Penny Pitfalls

Friday, June 09, 2006

The Pitfalls of Penny Stocks

Trading penny stocks has some serious pitfalls, first and most obvious is that a lot of them are cheap for a reason, simply because that’s what they are worth. Second is that even if you take the time and effort to find good penny stocks they can still be very volatile. Volatility is not necessarily a bad thing, and some make it a key in their stock picking, but if you bought at the top of a three day rally and it tanked, volatility sure feels like a bad thing. A third major pitfall of trading pennies is that good information on penny stocks can be harder to get since most of the market shuns them.

Despite these pitfalls penny stocks are great because they offer you serious leverage. You can buy 100,000 shares and if by some miracle it moves one dollar while you own it, you made $100,000. This is an extreme example, but the simple fact is, the more shares of a stock you own the more you make when it moves up. The low buy ins for large numbers of shares of penny stocks allow you to make really good percentage gains, and good money on relatively small capital with small moves. A word of warning, pennies that don’t have good average daily volume should be avoided for this kind of leverage plays, you can play them small, but if they don’t have a lot of trading interest large numbers of shares are hard to sell even if you are showing spectacular paper profits. If you use leverage with caution it is one of the best perks of pennies. I usually try to diversify and buy about 5000 shares, this shows a gross profit of $250 if it moves five cents.

Volatility makes pennies both attractive and scary. The seasoned penny investor will have some idea what he has, and not have to react emotionally to every little market fluctuation. These stocks have a real market value, and the whole idea of the game is to figure out what that is, and buy below it, and sell above it, in pure penny trading, time is not a big issue. If you buy 5000 shares at .07, and sell at 1.07 you make $5000 on $350 invested (and/or risked). To most people that’s worth waiting six months for. That’s why pennies thrive on speculators who ignore fundamentals, and say to themselves, they make purple toeless tennis shoes (or whatever) that’s great, I’ll buy it. I think it’s better to take it easy on buying into a stock’s hype, but money can be made that way. Personally, I peg my penny analysis mostly to earnings, and try to buy them when the market value is below what I think is the real value.

Another aspect of volatility, that I found out the hard way, is that perfectly healthy seeming penny companies with earnings and everything can go bankrupt or out of business out of the blue. My rule of thumb is not to trade stocks that end in Q , PK, or similar exchange flag codes, do your own research here, I consider this one of the most valuable things I ever learned. You’re way ahead of me as a beginner by just knowing that such things exist. But remember, everybody in penny stocks gets burned now and then, from what I’ve seen I’d say one out of 60 or so trades will go bad for no predictable reason. The good news is when penny stocks go the right way, they often do a couple hundred percent gain, or occasionally more.

Most of my biggest mistakes came from trading on trailing twelve month (ttm) P/E ratios thinking last year’s data was current. Make sure you get the most current data you can. Having only ttm data doesn’t necessarily mean you can’t trade that stock, but read as much news on it as you can find in hopes of finding this years numbers.

Finding good solid trustworthy information in the universe of penny stocks is not an easy task. Most of the online brokerage and news sites treat pennies as an afterthought if they cover them at all. There are great opportunities out there in penny stocks, and since they’re cheap you can learn to trade without risking your house or selling your car, but do your homework, and don’t trade on nothing but hype and hope. Happy Penny Trading.