Day Trading Penny Stocks Strategy: Backtest Analysis - Quantified Strategies (2024)

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. At the end of the article, we provide you with a backtest and some sound day trading advice. After reading this article, you’ll have a better idea if day trading penny stocks is a good idea (for the novice trader). (You might also find our day trading guide informative.)

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 trader 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 of 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 The Risk Of Ruin In Trading?
• What is the optimal capital allocation in trading?

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.

What is day trading penny stocks? 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 trade them one way or another, given the liquidity risks and the pumping schemes that go on there. It makes little sense to buy and hold penny stocks forever, because they have proven to produce negative returns over time (as a group), 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, 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 a few reasons why day trading penny stocks are advocated as 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.

The above are the success stories and we are cherry-picking based on survivorship bias (how to avoid survivorship bias). Sadly, most penny stocks go to zero.

• Do Stocks Outperform Treasury Bills? (Not What You Expected)

How to make money day trading penny stocks?

There are, of course, 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. Unfortunately, this is pretty common among penny stocks because of the enormous price rise that can occur if a pump-and-dump scheme is successful.

Scalping penny stocks

Day trading is often about scalping, and that is difficult whenever whichever market you are trading.

• Why is scalping so difficult?

Scalping is difficult because you are competing in a zero-sum game where the competition is well-equipped traders or institutions. Additionally, most of the price action is random. Where you believe to be trading patterns or strategies that are not random, we remind you that even completely random-generated trading strategies can look robust and significant:

• Random Walk Trading Strategy

Actually, most trading strategies are curve fitted!

In trading, we believe you are better off trading longer time frames, and the best time frame is probably using daily charts:

• Which Time Frame Is Best In Trading?

You can also day trade by using daily bars, something that we believe is very underrated. For example, you can enter at the open and exit at the close (or sometime during the trading day).

How many day traders lose money?

Actually, almost all of them fail and lose money! In a separate article about what percentage of day traders make money, we concluded that at least 80-90% of those who try day trading fail to make ANY money at all. Thus, the odds are pretty stacked against you unless you have a good trading plan. For most traders, day trading is not a good idea. We also suspect that penny stock traders fare even worse.

Day trading penny stocks strategy (backtest and example)

We day traded stocks successfully from 2001 until 2018. We used 100% backtested trading strategies with strict trading rules and settings. This way, we were able to track our performance on a daily basis and we knew the historical performance and our trading strategy’s trading metrics. We are still day trading, but at a much smaller scale as we focus more on swing trading strategies.

We were (and are) successful because we were systematic and backtested everything we did and kept detailed trading journals (how to make a trading journal). We have previously written about our performance:

• Is It Possible To Make Money Day Trading? My numbers July 2012 – July 2013
• Is It Possible to Make Money Day Trading? Can you make money day trading? (My numbers 2002-2012 – real money)

We were not scalpers but entered positions during the first ten minutes and exited within 180 minutes later – depending on the strategy. The buy rules were based on the overall market and the sector of the stock. It was partially a backtested sector trading strategy.

And we want to make one thing clear: we didn’t trade penny stocks. The reason is simple: our backtested results showed that these stocks were very erratic and on average were not suitable for day trading. Some penny stocks were good in one period but didn’t hold up in our out of sample backtests.

Why don’t we day trade so much anymore? Mainly because the market is much more competitive and faster now than it was before. Competition increased, and the “margin” and averages went down.

How can you day trade scalping? This is next to impossible to backtest for most traders, and thus you shouldn’t do it. You should not trade any strategy unless it has at least made some profits in the past. Those who claim you can successfully do scalping, are never backing up their claims with numbers. And that is for a reason: they are most likely not successful.

We would love to provide you with a backtested penny stock strategy, but we are not able to, unfortunately.

Online day trading course

In our shop, we have an online day trading course that includes three trading strategies. Two strategies are based on intraday price data, while one is based on daily bars. The latter strategy is based on Russell 2000 (IWM or @RTY) and has the following equity curve:

When day trading you need many trading strategies – not just one. There is no best trading strategy, but rather a sum of many strategies that is the only holy grail trading strategy.

Day Trading Penny Stocks Strategy – conclusion

Is day trading penny stocks a good idea for a novice trader? Overall, we would say no. Day trading is hard, and we believe it’s even more difficult if you want to focus on penny stocks.

Penny stocks are ridden with scams and schemes, and many end up pennyless by trading penny stocks. Do yourself a favor and realize that day trading is a profession like no other that you need trial, error, and backtesting to master. Unfortunately, we are not able to provide you with a day trading penny stock strategy, simply because we have yet to find something that is profitable.

FAQ:

What defines a penny stock, and why are they considered risky?

Penny stocks are stocks that trade for less than $5 per share. They are often associated with small companies and are considered risky due to unproven business models, lack of liquidity, and susceptibility to manipulation. Any trader can day trade penny stocks. However, they come with risks such as unproven business models, lack of liquidity, and susceptibility to manipulation, including pump-and-dump schemes.

What are the pattern day trading rules, and how do they apply to penny stocks?

The pattern day trading rules, set by FINRA, designate a pattern day trader based on executing four or more day trades within five business days. These rules apply to day trading penny stocks and may limit trades for accounts with less than $25,000. Day trading penny stocks is advocated for several reasons, including less competition, lower entry barriers, and the potential for significant short-term profits due to the volatility of these stocks.

How can one make money day trading penny stocks, and what strategies should be employed?

Making money requires quantified strategies, a well-defined trading plan, and a focus on high-probability setups. It’s essential to be systematic, have an edge, and adhere to a trading plan. Penny stocks are risky due to unproven business models, lack of liquidity, and susceptibility to scams like pump-and-dump schemes. These stocks are often associated with scams due to their potential for significant price manipulation.