Some say avoid penny stocks
Many speculators turn to penny stocks when their trading capital is limited, even though it is well-known that such issues are associated with higher risk, and sometimes are even subject to illegal manipulation. Many successful and highly regarded stock advisors advise against trading penny stocks, for instance, William J. O’Neil, famous trader and publisher of the Investor’s Business Daily (IBD), says they are “unduly speculative and low in quality”.
Elsewhere on this website, I have recommended the books of William O’Neil as ideal reference sources for anyone wishing to learn stock market basics, but even so, I would not agree with avoiding penny stocks altogether, but just be aware of the potential problems and implement the suggestions described below.
An added attraction of low cost stocks is the general belief that they can be more profitable because low priced stocks, when they do trade up in price, can more easily gain a big percentage in doing so than would high priced stocks that are admittedly safer propositions.
Suggestions on what to watch for
1. Liquidity
Don’t buy stocks that trade infrequently. Many low priced stocks trade in low volumes each day and that means it can be difficult to sell a position at any given time because of the lack of buyers for the stock. It is also possible that there will be a wide spread between bid and ask prices meaning that selling the stock will recover less of the investment. Opinions vary on minimum trading volumes but I prefer to only trade stocks that average at least a daily volume of 250,000 for the prior 3-month period. That information is readily available at Finance.Yahoo.com
2. Know when to exit a losing position
In the stock market, stocks don’t always perform as expected and some losses are inevitable. Knowing this, experienced traders establish an amount of loss that they can tolerate and if a loss should occur, they know when and how to exit in order to preserve their working capital and move on to something else.
It is a common practice to establish a percentage amount for a potential loss and either place a firm stop-loss sell-order with a stockbroker ahead of time or use that same percentage loss amount as a mental stop, an amount to keep in mind to be acted upon should it be required. There are differences of opinion as to the merits of each of those methods, but what is most important is to cut the losses promptly.
3. Trends and charts
Don’t buy into a stock on a downward trend. A standard guideline in stock trading is to not buy when a stock is declining in price and definitely to not add to a losing position so that you can “average down”. On the other hand, in many cases buying on an upward trend is a good move. A way to instantly see the trend of a stock is to look at a chart of the stock, Stock charts are available free of charge at several websites in the internet.
4. Stock chart interpretation
Learn how to recognize patterns of stock price movements that are depicted on stock charts. While not foolproof, certain stock price patterns can point to the possibility of where the stock might move and even to what extent.
As an example, it is well known that stocks making new highs often go on to establish continuing new highs, thus enabling an entry into a stock and to ride on the wave of its advances. That situation can easily be seen on a stock chart. Another popular chart entry signal is a breakout from a price level that has been acting as a resistance, a price “ceiling” that when reached previously has appear4ed to stop the stock trading higher in price. There are many more patterns that should be studied.
For example, in the following chart, MRGE appears to breaking out above the $3 level (indicated by the added horizontal orange line). This can be considered as a positive alert to take a long position — subject to other due diligence factors being met of course.
Click on Chart for sharper enlarged view.
Stock chart of MRGE July 13, 2012
5. Trade the listed and higher priced penny stocks
Avoid the OTC and Pink sheets stocks. It may sound strange that stocks categorized as penny stock are not limited to those that trade for one dollar or less, but by general agreement in the stock market, stocks that trade up to a few dollars, typically up to $5, are also considered as penny stocks and many of them are listed and trade on the major stock exchanges, thereby adding an element of safety because of stricter regulation by the Securities and Exchange Commission (SEC). There are plenty of such stocks whose charts show some of the promising attributes described above. For more on this topic, check out Penny Stock Trading.
