​Why Penny Stocks Are Unpredictable

Chuck Fulkerson  |

I remember growing up as a child, my grandparents once took my Brother and me to a toy store for our birthdays. We both got twenty dollars to buy what we wanted and were so excited! I was trying to be smart and get a lot of toys for my $20; so I bought a bunch of little toys that were the cheapest ones I could find. Much to my chagrin, they almost all broke in the first week I owned them, while my brother's one toy was still intact. Seeing my dismay, my Grandpap told me something that I never forgot. He said, “Chaz, things that are cheap are cheap for a reason.” Sound advice for a 10-year-old but even more sound advice for an investor.

The allure of penny stocks is real. There are documented rags-to-riches stories centered on small startups that became big investment opportunities. There are riches-to-rags-to-riches stories like Apple Inc. (AAPL) or Priceline Group Inc. (PCLN) where a company started small, clawed their way through a powerful industry to become a household name only to be humbled and return triumphantly. For every one of those there seems to be 20 like Andrea Electronics (ANDR) that got as high as about $18.00 per share and is now trading around $.05 per share or a company like Andalay Solar (WEST) that in 2008 peaked around $67 per share and is now trading at $.0003 per share.

The allure is simple: Buy a company like ANDR for 0.05, and sell it on a spike up to 0.25. You have a 500% return, but the real questions are:

  1. What causes a company’s stock to move?
  2. If I want to buy, who is selling? If I want to sell, who is buying?

Let's first look at question number one: "What causes a stock to move?" The movement of any stock or anything for that matter is simply buying and selling. When there are no more willing sellers at a specific price point but there remains an inventory of buyers, price will always rise. When there are no more willing buyers at a specific price but there remains an inventory of sellers, price will always fall. Consider the following illustration:

It is easy to see that price fell from the area highlighted in yellow. Why price fell is really the better question. In the yellow shaded area, there was a period where buyers and sellers were in balance. At some point, there were no more willing buyers at that price level and so price fell out of that level, leaving an inventory of unfilled sell orders in its wake. There is no way of knowing this move will happen before it does and we cannot truly profit from this with any calculable probability. On the return, however, we can sell at the same point where in the past there remained unfilled sell orders, and we know that banks and institutions were selling.

How do we know that banks and institutions were selling? We know because of what we are trading in this example. As you read this, you personally probably do not have the money to move the crude oil markets; therefore, it is reasonable to assume that it must be a bank or institution that is influencing price. Because the product takes a lot of capital to move, we have a certain amount of confidence that we will be trading in an arena with other professionals, supported by institutional monies. Now we can talk about our second question in the case of a penny stock. Who is on the other side of our trade? Look at the chart of WEST to discuss:

Looking at this chart of WEST we can see that it trades for $.0003, and with a volume of under 4 million shares traded, it means that the entire stock only has $1,186.85 worth of transactions in the last trading day. When a trader wants to buy this stock, a $1,500 purchase can cause a significant change in the price of the security. This brings us to the bigger problem: the ease of manipulation. I once met a man convinced of the power of penny stocks, and so he kept buying one stock and drove the price up himself. The price was higher and he felt great about himself, but when he went to sell he was unable to get his orders filled, because there were no buyers willing to pay the price he wanted. Even worse are the litany of “penny stock newsletter services” that pop up on the net to show the latest hot penny stock for you to buy, only to find out that they are the ones selling the stock to you after they artificially manipulated it higher. This is similar to the movie "Boiler Room" except it just happens to be on the internet and a computer instead of using phone brokers to manipulate unknowing investors. This is in no way an indictment of the companies themselves, but rather on the system of promoting penny stocks as “hot investments”

When it comes to penny stocks, my belief is simply that if you invest in one think of it as an investment in a long-term growth opportunity in which you are willing to lose 100% of your investment. When it comes to highly probably growth opportunities, trading stocks over $15.00 per share that are optionable and shortable with over 1,000,000 shares of average volume will allow you to utilize the ever-important probability in your investments and trades.

Chuck Fulkerson is the Director of Student Development at Online Trading Academy, a leader in investing and trading education for any market or asset class. Fulkerson helps education individuals across the globe in what it means to be a successful investor and trader. He currently trades options as a swing and position trader; futures and currencies as a day trader; and equities as an investor to round out a truly diversified trading portfolio.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.


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