Your Penny Stock Trading
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How To Allocate Your Portfolio

Key Terms

What Are “The Markets”

In Arlington, Texas between the middle of June and the end of October there’s a huge Farmers Market. I’m sure there’s one in your town too. Think about what happens at that “market”. Folks come from all around to buy and sell fruits, vegetables, and homemade treats. It’s great fun for the kids. I highly recommend it.

Well, financial assets, things like stocks and bonds are likewise bought and sold in places called markets. Some of those markets, or exchanges, are physical. Think of the New York Stock Exchange. You may have seen people on television reporting “from the floor” of the exchange. That’s a physical place where stocks are traded. Other financial assets trade electronically via virtual exchanges. These virtual exchanges are referred to as over-the-counter, or OTC Markets. Bonds are traded over-the-counter as are many penny stocks. So, the stock or bond market is the same thing as the farmers market. Maybe not so much fun for the kids, but still highly recommended by me!

Stocks & Bonds

While I’m on the subject of stocks and bonds, this is probably a good time to explain the difference. Both are issued by companies. Stocks represent pieces of ownership in the companies that issue them. So, penny stocks, like all common stocks, represent a proportional share of ownership in the issuing company. That’s the reason they are called shares. Own a share of stock and you’re one of the owners of that company. It’s what makes America great! Finally, companies that issue (sell) shares of stock to the public are appropriately named public companies. It sometimes amazes me how creative people on Wall Street can be. Bonds are not the same as stocks.

Bonds are proportional pieces of a company’s debt. Bondholders are not owners of the company. They are creditors. Think about it in terms of the mortgage on your house. That loan is the same thing as a bond. The only exception is that there is only one creditor – the bank that lent you the money to buy the house. A company that issues bonds may have thousands of creditors. Those are the people who own the bonds. There’s one other really important difference between stocks and bonds. And, it’s the reason investing in stocks is so lucrative.

Stockholders, the people that own penny stocks for example, have an ownership interest in the company. So, if that company is successful and increases in value, then the shares of stock that those investors own will likewise increase in value. Think of the adage, ‘buy low, sell high’. That’s the whole point of owning a piece of a public company. It’s why we trade penny stocks.

Bondholders aren’t owners. They’re lenders. So, if a company that issues bonds increases in value, it will have no effect on the price of the bonds. They won’t go up or down. So, the bondholders’ investments likewise won’t go up or down. Bondholders do not participate in the profits of a company the way that shareholders do. Bondholders get paid interest.

That’s a quick introduction to and comparison between stocks and bonds. But, the whole point of your reading this isn’t to learn about bonds, it’s to learn about stocks – penny stocks to be exact. So, let’ get to that. And, the best way to learn about penny stocks is to compare them to…well…non-penny stocks. Wall Street doesn’t have a clever word for those.

Types of Stocks

 
Before I go into a comparison between penny stocks and non-penny stocks I have to make a confession. There is another type of stock out there that companies issue. It’s called preferred stock. A preferred stock behaves more like a bond than a common stock. That’s why we’re not going to spend any time on this class of security. After all, our focus here is on penny stocks.

And, there’s really only one difference between penny stocks and non-penny stocks: price. That’s it. From a practical standpoint this means that you can find penny stocks trading right alongside non-penny stocks on the biggest, most liquid exchanges. And, that flies in the face of what many people think about penny stocks.

The term penny stock has a negative connotation for lots of people. They incorrectly assume that penny stocks only trade in the dark recesses or sweaty underbelly of Wall Street. Sure, some do; but not all. I’ll get to that later. For now, it’s important that you know that penny stocks actually trade on both physical and virtual exchanges. Nevertheless, it is a fact that most penny stocks do trade over-the-counter.

For all intents and purposes there really is only one physical stock exchange left in America – the granddaddy of them all – the New York Stock Exchange: the Big Board. It’s the oldest stock exchange in the country and the largest stock market in the world! The NYSE is where the bluest of the blue chips and the oldest of the old guard are traded. And, guess what? Trading right alongside those huge titans of American industry are tons of teeny-tiny enterprises whose penny stocks also qualify for listing on the Big Board.

The term listed stock means that a company’s shares are traded on an exchange like the New York Stock Exchange. But, the NYSE is not the only exchange in America where stocks must qualify to be listed for trading. The other well-known exchange is the National Association of Securities Dealers Automated Quotations, or NASDAQ exchange. NASDAQ is a virtual, or OTC, exchange and is the second largest stock market in the world. And, just like the NYSE, NASDAQ is home to some of the biggest companies in the country (heck, the whole wide world, for that matter). Most of America’s leading technology companies are listed on NASDAQ. And, wouldn’t you know it, so are lots of smaller companies whose shares sell for less than $5.00 (aka – penny stocks)!

NASDAQ is not the only OTC market in America. But, it is the one with the most stringent listing requirements. Other OTC markets don’t have listing requirements. There are primarily two entities that operate these other OTC markets. One is the Financial Industry Regulatory Authority (FINRA). FINRA is a non-profit organization that was authorized by Congress to regulate broker-dealers. The other is (interestingly) a public company called OTC Markets Group, Inc. (OTCM).

FINRA operates an electronic inter-dealer quotation system called the OTC Bulletin Board, or OTCBB. The OTCBB does not have listing requirements, but it does have eligibility requirements. Those eligibility requirements are not onerous. Still, a company must make regular statutory filings with the SEC in order to maintain their eligibility to be quoted on the OTCBB system. No quote, no trading. That’s kind-of a big deal to a reputable public company. So, penny stocks quoted on the OTCBB system are very much solid citizens.

OTC Markets Group operates the other electronic inter-dealer quotation system. It’s called OTC Link and is broken down into three segments:

• one for companies that are current in their reporting to the SEC;
• another for companies that are either current in that reporting or are not required to report but meet OTC Link’s financial standards and disclosure requirements; and,
• a third that has no financial standards or reporting requirements at all

To me OTC Link offers the good, the bad, and the ugly. The good ones are those that are compliant with the SEC. The ugly are the ones that aren’t required to report. The bad ones are those that aren’t held to any standard.

The good news is that when it comes to how to trade penny stocks, all three of these categories is acceptable – if you know what you’re doing – and oh, by the way that’s what I will teach you.*

Now that you’ve got a basic idea of what a market is and have been introduced to a couple of different types of stocks and the different exchanges where they trade, this is probably a good place to talk about how all of this stuff comes together in the real world. After all, those exchanges wouldn’t operate efficiently if it weren’t for actual people.

Market Mechanism & Participants

There’s no question that today most stock trading takes place electronically. You send your order to buy or sell a stock to your broker by a click of your mouse. And, then that order gets routed to the person on the other side of the trade who has the best price at the time. It’s a seamless, beautifully efficient process. This is the case even at times when the market runs into traffic where there are more buyers than sellers or vice versa. The good news is that the market never has the kind of traffic jam you experience during rush hour.

The reason for this is that in between you and the person on the other side of your trade is a mediator (not really, but that’s what we’ll call him or her for now) whose job it is to make sure that the transaction goes through without a hitch; even if the two of you can’t agree on price. On the floor of a stock exchange this person is known as a specialist. In the over-the-counter market, he or she is called a market maker.

The role of the specialist and market maker is to maintain an orderly market. To do this they take stock into inventory to ensure that the market remains liquid. They’ll quote a set number of shares of the stock on both sides of the trade and will buy stock from a seller at one price and will sell that same stock to a buyer at another, slightly higher price. The result is that there is always liquidity in the market. The market, like beer, is always better when it’s flowing freely.

Bid/Ask Spread

Before I talk more about liquidity (and beer for that matter) I want to make one last point about market makers and specialists. They are not in the business to speculate on the direction of the stocks in which they make a market – that’s our job, you and me. Their role is simply to keep the market moving.

The way they make their money is by keeping that small difference in the price between what they buy the stock for and what they sell the stock for. The price they quote to sellers is the bid price. The price they quote to buyers is the ask price. The slight difference between these two prices is referred to as the bid/ask spread.

Understanding the bid/ask spread is important, not because it’s how the market maker makes a living, but because it’s an indication of how liquid a stock is. The more liquid the market for a given stock, the narrower the bid/ask spread is going to be. The less liquid the market is for a stock, the wider that spread is going to be.

Liquidity

Okay, so just what is liquidity and why does it matter? And, what the heck does it have to do with trading penny stocks? I have to go to another beer analogy on this one. Let’s say you go to your favorite brew pub and there’s a line at the bar. The first guy orders a beer and pays with cash. Bang! That transaction happens fast. The next guy in line pays with a credit card. This takes a little time to process because the bartender needs to run the card and get the guy to sign a receipt before he can wait on the third guy in line. This guy just came in from the farmers market and tells the bartender that he can only pay for his beer with the rutabaga he spent all his cash on. This is going to bring things to a screeching halt and you are going to go without any tasty beverage for a very long time.

Liquidity is the ability for things (penny stocks in our case) to change hands quickly and easily without anything getting in the way to bring the process to a screeching halt. Liquidity is also the measure of how easy it is to acquire as much or as little of something (again, penny stocks in our case) without causing a disruption in the market or (more importantly) a change in price.

Market Cap

One of the biggest influences on a stock’s liquidity is the size of the company that issued it. This “bigness” is referred to as the company’s market capitalization. Market cap is determined by taking all the company’s outstanding stock and multiplying that number by the current share price.

In general, the bigger the issuer is the more liquid its stock will be. Here’s a rough idea of the varying degrees of market cap. Apple (APPL) is a great example of a “Mega Cap” stock. Its market value is more than $810 billion. It trades about 25 million shares every day. A “Large Cap” stock is one that has a market cap of more than $10 billion. Kellogg Company (K) is a good example of a large cap stock with a value of about $26 billion. “Mid Cap” companies are worth between $2 billion and $10 billion. NetApp, Inc. (NTAP) is at the high end of that range. Del Taco Restaurants, Inc. (TACO) with a market capitalization of $500 million falls close to the low end of what defines a “Small Cap” stock – between $300 million and $2 billion. $50 million to $300 million puts a company into the “Micro Cap” universe. A good example here is pSivida Corp. (PSDV) with a market cap of about $84 million. Companies that are smaller than $50 million are called “Nano Cap” stocks. Gevo, Inc. (GEVO) with a market cap of about $9 million is a perfect example.

There are plenty of small cap stocks that trade under $5.00 per share. There are even more micro caps that do. And, you can be pretty confident that you won’t find any nano cap stocks that trade for more than five bucks. All of these would be considered penny stocks.

Another generality about market cap is that the bigger a company is the less volatile its stock is likely to be.

Volatility

But, what exactly does the term volatility mean and why is it important?

Volatility describes the changes (up and down) in the price of a stock over time. Let’s look at a couple of examples to illustrate this. Below is a one-year chart of Aduro Biotech (ADRO). Notice how this baby’s been all over the place in that time. Traders would regard this as a pretty volatile stock.

What Are Penny Stocks

The examples above illustrate a pretty extreme difference in volatility. The mega cap stock isn’t real volatile while the small cap stock is. To an investor volatility can be unnerving. To a trader volatility is exhilarating. The whole point of the above comparison is to show that investing and trading are not the same things. An investment is something that you intend to hold a very long time. A trade is not. Typically we are in and out of our trades in a matter of days. The only thing that we are concerned about is the short-term trend. Fundamentals are not that important to a penny stock trader.

And, that’s the important point here. Of course we want to make sure that we know what we’re buying when we open a position. But, since our goal is to trade on a technical indicator and then sell once we achieve our objective, the fundamentals of the company underlying the stock we’re trading don’t matter. We’re more interested in the stock’s volatility than we are its earnings (for example). As a result, a penny stock trader can make money on a truly worthless garbage company.

Don’t get me wrong. Not all penny stocks are garbage. There are some gems out them. One of them may be the next Apple (APPL) or Alphabet (GOOGL). But, our goal isn’t to be Wall Street analysts sifting through a football field of haystacks looking for one straight pin. Our goal is to spot trends and trade on them even if that means that a stock we buy is fundamentally flawed in part or whole.

Risks & Rewards

 And, that brings me to the issue of risk. This is where penny stocks get a bad rap. As I mentioned earlier, some penny stocks do trade in a shadowy, not-so-transparent world where they neither have to report earnings or even have earnings. But, that doesn’t make them bad stocks to trade. It just makes them bad stocks in which to invest. People who lose money investing in penny stocks have only themselves to blame. It’s not the stock’s fault!

Over the weekend my kids and I took our three-year-old lab puppy to the park. About ten feet away a Pitbull Terrier came charging toward us towing its master by his leash. I thought the dog was going to pull the guy’s arm out of the socket. I asked our puppy to sit, which he did instantly. Butt magnetized to the ground like it was galvanized. The puppy sat motionless. The guy with the Pitbull struggled, tugged, jerked, and pulled on the leash to keep the monster from getting close enough to take a bite out of our pup’s face. The dog was in full attack mode, barking insanely and coughing as his collar dug into his esophagus. Finally, the dog’s owner gave the beast a shot in the face so hard that it winced. Humiliated, the dog retreated as the guy dragged it away.

My guess is that the dog’s owner had never been trained on how to handle such an animal. I also figured that the two of them had never been to an obedience class or place where dogs can learn to socialize with one another. And, yet, this guy’s solution to his unruly dog was to blast it in the head with his fist. He probably was in a bad mood because he lost money investing in penny stocks. Nevertheless, it wasn’t the dog’s fault.

The market for penny stocks can be the Wild West. It is wrought with risk. But, just as a dog owner can be trained to handle an unruly pooch, so can a novice investor be trained on how to successfully trade penny stocks…and oh, by the way…that’s what I will teach you.

Without the risk there would be no reward. And, trading penny stocks can be remarkably rewarding. I have made hundreds of thousands of dollars trading – just part time – and I will teach you how to maximize profits and minimize risks.* Not all trades go my way. I do take losses. But, the methodology I use (which I will teach to you) is designed to mitigate trading losses. The biggest part of having a winning strategy is knowing when to fish and when to cut bait.

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