becomes not just enticing, but exponentially to good to be true. To get an idea as to just how risky buying a
Penny Stock could be, let's look at a worst case scenario, and then focus on how to avoid these types of
situations. Seeing how high a stock has been in the past and how low it is today forces us to send an
order through to our broker using half of our account value. We noticed the stock because it skyrocketed
today on high volume, and the press release that came with it makes the company seem unstoppable. We
calm our nerves by telling ourselves we will sell the stock at a moments notice if it gets down to a certain
level. The very next day the stock moves up a little bit more early in the morning, and we are euphoric, and
even whisper that we can now sell the stock should it fall back down to break even, thereby making it risk
free from here on out. But this is not really an issue, because we are certain that the stock will not even go
back down to those levels. Lunch time comes and volume slows to a standstill and you start to think about
lunch yourself. When you return to the screen, you see a lot of activity on the Level II screen, and feel
something is brewing; perhaps this is the big run. The first few trades look good, but you soon
comprehend that the stock is tanking fast, you are concerned but convince yourself that it must just be a
shake out before the next peak. It has already fallen below your break even level and even below your point
of no return. As you page through different time frames on your charting software, you quickly realize that
your penny stock has now fallen back to where it was before the run began, and is even right near its all
Instead of firing your sell order, you begin to hypothesis that if it was cheap when you first bought it, it must
be at bargain basement levels now. You decide to use the rest of your account value to enter another buy
order, and then quickly calculate how high the stock will have to go to break even. Solace is found in the
fact that it is less than halfway between your two buy points, and you continue to hold for weeks, even
months as the stock slides ever downward. Perhaps the stock falls below a penny, and maybe you even
scrap up a few more dollars to add to the position. Eventually, after trading between $.0001 and $.0002 for
what seems like a lifetime, the company announces a 1 for 900 reverse stock split. After you find the new
symbol and see your account updated, what seemed like a substantial position in the company has been
reduced to a mere couple of hundred shares, but at least it is worth close to a dollar per share. Over the
next few days the stock plummets back to sub-penny land almost as fast as the pit in your stomach
develops as you come to the devastating conclusion that selling the stock now would not even yield
enough to cover the commission.
There are far to many morals in this story to illustrate, but we will try and point out the essential ones.
The most obvious moral is diversification, which is covered in our penny stock allocation section. Penny
stock allocation is two fold; emphasis must be placed on allocating a very small amount of ones overall
investment portfolio in stocks under a buck just as we should with all high risk investments, and upon
expanding and broadening the scope of that particular segment. By not putting all of your eggs in one
basket, you can virtually eliminate the most devastating aspect of the above demonstration, losing all of
your cash. The types of penny stocks we trade have several risk management tools already built in that
pertain mostly to the idea that you can at least not lose more than you are willing to risk. Short selling and
trading on margin are practices which both open the door to an investor risking an infinitely larger amount
of capital then they use for the investment. Trading penny stocks in this manner is next to impossible, and
chances are you will not obtain any support from your broker in the form of loaning capital to trade unlisted
stocks on margin. Where you can find support from your broker is with stop loss and limit orders, or a set
price that will trigger a buy or sell order. As we discuss in our Stop Loss and Limit order section, most
brokers require a five to ten cent minimum spread between the current bid, and your stop loss order. This
is fine for stocks over a quarter, but we will need to try our very best at having steadfast conditions for our
lower priced stocks. By diversifying between many different price levels, we can minimize risk by only
having a few stocks in the portfolio that we can not automatically guarantee a minimum loss for.
Additional risk management and success will come with experience and technique. One concept we
adhere to is not buying explosive stocks that are skyrocketing on news with what we call too much liquidity.
With our time frames, these types of buys would almost always lead to the position immediately being cut
in half. Instead, we like to buy after activity has calmed down, and there has been no news for a while.
Stocks that are consistently active and historically moving up in a rational way are the best choices.
Understanding the different capital structures of these tiny companies will go a long way towards avoiding
that disturbing 1 for 900 reverse stock split. Perhaps the number one thing to take away from our risk
management theory is the overwhelming need to keep your emotions away from your trading desk, and
your entire investing career.
|©2010 Penny Stocks Weekly - Home - PSD 10 - Terms - A Message From The SEC - Important Information On Penny Stocks
Full article access includes Buy, Sell & Stop-Loss conditions along with a no nonsense
trading strategy. Don't jump in blind, subscribers also get a detailed risk analysis,
suggested position weight and time horizon ideas. Also access our Small & Micro Cap