TTOO - Trading Options on Penny Stocks: Risks Rewards and Strategy
2023-10-06 11:39:23 ET
Penny stocks , defined as stocks trading under $5 per share, are well-known for their potential to deliver exceptionally high percentage returns compared to regular stocks. However, these extremely cheap stocks also carry much higher volatility and risk. Combining options trading with penny stocks can further increase those risks but also amplify potential rewards. There is a lot traders should know before trading options on penny stocks.
How To Find Penny Stocks With Options
Not every penny stock has options available to trade. Generally, only penny stocks at the higher end of the price range, between $1 and $5, will have options contracts written on them. Additionally, for an options market to develop, the penny stock needs to have adequate daily liquidity and trading volume in the actual underlying shares. Thinly traded penny stocks with light volume likely will not have any options activity.
Traders looking for penny stocks that do have options should begin by scanning for stocks trading between $1 and $5 per share. They should look for stocks with substantial daily trading volume, over $500,000 in dollar volume per day. After identifying stocks in that price and volume range, traders need to investigate the option chain and look for existing options contracts.
There should be at least some open interest on the calls and puts, indicating that others are actively trading the options. Finally, check the bid-ask spread on the options. Tight spreads signal higher liquidity, while wide spreads mean lower liquidity.
Understanding the Significant Risks of Trading Penny Stock Options
Although penny stock options can provide leverage and ways to hedge, they come with considerable risks that traders need to understand:
Higher premiums are very common in penny stock options, as implied volatility is extremely high. This leads to inflated premium costs to buy options. Illiquid options have much wider bid-ask spreads, increasing overall trading costs. With little open interest, penny stock options may be inaccurately priced and not reflect fair value. The underlying penny stocks have high volatility, which directly translates over to large price swings in the options as well.
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Combining options with already volatile penny stocks amplifies risk even further due to greater leverage. Another issue is that entering and exiting trades can be very difficult with wide bid-ask spreads and minimal open interest. This leads to overall liquidity challenges.
The Potential Rewards and Benefits of Trading Penny Stock Options
Despite having more risk, penny stock options can potentially deliver higher rewards:
The cheap absolute price of penny stocks allows options to generate exponentially larger percentage gains versus options on more expensive stocks. Options enable traders to hedge the risk of a long or short position in the underlying penny stock.
They provide leverage for a smaller initial capital outlay compared to buying penny stock shares outright. Puts give traders a way to profit from a penny stock declining, without needing to short shares. Options also let traders precisely define maximum risk, which is limited to the premium paid upfront.
Developing an Effective Options Trading Strategy
Here are some tips for traders aiming to trade penny stock options:
Start very small when initiating positions, keeping total risk low to account for the high volatility. Focus only on options with meaningful liquidity, where entering and exiting are actually possible. Debit or credit spreads can lower premium costs and risk versus buying single calls or puts. Always use limit orders so you trade at your expected price. Avoid market orders that will fill at any price. With volatile penny stocks, use stop losses to control the downside.
Some of the most active penny stock options today include SiriusXM ( NASDAQ: SIRI ) $4 Put Options expiring on November 17, 2023, Stem Inc. ( NYSE: STEM ) $10 Put Options expiring on October 20, 2023, Canoo Inc. ( NASDAQ: GOEV ) $0.50 Put Options expiring on October 13th and October 20, 2023, Archer Aviation ( NYSE: ACHR ) $5 Put Options expiring on November 17, 2023 and T2 Biosystems Inc. ( NASDAQ: TTOO ) $0.50 Call Options expiring February 16, 2024.
Also, it is best to avoid earnings dates altogether due to uncertainty. Look for mispriced options compared to historical volatility or the stock’s price trends. Use options to hedge the risk of directional bets in the underlying penny stocks.
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Implementing a defined options strategy tailored to penny stocks is key to managing risk while maximizing any rewards. Traders should align options trading with their personal risk tolerance and available capital. With proper risk management, penny stock options can provide leverage while capping downside exposure. Following a strategy consistently gives an edge over emotional trading.
Should You Implement An Options Trading Strategy With Penny Stocks?
Penny stock options introduce substantial risk along with the potential for greater rewards. With research, capital preservation, and a defined options strategy, traders can successfully trade penny stock options.
The leverage they provide allows smaller accounts to achieve outsized returns compared to simply trading the shares themselves. However, uncontrolled speculation can just as easily lead to major losses in volatile penny stocks. Managing risk is absolutely essential for trading penny stock options profitably over the long term.
Ready to Explore Penny Stocks?
Now you’re armed with tips for researching and evaluating penny stocks with options wisely as a beginner. Before jumping into real trades, paper trade to test strategies. Start small with position size and set stop losses. Tame your trading psychology and stick to your plan. With the right foundation, penny stocks can be an exciting market to explore.
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