Penny Stocks 101: What’s A Stop Loss & How Do I Use It?

As traders discover new strategies, they look for more advanced ways to improve their profit margins. When it comes to penny stocks, certain situations may require you to protect your profit during volatile times. One of the methods traders learn quickly is the answer to the question: what are stop-loss orders?
Stop-loss orders occur when traders place a trade to sell penny stocks when they reach a specific price. Once a penny stock gets to that price, the order turns into a market order and attempts to fill it.

They help traders pre-set the amount of loss they are prepared to incur in the event a trade turns sour. The beauty is that traders and investors can do this without having to hover over penny stocks 24/7.
Stop-losses can be used in a variety of situations. Traders use them in both long and short term positions as they function the same for both. When trading in the short term, it can help traders protect their positions.

Penny Stock Basics: Developing A Further Understanding Of Stop Losses

The phrase “stop-loss order” is misleading because of the word “loss.” However, they can also be used to protect profit. If you set hard limits, you can potentially take profits before the stock comes back down. This is where a stop-loss order can help investors. The idea of “trading on the way up” leverages stop-losses to secure gains. This is known as a trailing stop-loss. Adjusting your stop loss as penny stock prices increase to allow you to both mitigate risk and protect gains.

For example, let’s say you buy penny stocks trading around $0.50 and the move is to $0.60. In the example, maybe the market gets volatile and you want to protect some of the $0.10 gains you’ve seen so far. Some may set a stop-loss at $0.55. In the event the stock is heavily sold down to $0.45, the stop-loss triggers at $0.55 and you secured at least a little profit. From there, you can always buy back in if you think the penny stock is still worth your investment. If not, it’s on to the next one.

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While stop-losses are designed to mitigate loss, there is a situation where they miss. If a stock gaps down below your stop-loss, it will trigger the order but at the gap down price. This means you could take a much larger loss than you had planned for.

More Examples Using Stop-Losses For Penny Stocks

A trader went through the fundamental and technical analysis process and has picked out a penny stock to buy. Through using technical analysis, it’s determined that the trader wants to buy the penny stock at $1. They also determined that they are only willing to take a loss of 10% on the trade and nothing more. Because of this, the trader placed a stop-loss order at $0.90 for the stock.
Here’s a really good feature of this order placement. Let’s say this trader was in the position for a few days and couldn’t afford to watch the stock constantly. The stop-loss comes in handy for the trader in this case. Let’s say the stock falls to $0.90 when you aren’t watching. Instead of it falling lower, the trader can cut losses thanks to the pre-placed stop-loss order set as “good til cancel.”
Timing is important when choosing penny stocks to buy or sell. If you want to buy penny stocks and set a limit order, you need to understand the time frame of that order. Is it good for just the day or is it good until you cancel the order. The difference is that a good til cancel or “GTC” will remain active until the order is either filled or you manually cancel the order. The same holds true for stop losses.

But The Penny Stock I’m Watching Won’t Allow Stop-Loss Orders

While it’s true that stop-losses can make your life much easier as a part-time trader, some stocks don’t allow certain buy or sell options. Most of the restriction is on OTC penny stocks. Because of volatility, higher risk, and other specifics, most brokerages won’t allow stop-loss orders for OTC penny stocks. In this case, you will need to actively monitor your positions.

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However, at the same time, it’s still important to stick to your strategy. So, if you’re reading this and stop-orders are part of your trading strategy, you can still do something about OTC penny stocks. That “something” is setting mental stop losses along the way. Even though it won’t be a manual trigger, selling when penny stocks hit what would be your stop-loss level maintains your strategy. You just have to do this manually.

Risks of Penny Stocks & Stop-Losses

You’re likely reading that heading and questioning everything else you read. But the fact remains, stop losses carry their own set of risks. They grow exponentially the lower in price a specific penny stock trades. The main risk is to the upside.
By now you understand that penny stocks are volatile. As such, they can swing 10, 20, and even 50% or more in a given day; let alone week. Because of this, “tight stops,” or stop-losses set within 5%-10% of your purchase price, may actually cause you to exit a trade too early.

Penny Stocks & Missed Opportunities

Let’s take the hypothetical stock “ABCXYZ”. In this example, ABCXYZ is trading at $1 and you buy it at $1. You’re only willing to take a 10% loss at most and would like to start taking profit when the position is 10% or better assuming the market is still bullish. Sure enough, you set your stop loss at $0.90 and aim to start taking profit when it hits $1.10 or better. ABCXYZ penny stock’s trading fluidly and hits a high of $1.08 on strong volume but then releases earnings.

While the market digests the earnings results, ABCXYZ starts seeing major volatility. It drops to $0.92 then bounces back up to $0.97. It then settles back at $0.919 and trades sideways for 10 minutes between $0.919 and $0.93.
All of a sudden a shoots down to $0.89 for a fleeting moment right before ABCXYZ CEO starts speaking on the earnings conference call about a new revenue stream. Then ABCXYZ penny stock shoots back above $1 where it continues to trade steadily higher the rest of the day.

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Though it only printed $0.89 for one small trade, the fact remains, it happened and sure enough the $0.90 stop loss triggered. Tight stops like this are difficult to decide for or against especially when it comes to volatility. Your trading strategy will dictate that for you over time. Needless to say, this is a risk when it comes to stop-loss orders.

You may have not lost a lot (or any) money, but you were in a winning trade that your stop-loss kicked you out of early. At the end of the day, keep things like this in mind and if anything, paper trade to get more comfortable with this first.

* This article was originally published here