Section 8: Penny Ante

A Guide to Penny Stock Trading

Nothing in the market is more enticing to the public than “penny” stocks, particularly to traders who have relatively small accounts. The reason for their attractive, rightly or wrongly, is the amount of leverage one can get if the right stock is chosen. More than likely, every one of us have fantasized about owning 1,000 shares of a $0.50 stock and have it skyrocket to $1 or $2 for triple digit gains.

In the real world, of course, latching on to such a windfall is highly unlikely, if for no other reason than pure mathematics. For each $1.00 stock that soars several hundred percent, there are thousands of others that go nowhere, or move lower, because in the final analysis, most inexpensive stocks are cheap for a reason. More often than not, those reasons remain constant, or worsen.

However, there is a right way to play cheap stocks, and this section is devoted to such a strategy. If you follow a few crucial guidelines, you can play cheapies in a conservative and reliable way.

Definition

For our purposes, a “penny” stock is one that trades below $10 per share, but not less than $2.00. The cutoff point of $2.00 is somewhat arbitrary, but I find that trading stocks below that mark is inherent with high risk and probable losses.

Much of this has to do with leverage, which is a double edge sword. While it is true that a 50-cent stock only has to move 5 cents for a whopping 10 percent gain, it can also drop a nickel to lose a bundle. Trading stocks below $2.00 is more trouble than it is worth.

So the first rule about trading penny stocks is to rule out anything below $2.00, and ideally, stick to the $4 to $7 range for optimum results.

Penny Theory

The first thing to realize about “penny” stocks is that they are rarely supported by institutions (mutual funds, pensions, etc.). In fact, some fund managers are prohibited from even considering a stock below $10 per share. Unlike the higher priced securities, you can’t expect a lot of deep-pocketed firepower to drive up your favorite penny play. For the most part, you are relying on the general public, or traders like yourself, to jam a $5 stock to higher levels.

But therein lies the key: If you recall, the secret behind successful trading is to anticipate the next move of the speculator, that is, to speculate on speculation. And, the only difference between a $5 stock and a $25 stock is the kind of speculator that backs them. And, as a rule, these are ordinary traders, often with limited bankrolls, and as a result, cheap stocks follow the market’s lead, but with exaggeration and lagging.

In other words, when the market turns bullish, so do penny stocks---but overly so. When the market heads south, penny stocks follow suit, but more furiously to the downside. In both cases, however, there is usually a lag. If the NASDAQ rallies, and continues to rise, you can rest assured that the penny stocks will soon follow, give or take a few days.

Consider the three charts above, the top one being the NASDAQ composite during the final six months of 2004. The two charts below it are two “penny” stocks that I selected at random. The vertical line is where the NASDAQ halted its bearish decline, and began to turn higher.

You will immediately notice that both Stock 1 and 2 turned as well, with a slight delayed reaction. This is because of the type of traders that back the cheaper variety, and the nature of their speculation. Also notice that each stock gained a whopping 100%+ during the market upturn.

The theory is that the public is both risk averse and a follower, not a leader. If the market performs poorly, they tend to stay clear of the market, but if things start getting bullish, the public musters the courage to get back in, and they jump all over the inexpensive securities.

The only reason why this method works is because the best, most solid stocks are already perceived to be too expensive to begin with, and this becomes overly so when the market rallies to higher levels. The ordinary trader, reluctant to chase high prices, looks to alternative, cheaper groups.

Hence, the first golden rule of trading penny stocks: Avoid playing them during bear markets or downturns.

Otherwise, if the market takes a bullish stance, look to the $2-$10 stocks to get heavy action shortly after the more expensive groups begin to run their course.

Blind Buy

Of course, you mustn’t just blindly buy your favorite penny stocks during market upturns. True, the cheaper variety has a better chance during a bull market, but you should still use the winning strategies outlined in previous sections to make your selections. Never buy a stock merely on the basis that the “market is going up.” Instead, look for the winning patterns that work well in more favorable climates such as the Breakout and the Staircase to Heaven.

When time is scarce