Maybe you have seen them before: advertisements with a celebrity claiming that day trading or penny stocks made them rich – and that it can work for you, too!

That reminds me of ads of the “How I got cured of cancer by only taking Vitamin C” type…

It’s not a complete impossibility. But you need a serious amount of luck to make it work for you. I certainly would not bet my life on it.

Don’t get me wrong. Trading penny stocks can work. But it’s riskier without being more rewarding.

It could work. Just not very often…

Recently I saw a video, showing a 3-year old child playing the piano perfectly. I could never play as well as that child even with years of practice!

It was very impressive.

So… should I worry about my own children’s talents? If they “play” piano it sounds as if a cat is walking across the keyboard 🙂

I did a bit of research to see how worried I might want to be… let the numbers talk helps to gain some perspective.

Case closed… my kids fall into the blue category… like nearly everyone else. Looks like a stroke of luck… or simply randomness.

The same is valid for lottery winners or people who got rich quickly. Luck was on their side. And I have no problem with that… in fact, I am happy for them! Just don’t count on it for your own success in investing.

Now, what about penny stocks?

Penny stocks are risky

Penny stocks are stocks that are 1) not traded on regular exchange markets and 2) at a low price (usually less than $5 per stock, often less than $1).

They are considered very risky for several reasons:

• Lack of information: not enough to make informed decisions (or unreliable sources)
• No Minimum Standards: these stocks do not fulfill the minimum standards required to be traded on the big exchanges… for a reason…
• Lack of History: either no track record or a poor one
• Liquidity: means you either cannot find a buyer or seller easily or your trade moves the price. This is often used for price manipulation (more on that later). It also causes high volatility (means, prices jump up and down a lot, making it more difficult to minimize risk).

It’s not impossible to make money with penny stocks. There are people who trade them successfully. With a proper system in place it can be managed… simply don’t expect miracles – tight risk control will limit potential gains.

But… some people become rich, right?

Yes. Some do, or at least they say so (it’s difficult to verify such claims unless you know someone personally).

All I am saying here is that there is no getting rich quick scheme. And I have not met anyone yet who actually succeeded with them.

I do have some friends who traded penny stocks, some with mixed results, some with terrible results. Here is what happened to one of them:

• He got a tip-off that a certain penny stock would rise in price soon
• He bought a large amount of that stock and saw how the price went up (Yay!)
• Shortly afterward, the price started to fall again. And way below his purchase price.
• He had borrowed money from his broker to buy more… exposing him to additional risk…
• His broker sold the stock to recover the borrowed money and my friend was left with nothing! ZERO!

So what went down there? I will explain.

 

Liquidity and what happens if it’s low

The main reason for the price increase was low liquidity. What does that mean?

Liquidity = The degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.

If there are not many stocks available, and you buy or sell a large portion of them, your transaction will affect the price.

My friend bought many stocks, so the price increased. Later, when he tried to sell, the price fell quickly because nobody wanted to buy and he was the main share owner. He became trapped in a “squeeze”.

Don’t trade stocks that expose you to low liquidity risks. Your losses can be mind-boggling and unpredictable.

 

Penny stock prices can be manipulated easily

Did you watch the movie “The Wolf of Wall Street”? If not, go and watch it. It will show how money is made with penny stocks… illegally.

Here is how it works:

Scheme #1: The Boiler Room

Open a call center (the “boiler room”), call thousands of people and convince them to buy penny stocks. Cash in on high commissions.

Scheme #2: Pump and Dump

Buy a certain penny stock and tell everybody that it will increase in price very soon. Everybody who buys it will help to increase its price (Pump). Once the price increased, quickly sell your stocks before anybody else does (Dump).

Sounds familiar? Looks like my friend fell for Scheme 2! Or maybe he was just unlucky.

In conclusion: penny stock trading can work, but I consider it very risky in comparison to trading normal stocks. And on average I believe the rewards are not big enough to justify this risk.

So if you want to go for it, practice first with normal stocks. Then see if you can adapt your trading style to penny stocks.

 

What about day trading?

Day trading is simple as a concept. It means that you start trading once the markets are open, and you sell all your stocks before the market closes.

Like this, you eliminate one big trading risk: overnight price jumps.

Price jumps happen more often than you might think. Just have a look at the below chart of BIIB (Biogen, Inc.). There are multiple overnight price jumps, in both directions, over only 6 months.

 

 

Most price jumps are small, but sometimes they can be large, causing your portfolio value to suffer (or gain… depending on the jump direction!).

With day trading, you can avoid this risk and literally sleep well at night.

For that reason, your broker usually allows you to use more leverage with your available funds (means, you are allowed to borrow more money from the brokerage). Often you can use up to 4 times more than your actual available cash.

Obviously, I had to give that a try. And how did I fare with it? Read on to find out.

My day trading (tragic) story

In my early trading days I read up on day trading and I decided to give it a shot.

After some research, I came up with my own, “sure-fire” strategy to make it a success. Here it is:

• Sit on the big screen(s) and monitor stock moves all day long
• If a stock looks promising, buy it
• If a stock looks like tanking, quickly sell it
• Sell all stocks in the portfolio before the end of the day

Sounds good?

The result? After doing this for a couple of days… I QUIT. And not because I became rich 😉

In a nutshell: I not only lost thousands of dollars, but I also felt incredibly stressed out. I did not sleep well anymore and dreaded the next day. I felt burnt out.

Losing money is bad. But it is not the end of the world. However, if your lifestyle and ultimately your health suffers… then it is really time to pull the plug.

Why I could not make it work for me

After stopping my day trading experiment, I analyzed what had stopped me from succeeding:

• No proper strategy – no systematic approach. All decisions I made were based on a gut feeling in a fast-paced, stressful trading environment.
• My risk taking was outrageous – small jumps would create massive losses. And I had set no exposure limits, either.
• A trading day is quite long. It was tiring and I could not keep up with what happened with all those stocks all day long.
• I was distracted frequently, by phone calls, children, spouse, etc. Don’t do day trading in your home office!
• Watching the screen(s) every minute, every second, for many hours… too much work! And failure prone. One typo, one wrong click of a button can lead to massive losses.
• Other issues: wrong time zone, not enough screen space, etc.

Day trading can work – but you need to have a perfect setup, no distractions, constant will power and a system that protects your portfolio.

Ironically, the one benefit of day trading did not work for me at all. I did not sleep well at night (though for different reasons).

My recommendation is…

… plain and simple:

If you have never traded stocks before: learn and practice trading normal stocks first.

If you trade stocks already and you want to try it, go for it. But keep your risk exposure as low as possible.

I prepared a concise summary table that compares penny stocks and day trading with normal stock trading, showing pros and cons. See below.

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