Why Short Term Trading Penny Stocks is a Bad Idea
Search Google for penny stock and you will be deluged with sites promoting the active, short term stock market trading of penny stocks. This attracts people due to the greed factor (the promise of huge % returns in short time) , the “I don’t have much money” factor, and lastly the knowledge (or lack of) factor. All these sites prey on these three aspects to get people to sign up to learn about trading penny stocks or at least try to. Most of the time, their version of day trading is holding for a few days, rather than only go in and out the same exact day.
Now not all of these sites are bad. There are a few that are in it for the longer haul, really trying to find the diamond in the rough. The only issue that is never talked about is the true rarity of that happening. I do not have exact stats, but I would guess for every 1000 penny stocks, maybe less than 5 ever build up to a real company and get listed on a regular exchange. What is a regular exchange? Nasdaq NMS, Nasdaq small cap, or NYSE. The rest go to 0. It may take some time, but it happens - maybe a few get taken over or merge but rarely is it a huge boon to shareholders. Its usually a take under at some point. It is these types of stocks that people who want to learn to trade are drawn to often times.
Think about it for a second - the primary way companies go public is: 1 - Have a great idea for a business, 2 - incorporate, find partners, build business some, 3 - if its going well, raise capital with private placement OR VC depending on the industry, 4 - expand further, grow margins and get profitable or very close to it with a well defined plan, 5 - plan to go public OR sell/merge company with a bigger competitor. Now contrast this to the way most penny stocks are capitalized: 1. Think of a business idea, 2 - buy a shell company (listed on pink sheets, but no business or revenues, you buy the name and the other stuff from someone), 3 - formulate a business plan, talk with brokers about getting the word out about your company, 4 - issue press releases about your business (usually whatever is hot at the time is a magnet “to do” stuff), issue shares to pay consultants to pump stock, issue shares to pay yourself a salary, issue shares for rent, issue shares for equipment, issue shares to maybe hire someone (all of which get dumped into the pump scheme designed to keep volume in the stock), …. and on and on. You should notice a difference between the 2 by now. One is a bona fide business from the get go, the other is basically a concept reversed into a public shell, with everything else as an afterthought. That does not mean ALL are like that, but a large percent are or do a majority of those things.
If that did not deter you, lets look at the capitalization issue. A lot of penny names have 10s of BILLIONS of shares outstanding, I personally have seen as many as 800 billion outstanding. So lets take a lower number, but prob average of 5 billion shares outstanding for company XXYY. Also, lets assume the stock is trading at 0.002 per share (penny stocks can trade as low as 0.0001 that is the lowest increment before 0). But we are giving XXYY the benefit of the doubt. Lets see what the market cap is on XXYY. 5bil x .002 = 10 million bucks market cap. This is common. The company has 0 revenues (or very little at all), and is basically like saying your home based business with a big idea is worth 10mil - prob not even worth 10,000.00 with no sales. Think about it. If you actually had 10mil, would you give it to a company that has no products, has a unique concept and is working on a business plan? Hell no, not a chance. Even if a company was profitable, the general rule is a low multiple x earnings for last 12 months OR revenues, depending on the sector. This company has no earnings and no revenues or even a product. Its pure hype. So if the business makes 2 mil a year (profit, not revenues) you MIGHT pay 10mil for that biz. The hype is always so compelling - turn 2k into 1million bucks etc IF it works and IF it goes up bla bla bla.
The real driver of any company is only 2 factors: Earnings per share OR what another company would pay to take that business over. Lets see what it would take for company XXYY to earn .10 per share, then we will be super generous and let it trade at a 100 PE ratio so its a 10 dollar stock. That would be considered a home run in anyones book. To earn 0.10 per share, the company NET PROFIT would have to be $50,000,000 - now lets be generous again, hugely, and say XXYY is in the software business and gets the same margins as MSFT (Microsoft) of 80%. This would mean their revenues are about $70,000,00.00 with no expenses at all. Most of the time, the entire market for the good or service these companies are in, assuming 100% market share and no competition is not even that big. How many people go from a concept to 70mil in revenues? Very, very few. Most cannot even get product sales much before they implode.
If this still does not dissuade you, the fact that the company is not even regulated nor required to publish financials that are audited on the pink sheets, and the double combination of the pump schemes to hype stocks so the company can sell shares to earn money (them and their buddies) makes it a huge game of musical chairs. You can always buy penny stocks (market order, please!) but you will have a hard time selling them. The market makers do not want this junk on the books either, unless they have orders to buy it and they can make money reselling the stock at a higher price. If you are looking to learn day trading, I would advise you to stay away from the penny stocks unless you do not try to trade them, are an expert, and realize there is a very high chance you will lose 100% of the investment.
How to identify a slump when you are stock trading
Anyone who is day trading, or just trading for long enough will eventually hit a slump. What is a slump? Well, its when whatever you are doing is consistently not working for long enough to affect you mentally. Sometimes this can be due to bad habits being picked up, but often times a slump is simply a result of a shift in market dynamics in such a way that your style of day trading just is not gonna work.
Most traders will pick a style that sets up a trade setup they are comfortable with after a period of time - meaning they like breakouts/breakdowns, like to play retraces in a trend, like to pick reversals, play momentum etc. There are lots of styles. Unfortunately, the market will not always stay in phase with all these at the same time. It is up to the trader to determine when this “shift” occurs - usually this is through losing money. Sometimes you can be astute and in tune with the market to see the shift happening before you really lose, as a result of your trade setup not working as well as it has in the past.
Once you realize a shift might have happened, you should at the very least cut back your trading size on whatever style you are using that is having trouble. I usually cut it back to 1/2 to 1/3 of what I was doing before when I trade the stock market. Then you need to really look at what you have been doing and analyze if there is any modification that would make it work better. This is assuming your style is based upon well researched rules and trade setups that have worked very well in the past going back at least 6 months.
If after looking where you are entering and exiting, looking at the setup, looking at the stop and you determine there really is no way to predict a better entry (or other stuff) ahead of time, then you need to figure out another method that is working and try to concentrate on that. Usually if breakouts are not working, that means reversals are (guessing the turning point of a trend etc). If retraces are not working, then pattern failure trades are working and so on. The hard part here - will this type of market last long enough that if you switch to mainly day trading a different setup than you would normally do, that the market does not flip back and you get burned yet again as you are too late to the game. This has happened to me many times before, as I am sure it has happened to others. This becomes a mental game of deciding to try it or not. There is no easy answer.
In addition, sometimes the market will make short term chaos type trading work, which makes most other stuff not work. By chaos I mean whatever normally happens when the stock does x (x can be any type of setup), the opposite happens in a bigger way than if x worked in the first place. If you can identify this you can just do the opposite (going short instead of long when setup x happens …) IF you are really disciplined.
This type of switch in behavior can lead to bad habits happening, and you cannot be sure when the market will stop this type of trade setup. Usually rather than do the opposite of how I have always traded, I simply sit on the sidelines and wait until I see conditions improve - going against what I know is normally a real solid setup for a day trading is very hard to actually do. A good way to get by this is to trade a simulated account rather than a real one, when you start to be consistently winning again, its time to go back to real money.
You also have to worry about your mental state when a slump is happening. It makes you second guess everything (and rightly so if you think about it, your trading has gone from consistent to inconsistent) - but what gets frustrating is you second guess entries that actually work and you are not in them, then might actually enter one that does not work. All you can do here is to stop trading OR just trade a simulated account for a bit until some time passes. Usually a week or so of not really trading will clear out negative thoughts and you can get back to concentrating on how to get out of the slump and get back to winning.
