10 Penny Stock Trading Truths
Some realities in the stock market aren’t common knowledge even though they should be. With an understanding of the ten trading truths revealed here, you’ll make timely buy and sell decisions, bring greater clarity to your research, and reap more rewarding returns.
Investor sentiment is contrarian
Stock prices change based on the buy and sell decisions of the masses, and a cold, hard fact is that the mob (the majority of investors) is usually wrong. People tend to buy shares at price peaks and sell them at price bottoms.
This is why investor sentiment is a contrarian indicator, meaning that the more investors who believe that the stock market is going higher, the more likely it is going to fall. Similarly, the more investors are expecting a crash, the higher the probability of shares increasing in price.
Highly negative investor sentiment is usually matched up with a distaste for stocks, along with a good degree of fear and panic selling. Shares may come closer to being thrown away, let alone trading for fair valuations. Shareholders do not mind unloading their positions at rock-bottom prices, especially since they can’t comprehend how the stocks will ever have any value again.
When no one wants to talk about stocks, and any comments you do get out of them are very negative about investing and the direction the stock market is heading, it is a great predictor of coming upward momentum. With highly negative investor sentiment, it’s time to hunt for bargains.
You can have great investment success by playing sentiment. When you develop a good understanding of mob mentality, you may want to incorporate the concept into your overall trading approach.
Big moves occur during brief trading windows
Successful penny stock investors recognize that shares make their greatest moves in small amounts of time. About 80 percent of changes in share prices, whether to the upside or downside, occur over approximately one-fifth of the total trading time, while they are little changed during the other four-fifths.
You can verify this by looking at just about any trading chart. Measure the big moves, and you will see that when a penny stock changes markedly in price, it typically does so over the course of weeks, if not days.
To take advantage of trading windows, you should only put money into penny stock shares immediately before corporate events or news that could benefit the stock. You can then reinvest any profits into other trading-window opportunities, thus only risking your money for short periods before major events. With this technique, you avoid leaving your money exposed on the markets for longer time frames, during the weeks or months when you don’t expect any major corporate events.
Greater volume means greater sustainability
The more trading volume behind a price move, the more likely it is sustainable. If a penny stock sees its shares go up 40 percent on a $500 purchase of 20,000 shares, the price is highly likely to come right back down. On the other hand, if the shares rose 40 percent on $3-million-worth of purchases for a total of 8 million shares from dozens of different buyers, you can rest assured that the strength is more likely to remain.
Each share purchased is a vote of confidence in the underlying company, just like each share sold is from a shareholder who has lost faith. The more investors behind a move, the more probable the price change will be sustained.
Making up for losses is harder than preventing them
A stock that has lost 50 percent of its value needs to increase by 100 percent from its new, lower level just to get back to where it started. This sad mathematical truth of the stock market is the half down principle.
Picture a share of your favorite penny stock, which is trading at $2. If that stock falls to $1 per share, that slide represents a 50 percent decline. To return to the original $2-level from this new low point, it would need to increase by $1, or 100 percent.
It takes any stock a percentage rise that is greater than the original percentage decline to climb back to break even. Shares that lose 10 percent need a recovery of 11 percent to get back to predecline levels. Shares that fall 25 percent would need to increase by 33 percent to reach break even. If you own shares that sink 85 percent, they need to rise 460 percent from that level to regain their original value.
Bigger things take more energy to move
Larger companies are generally more stable. They are less influenced by events like contract wins, lost customers, the resignation of a top manager, or the appearance of a new competitor.
On the other hand, even minor events can significantly affect penny stock companies. Consider the impact of a corporation worth $5 million landing a $7 million contract versus that of a $500 million corporation landing the same contract. Obviously, the smaller company will be much more strongly affected by the event. The same principle applies to negative events, such as lawsuits or losing clients.
While this can be a cause for caution among investors, it can also be an opportunity for significant profits. Because events of lower relevance have the capacity to drive penny stock shares, and these same events can telegraph the potential direction of the company well into the future, shareholders positioned in the right stocks stand to profit to a much greater degree than they would have by investing in larger corporations.
It would take a series of significant events to cause the share price of a $1 billion business to halve or double in price. With a penny stock, a single event may be enough to create such a move.
Rapid rise, rapid fall
Price increases are generally sustainable if they develop over longer periods of time. On the other hand, the quicker and more dramatic a price spike, the more likely that these higher levels won’t be sustainable. For example, a stock that quadruples in price in a day is more likely to fall all the way back down than a stock that quadruples in price over a full year.
Based on this reality, you ideally want to own stocks that enjoy a gradual and sustained uptrend, because the gains achieved will probably be maintained. In contrast, while stocks that spike dramatically in short time frames are great for investors who sell quickly and near the peak, the stocks don’t usually hold those gains for more than a couple days (if that).
This concept is especially important in relation to penny stocks, because major and sudden price moves are more common among low-priced shares than other types of investments. To be a successful penny stock investor, when you see a massive price spike, consider taking profits rather than expecting the shares to keep on soaring.
Because penny stocks are thinly traded, they are also often targets for manipulation. Promoters drive the prices higher through free newsletters and dishonest message board posts. When the promoter has taken enough profits, they stop pumping the shares and the penny stock collapses.
Dilution disguises losses
Some penny stocks have done a lot worse for their shareholders than appearances may seem to indicate. Most investors look only at the price of the stock, or the trading chart, and if the price of the shares is up, they assume that everything is fine.
Unfortunately these same investors may not be looking at the total number of shares trading on the market. Because most companies raise money by selling more shares, the total number outstanding increases. The end result is dilution of the company’s stock — because there are so many more shares, the proportionate value of each is less. As the total number of available shares increases, the value of each gets watered down.
Penny stock companies often need to do two things: raise money and hide losses. They can accomplish both via issuing more shares, and this dilution often misleads investors as to the company’s actual progress.
Buy the rumor, sell the fact
Shares often react exactly the opposite way that you expect. For example, the stock welcomes great news with a major sell-off, or answers bad news by increasing in share price.
The phrase that best captures this stock market activity is “Buy the rumor, sell the fact.” In other words, as traders position themselves to benefit from an event, they tend to push shares higher (or lower in the case of pending negative news). The shares often over-extend beyond what the actual event justifies, so that the result of the official news or occurrence is a falling stock price despite the positive (or rising stock price despite the negative) information.
You can profit by purchasing stocks that will rise along with a growing rumor. The trick is to be ready to take your gains out before the actual fact occurs, because even seemingly positive events may result in a sell-off of the shares.
When trading penny stocks, keep the “buy the rumor and sell the fact” concept in mind. You may then turn surprising and unexpected stock price moves into profit opportunities.
Don’t try catching falling knives
When a penny stock falls from $2 per share to 25¢, does it represent a good value? That depends on the reason for the fall and the strength of the underlying company. Even at 25¢ it could still go lower, and you may lose 100 percent of whatever money you invest in it.
Trying to buy shares as the stock is falling is referred to as “trying to catch a falling knife.” As long as the trend of the shares is heading lower, you should wait before you invest. Only after the downward slide stops or reverses, should you consider getting involved.
Keep in mind that a $2 stock had investors who thought they were getting a deal when it was trading down to $1.75, and then again when it hit $1, and yet again when it was down to 50¢. Don’t be the investor who comes along to make the same mistake as they did, by believing 25¢ is a great value considering that the stock used to be a worth eight times that much.
The former value, whether it was $2 or $55 per share, is absolutely meaningless. The current value of any stock is whatever someone is willing to pay you for it — and not a penny more — right now.
Resistance levels can flip
Resistance levels are price ranges above which a penny stock’s shares may have trouble reaching. Very often these levels occur at key price points in penny stocks, such as $1.00, $1.50, $1.75, and other significant numbers because many shareholders sell at threshold prices, rather than mid-range levels, such as $1.07, $1.23, and $1.72.
Because breaking through a resistance level is difficult, when shares do push into higher prices, investors can be more certain that the underlying stock has significant buying demand behind it.
After shares break through a resistance level, that level often flips, or transforms into a support level. Picture a stock that breaks through a resistance of $1 after ten months. That $1 level very often becomes a support level, where shares remain above for the indefinite future.
The same concept holds true in reverse, where support levels fail and then become the new resistance level. Shares may remain above $2 for years, but after the stock dips below that price, they may never be above $2 again for just as many years.
Look to a trading chart to identify support and resistance levels. Use them to gain an understanding of how the share’s prices may act, but be aware of their potential to flip and the resulting ramifications.