is a high chance of a false breakout. When a stock breakout with strong volume; it indicates strength and the chance of a false breakout is much lower.
For example, If a stock usually trades under 200,000 shares per day, during the breakout day, the trading volume should be over 10 million.
We should always stick to the breakout stocks that have unusual volume, and avoid the ones with low volume.
How to Trade Breakout Penny Stocks?
There are two ways to trade breakout stocks.
Penny Stock Breakout Strategy #1
Buy a stock when it breaks out of resistance with a strong volume
Set a 12% stop loss
Set a Profit Target of 25%
Time Limit - must sell the stock on the same day no matter what, that means we need to sell the stock before closing.
Using the stock ENG as an example, there are three buying opportunities when ENG breakout on 10/7/20, 11/23/20, and 01/07/21.
Trade Entry 1
10/7/20 - The stock rose with volume that was stronger than usual and broke out of the resistance level of $0.98. We would place our buy points at a little above the resistance in case of a false breakout. A good buy entry would be around $1.02.
Set stop loss of 12%, or $0.89. This is the price that we would sell our stock and cut loss in case the trade goes against us.
Set a profit target of 25%, or $1.27.
The stock made an intraday high of $1.33 which means it hit our profit target and we exit the trade with a profit.
Let's say if the stock didn't hit our target or stop loss, we would exit the trade before the market closes that day.
Trade Entry 2
After the breakout that happened on 10/7/20, the resistance is now the closing price that settled on that day which was $1.22. Since that day, we hadn't seen the stock move higher than that price with strong volume.
Then on 11/23/20, the stock rose again with unusual volume and broke through the resistance.
Buy the stock at $1.36.
Set stop loss of 12% which would be $1.19
Set a profit target of $1.7
The stock easily hit our profit target and we would exit for a profit.
Notice the stock went much higher than our target price and continued to go up the next day. A beginner would be kicking himself for missing out on all that profit instead of feeling happy about his 25% gain. This kind of feeling is understandable. However, we can never predict how high a stock would go, and oftentimes the stock would pull back after hitting our profit target.
Trade Entry 3
The stock made a new high on 11/24/2020, and the resistance was set on that day with the closing price of $2.86. The stock then pulled back and rose again, and then consolidated around $3 when looking at the closing price.
On 1/7/21, the stock rose again with higher than average volume and rallies above the intraday high of $3.56 that was settled in the consolidating area. This is when we would go long.
Buy the stock around $3.65
Set stop loss for $3.21
Set a profit target for $4.56.
Again, the stock hit our target price and closed at $5.10.
One thing to note is that we should never jump on a trade early and expect a breakout. We should always wait for the market to show us the pattern rather than anticipate a pattern.
Penny Stock Breakout Strategy #2
The above breakout strategy requires us to watch stocks closely during the day, waiting for breakouts to happen. However, for traders who don't have time or don't want to look at their screen all day long, here is another breakout strategy that they can use. This strategy is to wait for a pullback after a stock makes a breakout.
Usually, when a stock makes a breakout of resistance, it will retrace the next day but manage to stay above the previous resistance or the new support. When a stock breakout of resistance, that resistance becomes the new support.
In the case of a multi day runner, the stock may retrace after a few days. I would watch the stock and put a limit order to buy the stock when it drops to the new support. If the stock doesn't drop and continues to rally, I would skip that stock. There is no point in chasing a stock that has run away.
Here's the strategy in a nutshell,
Look for stocks that breakout of a resistance
Wait for a pullback on light volume
Enter a trade near the support level
Let's use the same chart example ENG to demonstrate this strategy.
Trade Entry 1
After the 10/07/20 breakout, the stock retraced from an intraday high of $1.33 to around $0.7 which is about a 47% retracement with low volume. The support was around $0.69.
The stock consolidated in the price range of $0.7 to $0.84 between 10/29 to 11/10. This is where we enter a limit order to buy the stock.
We want to buy the stock as close to the support of $0.69 as possible because we have to set a 12% stop loss which should be below the support. Let's say we bought the stock for $0.76
Set stop loss of 12% or cut our loss at $0.67
Set a profit target of 25% or take profit at $0.96
The stock hit our profit target in less than 2 weeks.
Trade Entry 2
The 2nd buy entry is on 12/04/20.
After the stock broke out for a 2nd time on 11/23 and 11/24, again the stock pulled back over 65% with low volume and formed new support at $1.5 on 12/02/20.
The fact that $1.5 is a round number increases the chance that the support may hold. We will talk about round numbers in a future article. For now, just remember, round numbers around support and resistance are a strong indication that these levels would hold. However, in the case where the support level is broken around round numbers, you need to get out as quickly as possible; it is a very bearish signal. On the other hand, if a breakout happens around a resistance level at a round number, it is a bullish signal to go long on the trade.
Buy the stock on 12/03 or 12/04 at around $1.55 to $1.6.
Set a stop loss of 12%
Set a profit target of 25%
In this case, the stock would have hit our 25% target in less than 2 days of holding.
At the time, the ENG stock pulled back from the small rally from 12/3/20 and 12/7/20 with pretty low volume. It is now trading around the support level of $1.5 that was established on 12/2/20.
The stock retraced for a few days and then consolidated for 2-3 days around the price range of $1.63 to $1.75. This gives us the green light to go long around this price.
Enter a trade on 12/17/20 anywhere in the price range of $1.67 to $1.73
Set stop loss for 12%
Set a profit target of 25%
The stock rebound and would have hit our profit target of 25%.
When to Take Profit?
Profit-taking is important, not only does penny stock move up quickly, they pull back even faster. It is not wise to hold a penny stock and expect it to rise for weeks.
Yes, you might have seen some of these winning stocks that jump 1,000% in a few days or even in a single day. The odds of picking one of these stocks and sticking to the trade are small.
There are hundreds of penny stocks, and most don't go anywhere. Our goal is not to pick one stock that goes up 1,000%; we are aiming to make 1,000 trades, averaging 5-10% per trade.
There are two ways to take a profit.
Set a 25% profit target for each trade
Take half of your position off at a profit of 25%, and let the other half run with the trend.
Sometimes, stocks gap up before hitting our target price which would give us a much bigger profit.
Entering a trade without a plan for cutting loss is one of the top 10 trading mistakes that traders make. Penny stocks are more volatile than regular stocks, therefore you need to have a bigger stop loss than if you were trading higher priced stocks.
For every trade I make, I have a 12% stop loss. As soon as a stock hit my stop loss, I would sell it.
In penny stock trading, we want to maximize our rewards and minimize our risks. Before you enter a trade, you need to calculate your risk-reward ratio, which is represented as 1:1, 1:2, 1:3, and so on.
A 1:1 risk-reward ratio means that you are risking $1 to make $1.
A 1:1 ratio is not an ideal trade. As a penny stock trader, we want to have at least a 1:2 ratio for our trades meaning if we are risking $1, our goal is to make $2 or more.
Therefore, if you have a pattern with a 1:1 ratio, that means it is not a good enough pattern. You need to find patterns that have at least a 1:2 risk-reward ratio.
When to Exit a Trade?
Breakout trades usually breakouts, retraces and makes another high within a few days. If a trade doesn't move, I would sell it and move on to the next one.
I have a time exit rule which forces me to exit a trade in 2 weeks no matter what. I don't wait for my stop loss or profit target to get hit, I would just sell the stock after 2 weeks. Holding a penny stock is risky. If the pattern doesn't work out for this trade, that is fine.
Usually, I have 5-7 stocks at hand, if I'm holding too many stocks that don't move, my money is going to be tied-up, and I can't trade anymore.
Sometimes, I would clear my position earlier than 2 weeks when I don't feel right about a stock, or if I need the fund for a better setup.
Planning & Penny Stock Watchlist
Please note not every trade works out as perfectly as this stock. Also, it is impossible to catch every trade entry. Sometimes you may have to wait a little longer for stock to run, or you may get stopped out when a trade is not working your way.
To find optimal trade setups, we must watch a lot of stocks.
At any time, I have a bunch of stocks that I watch. These stocks do not meet my buying criteria yet, but they may trigger a buy entry at any time.
I import my watchlist to Fidelity Active Trader Pro which updates in real-time all the stocks that I watch. Fidelity is the trading platform that I use to trade stocks, and the Active Trader Pro is a free desktop software for every trader who has an account with Fidelity.
Planning plays a critical role in penny stock trading. I plan my trades every night on which stocks I may trade the next day and how I will trade them.
Patience is key here. Do not jump on trades that did not meet your criteria. Wait for the profitable pattern to form rather than anticipating it.
How to Find Breakout Penny Stocks?
Most of the stocks I watch can be found on hot penny stocks to watch which updates every day after the market closes.
These stocks usually made a breakout recently and maybe pulling back now. I study the stock charts of each stock on a daily basis and watch closely during intraday on the ones that are about to hit my buy entry.
Sometimes, a stock on my watchlist would suddenly drop a big percentage and trades just above the support level. That's when I enter a trade.
I don't watch my screen all day long so I miss profitable trades from time to time. However, that also prevents me from overtrading which is one of the top 10 trading mistakes that beginners often make.
Another useful way to find breakout penny stocks is using our free penny stock scanner to get a list of daily gainers.
Trading Psychology & Statistics
Just because a pattern looks good doesn't mean it will work out for every trade. If that were the case, then a monkey can make money following chart patterns.
Recognizing a profitable chart pattern gives you an edge, and you will make money in the long run with that pattern, but it doesn't mean you will make money on every single trade.
For example, if you throw a coin, the odds of getting a head or a tail is 50%. If you throw a coin 10 times, you might get 8 heads and only 2 tails. However, If you throw the same coin 10,000 times, the number of heads you get will be very close to a tail, or about 5,000 times.
Likewise, if you know that your pattern works about 80% of the time, then it will fail 20% for your trades. Your goal is to make money when you are right, and get out quickly when the pattern fails. This way, if you trade the same proven pattern 10,000 times, you will make money on 8,000 trades.
However, there are many traders who are so stubborn with their patterns that they allow a single or a few trades to destroy their portfolio. They get stuck on their losing trades for far too long. Some even double down on their losing positions instead of cutting losses which compounds their mistake.
Maybe they are trying to get rich quickly or their ego is too big to take a loss. But that's not how trading works. If you want to make money trading penny stocks, you need to have the mentality of getting rich consistently rather than quickly.
I often get asked whether a penny stock would go up. I am not a magician, I don't know if the stock would go up or down.
Instead, I have a trading system in place that works for me. I only trade stocks that follow certain patterns. I have about two dozen stocks that I watch regularly for trade setups and I don't care about the other 7,000 stocks out there.
To find a profitable chart pattern that works for you, you need to start collecting winning charts. After you go over 1,000 of these charts, you will come up with some type of pattern that works.
Trading is hard work, there is no shortcut. If you are not obsessed with the market, you are not going to make money in penny stocks.
To learn more about penny stocks and how to find a winning pattern, read the following articles.
Penny Stock For BeginnersTop 5 Penny Stock PatternsTrading Mistakes to Avoid
List of Breakout Penny Stocks
Follow is a list of potential breakout penny stocks that you can watch.
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