The financial markets can be a challenging place to seek your fortune and trading microcap stocks is certainly not without risk. Limited liquidity and the extreme volatility of microcaps make navigating these trades especially difficult for novice traders without the necessary experience to avoid the common pitfalls that cause most traders to sustain heavy losses in their early careers. If you’re interested in trading penny stocks but looking to avoid some early losses, here are seven tips for trading penny stocks.
Limit orders allow you to secure your trades at a price that you specify. Although limit orders are generally good practice in the trading of any financial asset, they become especially important when trading volatile assets like penny stocks. These orders will allow you to avoid slippage; and any unexpected last-second price changes that may negatively impact your trades.
For example, you may wish to purchase a stock for $1 and notice that the stock is at your price target. However, after placing a market order the stock experiences a surge in volume causing the price to quickly spike to $1.25. Without a limit order, you would be subject to a higher price. If a limit order had been placed for $1, it would have automatically executed when the stock hit that price point.
Using limit orders is the easiest way to protect yourself from slippage losses when trading assets with less liquidity.
Due to the market capitalizations of these stocks, they are easy targets for scammers looking to conduct pump-and-dump schemes. In the digital age, these schemes are mostly orchestrated through social media channels like Twitter or Reddit. If you see microcap stocks being promoted through these channels, you are best advised to avoid the trade. Remember, the best trades are rarely advertised on social media. By the time you see it on Reddit, it’s already too late.
Volume refers to the amount of trading taking place with an individual stock. The more trading that takes place, the higher the volume of trade on that stock. As you may have guessed by the heading, volume is critical when trading microcap stocks. The level of volume allows traders to more accurately gauge market sentiment, liquidity, and price. The lower the volume being traded, the less reliable the price of the stock is and the more subject to volatility it becomes. Monitor the amount of volume traded and avoid trading on days when the volume of a stock is low.
Many new traders fall victim to what is known as naked trading. They fail to take advantage of any technical indicators and try to eyeball their entries into trades, exiting them only when they feel they have made enough of a profit (or sustained a heavy enough loss). Trading in this manner will result in significant losses sooner or later.
It is vital to set clearly defined entry and exit points when trading. To do this, traders often utilize technical indicators like support and resistance. A common strategy is to place your entry point just above a support line with your exit point somewhere below the line of resistance. Our next tip will elaborate on this further.
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As we know, stocks are prone to rise and fall with few stocks trading within a specific price range for very long. As a result, stocks can regularly climb above lines of resistance or fall below their support. To avoid losses when stocks fall below support, a stop-loss order will be critical. No trader should take any trade without a stop-loss order.
A stop-loss order will automatically sell a stock when it falls below a certain price point. Doing this will ensure that you are fully aware of the level of exposure you have on any trade and prevent you from suffering unmitigated losses. As a rule, it is often a good idea to place stop-loss orders just below the support line, ensuring that you will exit a trade if a stock falls through its support.
Unlike other aspects of life, size matters in trading. The size of your trades relative to your total portfolio will be a key consideration. Due to the risk associated with trading microcap stocks, traders should avoid making trades greater than 5% of their portfolio. For example, if your portfolio is worth $100, no individual trade should be worth more than $5. Limiting the size of your trades is an excellent risk management tool that ensures that no individual trade can decimate a trader’s portfolio. Regrettably, many inexperienced traders enjoy living dangerously and trade with large percentages of their portfolio, often leading to catastrophic losses when they inevitably make a bad trade.
Indicators are trading tools that help traders to inform their decision-making. While using too many indicators may overwhelm you with information, using too few is also inadvisable. Let’s look at an example of how an Average True Range (ATR) indicator can help a trader determine their position size.
In this example, trader Joe is looking to open a trade worth 1% of their portfolio. Their ATR-based stop-loss level is $0.20. Using this stop-loss level, Trader Joe can determine the appropriate position size. For example, if the total portfolio is worth $10,000 and the trade is worth $100 with an ATR-based stop-loss of $0.20, then the position size would be calculated like this:
$100 / $0.20 = 500 shares.
In other words, you divide the loss’s value by the trade’s value to determine the number of shares you should purchase.
In this example, trader Joe would purchase 500 penny stock shares to ensure their potential loss does not exceed $100 if the stop-loss order is triggered.
Indicators can be extremely useful in determining which stocks to trade, position sizes, and entry and exit points.
Conclusion
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