Day traders deal with so many tickers every day and it can be difficult to keep track of each and every one of them. All day traders have a different strategy for finding stocks to play. From stock scanners to trade alerts, there are plenty of ways to find good stocks to play each day. Regardless of how you find your stocks, you will always want to know why a stock is moving. Knowing why a stock is moving can help give you determine the magnitude of the move. I find most of my plays using a stock scanner so I have very little information when a stock is moving, other than the fact that it is moving. I don’t think I need to convince you that it’s important to know why a stock is moving, so let’s get straight to the point.
How to Find Out Why a Stock is Moving.
This list is in order of which to do first. Usually you can find out why a stock is moving from the first few items, but if you can’t, the others can be helpful.
Look at the stock chart for multiple time frames – First things first, I will look at a stock chart for the ticker I am interested in. I will look at the intraday trend, the short term trend, and the long term trend using a few different charts. This can help give you an idea as to how the stock trades from a historical perspective. It can also let you know if the stock is moving on a technical breakout. I use my trading software for charts, however, you can always use StockCharts.com.
Check for news – Most of the time, when a stock is making a big move, it is due to a news story or press release. I will check Yahoo Finance, as well as some other sources, to see if there is news moving the stock. This also includes analyst upgrades/downgrades. I will analyze the news to see how good/bad it is and try to determine how much it can move the stock.
Check for a Seeking Alpha article – Sometimes, when there is no news on a stock, there may be a Seeking Alpha article. These articles have been able to move stocks a lot as of recently. Sometimes, the article will be shown on Yahoo News, however, sometimes it won’t so I check the actual Seeking Alpha website.
Check the message boards – While message boards are usually filled with useless banter and wild predictions, they can be helpful to check when a stock is moving, especially if it is a penny stock. You have the advantage of a large group of people all working together to provide information. You can usually discover what is moving the stock because it will be mentioned on the board. I use Investors Hub as my go to message board. Don’t get caught up in listening to people’s opinions. Focus on the facts and learn why the stock is moving.
Check Twitter – This is similar to checking a message board. Just do a search for your stock name in the Twitter search bar with a dollar sign in front of it (ex: $AAPL). Sort results by “All” instead of “Top”, and you can see all of the most recent tweets about your stock. Sometimes you can get some valuable insight. Once again, focus on facts not opinions.
Check for a stock promotion – Stocks can move a lot when being pumped by people with large email lists. There are a few websites that keep track of these promotions. I like to use the Stock Promoters website to check quickly. I also subscribe to a lot of penny stock newsletters so I can find out earlier.
Check for a short squeeze – A stock can run exponentially when shorts get squeezed out of their positions. I like to know how many shares are short and how many days it would take to cover. You can use the Short Squeeze site for some bigger stocks or OTC Short Report for penny stocks. I don’t think this data is always 100% accurate but it is still good to know.
Check SEC Filings and OTC Market Filings – Sometimes a stock will move based on a recent SEC filing. Check the EDGAR website or the OTC Markets (for penny stocks) to see if a company just released an important filing.
Check indices and sectors – Some stocks move with the market so it is important to know what the market is doing. I pay attention to larger indices like the S&P 500 (SPY), Dow Jones Industrial Average, and Russell 2000. I will also check certain sectors to see if they are “hot” an a given day. I use my stock software to get this information, but you can always check a site like Bloomberg to get your information. This kind of analysis is best for bigger board stocks like NASDAQs.
What Next?
Finding out why a stock is moving is just the first step. You will want to create a solid plan for trading the stock next, but that’s a completely different topic. The process outlined above is simple:
Find out why a stock is moving
Determine the magnitude of the move
Create a plan to trade the stock
You can also use the resources mentioned above to find stocks for the next trading day. Knowing why a stock is moving provides clarity in the market and can help you become a better trader. The more you know about the move, the better.
If you have been trading penny stocks for awhile, you probably know that most of them are junk companies. Manipulation, poor business practice, falsified information, and other negativity surrounds the world of penny stocks. That being said, every now and then you can find a gem; a company that defies penny stock stereotypes and positions itself for future success. It can be very easy to get excited about a company like this, especially when you catch on to it before others. The thought of multi-hundred/thousand percent gains can be rather enticing. This feeling of excitement can be further stimulated when you read message boards where other people share your disposition to the stock and start building hype. There’s nothing wrong with that. These are all different elements that make the penny stock markets operate the way they do. But, you don’t want to be a pawn in the penny stock world, do you? If you want to have an advantage, you need to stop thinking like the masses and start seeing what others don’t.
Here are a few of the trades I have made using this strategy:
$1,212profitAMMXLong Stock Still holding more shares long. Just wanted to lock in profits
$2,260profitMYECLong Stock This is one of my fundamental long plays. The company seems like it has a bright future as of now. I locked in profits just in time, considering the price dropped a little over 10% later in the day
So many people love to say that they are long on a stock. “Long and strong man, yeah!” These traders will hold a stock for huge periods of time (at least they say so) because they are convinced that they found the next Microsoft on the ground floor. Don’t be naive. Most penny stocks fail. You need to take advantage of the price action if you want to maximize your profits.
You need to remember these things:
1. You are not indebted to the company. You don’t need to be a “loyal” shareholder. Loyalty is a good trait in the real world, however, it has no place in the world of penny stocks because there is no reciprocation of that loyalty. The company you invest in won’t pay your bills if you lose all of your money in their stock so don’t become a bagholder. Sure, you can brag about how you’ve been holding a stock for over a year, but no one really cares.
2. All stocks fluctuate, but penny stocks are more volatile. It’s important to keep in mind that all stocks go through cycles. Some days they will be up, others they will be down. The difference between penny stocks and big board stocks is that penny stocks are much more volatile. While a big board stock may trade in a +/- 10% range, a penny stock may be up 100% 1 day and down 50% the next. Your investments should not go up and down like a roller coaster because your portfolio will never have any stability. You need to take advantage of a stock’s big moves to keep your investment safe. This doesn’t mean that you don’t believe in the company you are investing in. It means you believe in the company, but recognize that the stock’s movement is not fully in your control or the company’s control. You are accounting for external conditions that affect your stock and taking advantage of them instead of allowing them to sabotage your investment. Some people like to call out “flippers” who constantly buy a stock when it is low and sell it when it is high, but these traders are the ones that keep the stock active. Think about it, if there weren’t flippers, there would just be a bunch of longs holding shares and the stock wouldn’t have any volume. True longs lock up the float so they have their place as well. There are pros and cons to each trading style, but I much prefer swing trading stocks (flipping) to holding for a long period of time and exposing myself to unnecessary risk.
3. The company doesn’t matter; the price action does. Let’s just say you found a company that has the potential to be “the next Microsoft.” Good for you. However, this company is only as valuable as the market perceives it to be. Yesterday (May 15, 2014) a company called MYEC (used in an upcoming example) released some impressive financials. They had a net profit of $1.3 million for the first quarter of 2014 and they are growing at a rapid pace. This is very rare in the world of penny stocks. You’d think the price would have skyrocketed on that news, right? Wrong. The price of the stock actually dropped around 10% following the financials. Clearly, the market didn’t care how “great” the company is. In order to take a holistic approach to your investing, you need to understand both the company and the people trading it. After all, traders/investors are the ones pushing the price up and down.
4. Understand the terrain. Know who you are trading with. Everyone has different trading styles and you need to think about how other people are going to be trading a stock. If you’re long on a stock, you need to understand that there are also scalp traders, swing traders, shorts, etc. Different traders have different styles. So, while someone who is long on a stock may hold it as it goes up a few hundred percent, a swing trader may be happy with quick 50% gains. The assumption that everyone will go long on a stock if the company is good and the price is rising is flawed logic. Not everyone is trying to invest in companies. Understanding this helps you understand price action. If a stock runs 100% in a few days, you can expect that there will be sellers entering the market soon. Using my strategy, you would sell during the run up and buy back when the price dips. You believe in the company but you also understand how the stock trends and, therefore, don’t fall victim to its volatility.
To better understand my strategy, let’s use an example:
MYEC is a prime stock to use as an example to convey this strategy. I first bought into the stock at .0025 because I did some fundamental analysis and actually liked the company. Mentally, I was long on the stock. I believed it had great potential. That being said, I didn’t hold all the way from .0025. I pulled swing trades along the way to limit my risk. This can limit your profit as well, but its important to understand that not all stocks play out the way you want them to. I would sooner take smaller profits than I would expose myself to big potential losses.
Let’s look at longs vs. flippers for a three month time period, assuming all orders were 100,000 shares.
The Long Strategy
Buy 100,000 shares at .0042 on February 18, 2014 for a cost of $420
As of today, May 16, 2014, those shares would be worth $3940 for an unrealized profit of $3520.
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Keep in mind, that this profit can go up or down at any time. On March 28, 2014, those same shares were valued at $8200. By the end of the year, the shares may be valued at $20,000+ if the stock goes up considerably, or back to $420 if the stock drops back down. There is a lot of uncertainty in this method because you do not know what catalysts will approach during the year. You can definitely make huge gains, but you can also lose a lot of money.
Now, look at a “mentally long” swing trader standpoint on the same 3-month period.
The “Mentally Long” Swing Trader Strategy
A swing trader must be able to spot trends, especially tops and bottoms. Rarely will a swing trader be able to time tops and bottoms perfectly, but you can get close. For this example, I used realistic numbers that were not exact tops and bottoms. They were prices that the stock traded at for a few days, making them feasible entries or exits.
Buy 100,000 shares at .0042 on February 18, 2014 for a cost of $420
The stock shows strength for awhile and you decide to sell at .03/share on March 3 or 4 for a profit of $2580
The stock pulls back down the next few days and you buy 100,000 shares again at .02 on March 5 or 6 for a cost of $2000
The stock runs again but starts pulling back so you sell at .038/share on March 10, 11, or 12 for a profit of $1800
The stock starts bottoming out and you buy back 100,000 shares at .023 on March 17, 18, or 19 for a cost of $2300
Now, the stock is moving again on news and you decide to sell shares at .069/share on either March 26, 27, 28, 31 or April 1 at .069 for a profit of $4300
The stock comes back down and you decide to buy 100,000 sharesagain at .041 on either April 2, 4, or 7 for a cost of $4100.
The stock starts to run and you sell at .059/share on either April 9, 10, or 11 for a profit of $1800.
The stock continues trending down and sideways while losing volume so you don’t place a trade during consolidation
On April 30, the stock drops a bit more and volume is coming in again. You buy 100,000 shareson either April 30 or May 1 at .029 for a cost of $2900
The stock starts gearing up again and you sell those shares at .048/share on May 12, 13, 14, or 15 for a profit of $1900.
Now, we are at present date (May 16, 2014), the stock is trending down and you don’t have a position. You wait to see where the price action goes and you follow it. You are not exposed to any risk because you are not holding shares.
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Keep in mind that throughout these past 3 months, you have been mentally long on the stock. You never short sell it, but you take advantage of the dips and spikes. You’re never holding shares for too long so you’re risk is minimal and you lock in gains that are used to buy future shares.
So let’s compare the two:
Long Strategy:
Initially, bought 100,000 shares at .0042 for $420 on February 18, 2014
Has an unrealized gain of $3520 by May 16, 2014.
Still holding 100,000 shares which can increase or decrease in value throughout the year
“Mentally Long” Swing Trader Strategy:
Initially, bought 100,000 shares at .0042 for $420 on February 18, 2014
Swing trades the stock for 3 months and has a realized gain of $12,380 on May 15, 2014.
No longer holding any shares. At this date, the “mentally long” trader is exposed to zero risk and can still buy back in at any time.
In Summary
Everyone has their own strategy, and if you are making money, you are doing it right. It is not my goal to critique anyone’s strategy because we all trade differently, and, at the end of the day, everyone is just trying to make money. The strategy outlined above is one that works exceptionally well for me. It allows you to minimize your risk and lock in profits along the way. Swing trading like this can limit your risks, however, it can sometimes limit your profits. If you are not holding shares before a strong catalyst is approaching, you may not be able to get your desired entry. That being said, I would rather miss out on profits than succumb to losses. As a long term investor, dips and spikes don’t matter. As seen on the MYEC example, the parabolic spikes in the stock didn’t even affect the true longs because they weren’t selling. I prefer to lock in my gains. Profits mean nothing until you claim them.
Try to focus on this strategy next time you find “the next hot pick.” Know that you can believe in the future of a company and be “mentally long” whilst taking advantage of the dips and spikes in the stock price. This works well for active day/swing traders. If you don’t watch the market every day, this can be much more difficult. My strategy revolves around active trading and I would never invest in a penny stock without watching it constantly; they’re far too volatile.
One of the most difficult things about investing is that it can be difficult to make sense of all of the information available to you. Most companies have an abundance of SEC filings, press releases, and other important documents. Chances are you have read plenty of quarterly reports, financial statements, and company press releases, but do you really know how to interpret these documents?
The documents mean nothing unless you can interpret them properly. That being said, filtering out the proper information is not always easy. I believe that this may be due to the fact that this information is not very relatable. After all, in your daily life, how often do you have to deal with cash flow, assets/liabilities, operating costs, etc.? You may be surprised to find that this information can be very relatable, and therefore understandable, if you know how to think about it properly.
If you are a business owner, you have an advantage. If you are not, you can still make sense of all of this. Every single day, you probably invest in something without even noticing. Just think about the last time you bought an electronic device, such as a smartphone. There are plenty of phones you could have purchased, but you settled on a particular one. You may have been influenced by the price, the value of the phone, the features, the warranty, the customer service, the resale value, etc. The point is that you either consciously or subconsciously thought about what your opinion of the ideal phone was and you analyzed the selection to choose a phone that best suits your needs. Maybe you didn’t buy an iPhone because you perceived it to be a bad value when you compared the cost to the features. Maybe you didn’t buy a Samsung because it didn’t sync well with your other devices. Regardless of the phone you chose, you had a list of criteria you were using to evaluate the product and you found the phone that best matched that criteria.
Investing uses the same framework. You have a list of criteria that you believe make up a good company and you try to find companies that best match those criteria. The thing most people get caught up on is creating the proper list of criteria. Creating this list can be simplified if you can find a better way to organize the information in your head. You should stop thinking of the companies you invest in as mystical entities that are hard to understand. Keep things simple by modifying your thought process. The strategy that works best for me is thinking of public investments in stocks as private investments in companies. This works well for me because I have bought and sold private companies in the past, however, a lot of the strategy is based purely on common sense so anyone can apply this.
Let’s break things down to how you would approach almost any purchase:
1. Is it a good value?
2. Does it fulfill a need of mine?
3. Is it a quality product?
4. Are there better alternatives?
5. Are there any clear red flags?
Let’s run through this thought process on something as simple as going out to eat.
(Yes, I am comparing investing to going out to eat)
Let’s say there is a new steakhouse in town and you are thinking of going.
1. Is it a good value? Are you paying $20/steak or $200/steak? Are the steaks worth what you pay for them? Lower cost doesn’t mean higher value. You get what you pay for.
2. Does it fulfill a need of mine? Am I hungry? Am I in the mood for steak?
3. Is it a quality product? How are the reviews of this restaurant? Do they serve good steaks? Is the restaurant nice? How is the service?
4. Are there better alternatives? Will this new steakhouse be better than the one I usually go to? Can I get a better meal elsewhere?
5. Are there any clear red flags? How is the chef’s reputation? Any cases of food poisioning at this restaurant? Does the restaurant have a good cleanliness rating?
I am well aware of the fact that using the example may seem somewhat ridiculous. Chances are, you don’t read many articles that talk about both stocks and steak. I am trying to make a point here. You make investment decisions subconsciously on a regular basis. These decisions are not difficult because you know exactly what you are looking for. You have a list of criteria branded into your thought process and you utilize that list for easy decision making.
Now, let’s look at this list of questions from the investment standpoint:
1. Is it a good value? How much is a share in the company really worth? If I buy 100,000 shares, how much of the company do I own? What is my money really paying for when I invest in the company?
2. Does it fulfill a need of mine? Does this stock fit my investment strategy? If I want to sell the stock in a year, will it be at the price I want it to? AAPL may be a good value and provide quality product, but they do not match my investment style so I wouldn’t buy and hold shares.
3. Is it a quality product? Is this a good company? How efficiently is it run? Do they sell something that people actually want? What are the chances of this company growing in their competitive industry?
4. Are there better alternatives? Are there any companies in this industry that are doing better/better values? Are there other stocks that are better values? where is my money best spent?
5. Are there any clear red flags? Does the management have a sketchy past? Does the company have a going concern? Are there any lawsuits?
Asking these questions is just the beginning of your research, however, they allow you to approach investing with a similar thought process that you use for making everyday decisions.
Now, let’s get to the good stuff. Let’s look at how you would apply this to a real company.
The goal is to think about companies like a private investment in order to demystify the world of investing.
Here’s a fictional example using an investment into a private company as the basis for comparison. The example is long, so you can skip straight to the lessons if you would like.
Sample Due Diligence Process:
Your friend has been running a restaurant for the past year and has learned that you invest in private companies. He approaches you because he wants you to invest in his company.
Your friend owns 10% of the company and offers you a 10% stake in the company for a $100,000. He believes the company is valued at $1 million so this is a fair deal.
From this one sentence alone, we already have so much information that relates to investing in stocks.
First off $100,000 buys you a 10% stake in the company. This relates to how many outstanding shares a company has. If you buy 100,000 shares in a company, how much of the company do you really own? Well, if the company has 1,000,000 outstanding shares, you own 10% of the company. If the company has 100,000,000 shares outstanding, you only own 0.1% of the company.
First lesson:Look at how many outstanding shares a company has. This determines how valuable each share is.
Another important thing to look at is the fact that your friend owns 10% of the company. This relates to insider ownership of a company. Look at how many shares insiders hold. For this particular example, your friend runs the company and owns 10% of it. He is asking you to buy 10% of the company as well. If the company is so great, why doesn’t your friend have more than a 10% stake in it? Why is he offering you 10% of the company instead of just buying it himself? If the company fails, your friend doesn’t have too much at stake, therefore, he may not be as motivated to make the company succeed. Additionally, this means that 90% of company is available to outsiders. From an economic perspective, supply is high, so price may be lower.
Second Lesson:Look at how many shares insiders own. This can help you see if management truly believes in the company.
Third Lesson: Look at a stock’s float. The float is the amount of shares available on the public market to be traded freely by traders and investors. The lower the float (supply), the higher the demand can be. Higher demand for a stock can allow the stock price to rise faster. This is why a lot of traders go out of their way to find low float stocks. Imagine a stock trades at $0.03/share and you want 100,000 shares. If the float is 500,000,000 shares, it may be pretty easy to get your shares at the desired price. If the float is only 1,000,000 shares, it would be harder to get 100,000 shares at $0.03/share without driving the price up. The lower supply of low float stocks means that demand for the stock can push the price up much faster as investors are “fighting” to get the shares they want.
The last piece of data available in the sentence above is that the company is valued at $1 million. Well, who decided this? Is this valuation fair? This relates to a stock’s market cap. The market cap is the number of outstanding shares multiplied by the share price of a stock. If a company has 1,000,000 outstanding shares valued at $1 each, the market cap is $1 million. The market cap is the company’s valuation as determined by the trading activity. A lot of investors will ignore this metric when placing trades, however, it is important to look at if you are actually investing in a company because this allows you to determine if a company is over valued or undervalued. You want to find undervalued companies.
Fourth Lesson:Look at the market cap to see a company’s valuation. Decide whether you believe it to be overvalued or undervalued.
Let’s move on with the example to help you understand how to value a company.
Being a diligent investor, you want to know more about your friend’s business. How much money do they make? Do they have a lot of liquid assets? What kind of liabilities do they have? Your friend tells you that their restuarant brings in revenues of $500,000 every year, $100,000 of which is profit. They have assets such as their restaurant’s equipment, their building, and some cash in the bank. The equipment is valued at $100,000, the property is valued at $100,000 and the company also has $100,000 in cash for a total of $300,000 in assets. The company is also paying off a $500,000 loan and they still owe their employees $50,000 in wages for a total of $550,000 in liabilities.
This brings up a few things you need to look at. First off, the company makes $500,000 in revenues but they only keep $100,000 of those. As a diligent investor, you wonder where the other $400,000 is going. Is that the cost of food? Is that the cost of paying management and staff? Knowing these things would help you determine how efficiently the company is being run. If the restaurant is spending $100,000/year on their floor manager’s salary, you may decide that the company is being run inefficiently. You can look at a company’s Cash Flow Statement or Income Statement to track expenses and revenues.
Fifth Lesson:Look at a company’s financial statements to see what is “under the hood.” Think about how money is being spent. Is the company getting the best prices on their inventory (Cost of Good Sold). Is the company paying their management team too much (Selling, General, Administrative costs)? Don’t let this part of a company’s financial statement confuse you, as it is very basic. Think about this: If you were trading stocks and made $500,000 on the year but had to spend $450,000 to do so, would you be trading efficiently? Sure, you made $50,000 on the year, but why the hell did you have to spend $450,000 to do so? Apply the same logic to how a company manages their money.
The next important thing to look at is how much your friend’s company owns and how much they owe. This relates to assets and liabilities. Your friends restaurant owns $300,000 worth of assets and owes $550,000 to other people. This means they have net tangible assets of ($250,000), meaning they owe much more than they own. Clearly this is not a good thing. Someone may own a Lamborghini valued at $200,000, but if they have $300,000 in outstanding credit card bills related to the purchase, they really aren’t too well off. You wouldn’t consider that person to be good at handling money, would you? Apply this same logic to a company you invest in. This shows how responsible a company is when it comes to managing money.
Sixth Lesson:Always look at a company’s assets and liabilities. This will help you gauge how much the company owns compared to how much they owe. Essentially, it is the company’s net worth. Look at a company’s net tangible assets to see if they own more than they owe, or vice versa. Don’t treat all assets and liabilities the same. Make sure you understand what they are. For example, a company may have $1.3 million in assets, however, if you look closer you may see that $1 million of those assets is intellectual property. $1 million in intellectual property is worth far less than $1 million in cash. A lot of penny stock companies get tricky/sneaky in this part of their financials so be careful.
Let’s move on with the due diligence.
Your friend’s restaurant has only been open for a year. You understand that it may not be the best idea to base your decision off of only one year of data so you dig deeper. You ask your friend to see monthly financial reports so you can see if the company is growing. Your friend shows you the reports and you see that revenues are growing by 5% each quarter, liabilities are growing at a rate of 10% each, and assets are decreasing at a rate of 5% each quarter.
First things first, you see that the company is bringing in more money each quarter (revenues). This is good. It means the business is growing and more customers are taking an interest in the restaurant. That being said, the company is growing their liabilities (things they owe) much faster than revenues are increasing (10% vs. 5%). Additionally, the restaurant’s assets (things they own) are dwindling at the same rate the revenues are increasing (5%). This means the revenue growth really is not too impressive.
Seventh Lesson:Look at a company’s growth rate from multiple perspectives. Look at revenues, profit margins, assets, liabilities, etc. A company may be able to increase revenues by 100%, but if they have to take out a loan to fund a massive marketing campaign, that may not be too impressive. Let the numbers talk. A company’s growth rate should be looked at holistically. Ask yourself this: is the company getting more or less valuable each quarter? This requires that you look at the company as a whole and interpret the financial statements at a core business level. Revenues may be decreasing or flatlining, but profit margin and assets may be increasing. This would tell you that the demand for the company’s products may be decreasing or flatlining, but the company is running more efficiently internally. Contrarily, the revenues may be increasing while the profit margin decreases and liabilities increase. This would show you that the company is stimulating demand for a product, but they are not scaling up their business model efficiently. In short, think about growth holistically in order to understand what direction the company is moving in.
By now, you have seen a lot of the numbers, but you want to better understand some other elements of the business. You ask your friend if there have been any problems at the restaurant? He mentions that their Yelp page has an average rating of 2-stars, their employee turnover is very high, and some new competing restaurants just popped up in the neighborhood. You proceed to ask him who is running the restaurant and what their plans are for the future. Your friend gives you a list of the key players in the restaurant and let’s you know that the restaurant plans to start franchising in the upcoming year in order to increase profits.
By asking your friend about some of the problems in the restaurant, you learn about the risk associated with your investment. The restaurant has a bad reputation based on online reviews, employee retention is high so their may be an internal management problem, and competition is increasing which may create a going concern. You know know about the business’s weaknesses and the factors that may threaten their existence. This leads to 2 important points.
Eighth Lesson:Look for red flags. Dissect a company’s business and see what you need to be worried about in the future. Any negative catalysts that may be approaching can put your investment at risk. You need to know about these.
Ninth Lesson:Look at competition. A company may be doing well, but there may be another company doing much better. Which would you prefer to invest in? Strong competition threatens a company’s existence. Analyze their competition to understand 2 things. 1) Is there a going concern for this company? 2) Is there a better company I can invest in?
The next question you asked your friend was about who was running the company. A business is only as good as the people running it. If you looked into your friend’s restaurant and found out that their management has a sketchy past and a history of running failed companies, you would probably avoid the investment.
Tenth Lesson:Look at a company’s management. Understand who is running the company and decide whether or not you think they are capable of making it succeed. Every decision a company makes is made my a person. If you know who these people are, you can gain some foresight into the company’s future direction.
Lastly, you asked your friend about plans for the future. Your friend mentioned that they want to franchise the company to increase profits. This could be huge if done effectively. You now know that a positive catalyst is coming and this may make the company more valuable.
Eleventh Lesson:Look at a company’s future plans and see if any positive catalysts are expected. A company may be decent based on their current performance, but a huge deal may be in the works that will take the company to a new level. Know what is expected so you can make a good long term investment.
Summarizing this example:
Here are the facts you collected from the analysis:
Your friend offers you a 10% stake in his restaurant for $100,000.
Your friend also owns 10% of the company
The company is valued at $1 million.
The company brings in $500,000/year (revenues) and keeps $100,000 (net income).
The company has $300,000 in assets and $550,000 in liabilities for a total of ($250,000) net tangible assets.
The company is exposed to risks such as poor customer reviews, high employee turnover, and increased competition.
The company has positive catalysts such as plans to franchise to increase future profits.
Revenue is growing at 5% while assets dwindle at the same rate (5%) and liabilities increase 10% each quarter.
So, Would you invest in this company?
Helpful Tip: Remove the extra zero’s from a company’s financials so they can be easier to understand. You may not be able to internalize the concept of paying $100,000 for a company that brings in $500,000 in revenues, but you may be able to fathom the idea of paying $100 for a company that brings in $500/year.
Personally, I would not invest in this fictional company for the following reasons:
Your friend, the owner, only has a 10% stake in the company. This doesn’t show much faith in the company’s future.
The company owes more than they own (net tangible assets). This means the company has a negative net worth. Why pay money for something that has a negative value?
Revenue is growing at a minimal rate, but liabilities are increasing twice as fast. The company is spending much more than they bring in. How are they going to be profitable like this?
The company is valued at $1 million. This seems like an overvaluation. They only bring in $100,000 year and they owe a lot of money. Let’s say I were to get 10% of the profits for my 10% investment in the company. That would mean I would make $10,000/year so it would take 10 years to break even on my investment, let alone make a profit. Additionally, this assumes that revenues do not decrease over the years. It also fails to account for the fact that liabilities need to be paid. The chances of me making a profit in the next 10 years are very slim.
Their are a lot of threats to the company’s existence. The negative Yelp reviews show that the product is not that great. The increased competition shows that their is a lower barrier-to-entry for this industry and making a profit is only going to become more difficult. Employee turnover is high meaning that management does not know how to keep their employees happy.
Sure, a franchising plan is in the works, but the company hasn’t even made their current business model successful yet. How are they going to make a new one successful?
In Summary
All of these numbers are made up and the analysis was not very in-depth, however, it is meant to serve a point. The main point of this entire article is to think about what every number means and how you can relate that to thought processes you already use. This helps you understand what exactly you are investing in. When you hear statements such as “The company brought in $1.8 million in revenues during the first quarter?” does it mean anything to you? No, that can mean anything. You need to put it in context in order to understand whether this is truly a good investment.
Make investments in public companies relatable to your daily life. Everyone can take different approaches to this based on how their brains work, however, the end goal is the same: demystifying investing.
Someone else may read the example above and decide that it looks like a good investment even though I didn’t. That is 100% okay. Everyone has a different investing style so everyone will want to invest in different companies. The goal is not to make the same decision as the majority of people; it’s to understand what you are analyzing. You need to be able to make sense of the abundance of data you have access to. If you can do that, you are ready to start investing.
For the longest time, I was focused solely on the percentage gains of any trade. I would look at a stock price and determine how much it would need to run for me to get my desired percentage gain. Usually, I would look for gains of at least 10%, so if a stock was at $8/share, I would want to make $0.80/share, and if it were at $2/share, I would want to make $0.20/share. If I didn’t think a stock could run at least 10%, I would avoid it. After all, high percentage gains are one of the main reasons I love penny stocks. That being said, I don’t only invest in penny stocks, so I account for other scenarios so I don’t miss out on easy trades.
Recently, I have changed my strategy for one main reason; I rarely use all of my cash in one trading day. Percentage gains really do not matter too much if you are not leveraging all of your cash. Additionally, I set my risk exposure based on dollar amounts and not percentage amounts. If my risk exposure for each trade is $200 (it varies for me), that remains constant, and I don’t care if I invest $1000, $2000, or $10,000 on the trade.
This post is not about some revolutionary new trading strategy, but simply a different perspective that may open the doors to more possible trades.
Think about this:
For this example, assume both stocks mentioned below have the same dollar risk/reward ratio of 1:1 with a potential risk of ($0.20)/share and a reward of $0.20/share. Here is how this trade would work when things go as planned.
Scenario A1: You buy 1000 shares of a stock at $8 and it runs to $8.20 where you sell it. You made $200 on an $8000 investment.
Scenario B1: You buy 1000 shares of a stock at $2 and it runs to $2.20 where you sell it. You made $200 on a $2000 investment.
Scenario A yields a 2.5% gain while Scenario B yields a 10% gain. Scenario B is clearly a better trade, BUT they both yield the same return of $200.
Both trades have their advantages and disadvantages. The obvious argument here is that you should compare both trades using the same initial investment.
Sure, let’s do that.
Scenario A2: You buy 1000 shares of a stock at $8 and it runs to $8.20 where you sell it. You made $200 on an $8000 investment.
Scenario B2: You buy 4000 shares of a stock at $2 and it runs to $2.20 where you sell it. You made $800 on a $8000 investment.
Scenario B is looking a lot better now right? Well, yes and no. You forgot that the trade can also go against you. Scenario B may expose you to more risk than Scenario A. Of course, every trade will be different, and it is important to assess risk levels before entering a trade. However, as mentioned above, these stocks have a risk of ($0.20)/share as well.
So, how would the trade work out if it went against you?
Scenario A3: You buy 1000 shares of a stock at $8 and it drops to $7.80 where you sell it. You lost $200 on an $8000 investment.
Scenario B3: You buy 4000 shares of a stock at $2 and it runs to $1.80 where you sell it. You lost $800 on a $8000 investment.
As we saw above, your gains were increased by using the same initial investment on both trades, however, so were your losses. If your maximum risk exposure was $200/trade, you could have never placed the trade in Scenario B because it exposes you to $800 of risk.
What’s the point of all of this?
In no way am I saying that the trade in Scenario B2 is a bad move. I’m just trying to shine light on the fact that percentage gains should not be your only focus. Imagine that one investor takes their portfolio from $1000 to $2000 by the end of the year, while another takes theirs from $20,000 to $25,000. The first investor enjoys an 100% portfolio gain, while the second enjoys a 25% portfolio gain for the year. At the end of the year, the second investor still made more money ($5000 vs. $1000) which is the real bottom line of investing.
Here’s a day trading example. Let’s say your average trade size is $10,000. If you make one trade in the day that yields 10%, you make $1000 for the day. 10% gains are harder to come by so you will be limited in the amount of trades you can find. If you make 10 trades that yield only 2.5% each on $10,000 investments, you can make $2500 for the day. Of course, stocks that run 2.5% intraday are much easier to find than stocks that run 10%.
What You Need to Account For:
1. How much free cash you have in your account – If you have a smaller account, you will want to focus on percentage gains because they will help you grow your portfolio faster. If you have a larger account and don’t use all of your cash every day, it would be wise to consider taking some smaller percentage gains to grow your account. This will be better than just letting your cash sit, especially if you can find low risk trades.
2. Pattern Day Trader Rule – Accounts with less than $25,000 are limited to a maximum of 3 round trips per week (round trip = buying and selling the same security during the same a day) based on SEC guidelines. If you can only make 3 round trips a week, you will want to make them count. You should be focusing on percentage gains because you are limited in the amount of trades you can make.
3. The Time Value of Money – This article is targeted towards day traders who buy and sell stocks within the same day. If you are holding a stock for more than a day, percentage gains are more important because your money is tied up until you sell the particular security.
4. The Dollar Risk/Reward Ratio for a Trade and Your Risk Exposure– This is by far the most important thing to account for. In the above examples (Scenarios A & B), there was an assumption that both trades had the same risk/reward ratio from a dollar gain/loss stance. This will not always be the case. When trading stocks with lower percentage gains, you also want lower risk. This allows you to leverage a higher percentage of your portfolio for the trade. So, in my fictional examples above, both stocks had a risk of ($0.20) and a potential reward of $0.20 (a 1:1 risk/reward ratio). Assuming the amount of shares you bought and the risk/reward ratio were constant, and the price per share varied, this made it so it didn’t matter whether you were investing $2000, $5000, or $10,000 because your risk was always $200 for the trade ($0.20 risk * 1000 shares). The percentage of my portfolio that I invest in a trade is relative to the dollar gain/loss per share, not the percentage gain. This leads to the next important reason why the risk/reward ratio is critical when focusing on percentage gains vs. dollar gains. Let me run through one more quick scenario:
Scenario A: Your portfolio has $50,000 in it. Your maximum risk exposure is $500 per trade. You find a stock trading at $10. The stock has a risk of ($0.10)/share due to a strong support level, and a potential gain of $0.30/share from an intraday bounce. The potential percentage gain is only 3%, yet the potential risk is only 1% for a 1:3 risk/reward ratio. This allows you to leverage a much larger percentage of your portfolio in the trade. In fact, based on your set risk exposure, you could even leverage your entire portfolio (you should never invest your entire portfolio in a trade, but this is a theoretical example). You can now purchase 5000 shares of the stock at $10, for a maximum loss of $500 (your set risk exposure) and a maximum gain of $1500. This fictional stock only has to run 3% for you to make $1500.
Scenario B: Your portfolio has $50,000 in it and your maximum risk exposure is $500 per trade (Kept constant throughout both scenarios). You find a stock trading at $1/share. The stock has a risk of ($0.25) based on a strong support level and a potential gain of $0.50/share due to a positive press release. The potential gain is 50% and the potential loss is 25% for a 1:2 risk/reward ratio. Based on your maximum risk exposure, you can buy 2000 shares at $1 (2000*$0.25/share risk = $500). If the trade goes in your favor, you make $1000. If it goes against you, you lose $500. This stock has to run up 50% for you to make $1000.
Scenario A yields a better dollar gain ($1500 vs. $1000) even though the percentage gain is 47% lower than Scenario B. Of course, you had to use more cash from your portfolio, but as mentioned in the first point on this list, if you have the free cash, you might as well use it. Keep in mind that understanding the real risk/reward levels is critical to the success of this tactic, and, you should always account for the fact that things may not go as planned. A stock’s price action doesn’t follow definitive rules and risk/reward levels may be breached at any time.
How to Use This in Your Trading
As mentioned at the beginning of the article, this is not some revolutionary new trading tactic. It is just a different way to look at day trades. I’m sure many traders already utilize this strategy. Apply this in a way that compliments your current trading style.
By no means do you want to turn this perspective into a strict trading rule. Both percentage gains and dollar gains matter at different times. Personally, I have used this strategy to shift my perspective on trading gains in a way that has opened the doors for more profitable trades. By recognizing that the bottom line of trading/investing is how much money you can bring in, you can look at certain trades in a new light. I look at each new trade based on how much money I think I can make while limiting the position size to account for my set dollar risk exposure. Some traders recommend choosing position sizes based on a percentage of your portfolio (eg: 10% of your portfolio used for each trade). That strategy is solid and helps minimize risk, but it can also limit your trading possibilities. I no longer care how much of my portfolio I leverage as long as I keep my risk exposure constant, nor do I care about my percentage gain on a trade as long as I achieve the dollar gain I desired.
As a day trader, you see a lot of stocks on a daily basis. It is easy to focus on the present movement of a stock and forget that it has a long history. Of course, you analyze charts from multiple time frames, however, this is sometimes not as insightful as it should be. While it wouldn’t be efficient to learn the back story of every single stock you trade, there are certain times when it is appropriate. The first one being for sub-penny stocks or anything under $0.05 trading on low volume.
Sub-penny stock movement confuses a lot of people because they don’t know what drives it. While there are obviously a lot of factors driving the price movement, there is usually one that overpowers them all: the story. If you’ve traded sub-penny stocks before, you must be familiar with “the story.” Every stock has one. It either goes something like “This company is garbage and we are waiting for them to fail” or “This is the next Microsoft. Millionaires in the making here..” 90% of the time, a stock’s back story is as unsubstantiated as this statistic. That doesn’t matter though. What matters is that people tell themselves a story and trade accordingly. Additionally, other people are influenced by the stories of others, which affects price action as well. Read my post on market sentiment to learn more. Learning these stories can help you understand why a stock’s seemingly random movement is actually not random at all. Sometimes movements can be triggered by a post on a message board, a social media update from the company, or an expected news event that was announced months ago. It can be hard to understand this story simply by looking at the press release history, especially if you are looking for recent news. Sometimes a press release may seem like good news, but a stock’s story can disprove that theory or solidify it even further.
Another time you will want to know the back story of a stock is when it is moving upward exponentially. Sometimes this can be due to a pump and dump scheme, positive news, or some other factor, however, learning a stock’s history can tell a lot.
Let me use a simple example to support my point. Last week, I did a post on a stock called HDY because it had a perfect intraday technical breakout. What I missed was that the press release that triggered the breakout was more important from a fundamental standpoint than I expected.
Let’s look at the HDY daily chart real quick:
Notice anything that seems important? How about the huge drop on March 12, 2014? There’s also the huge breakout on May 5, 2014. Could the two be related? Well, obviously that is my point.
Now, if you were new to this stock, as I was, this news may not seem like a big deal. After all, I barely remembered what a Force Majeure was from my previous law classes so I did not expect the stock to run. Doing some basic research on the history of the stock would have told you that this was a huge event. The story on May 5, 2014 practically filled the entire gap caused from the gap down on March 12, 2014. This movement makes sense, however, HDY jumped almost 200% on May 5, 2014 so the move didn’t seem very sustainable.
So, How do you incorporate this into your trading strategy?
Always take a holistic approach to your trading. Take all factors into account. Think about who is currently invested in the stock, who has the stock on their watchlist, what major catalysts can move a stock, etc. Charts are useless if you do not use them to tell a story. Try to think about a stock like a real business. If you were buying a real business, you would want to know all of the details. If the business’s value dropped considerably at one point, you would want to know why. You would also want to know who the customers of the business are (shareholders for this analogy). You would want to know about all current issues the business faces.
Don’t get me wrong, the majority of the time I trade, I don’t do this. I make trades off of the charts and don’t think twice about what a company does. That being said, I try to make my strategy as holistic as possible. When I see a big mover that is worth my time, I do fundamental research. You can never know too much about the stock. This is a whole different strategy from technical trading. I don’t only trade technical setups. In fact, some of my most profitable trades have been from learning a company’s story and placing trades accordingly. Keep in mind that knowing a story is different then believing a story. You want to know the story so you can understand how other traders are thinking. You do not want to believe the story as you will fall victim to the same thought process of the majority of investors, which can cause you to lose your competitive edge.
As always, do not take my trading tips as concrete strategies that should be implemented into every trade. Use these tips as tools and use them when they are necessary. I use different strategies for different trades, however, I like having a full toolkit at all times.
One of the hardest mental obstacles to overcome when trading is recognizing that stocks can still run higher when they already seem overextended. Common sense tells you that the stock has already seen its run and is ready to come down. Even if it doesn’t come down, it doesn’t seem very likely that it will move up much further. Consequently, common sense is hindering your trading strategy in these circumstances. The market doesn’t operate around common sense, which is proven by the massive amount of companies that are both over and under valued. So, if you can’t turn to common sense, what do you do? Try to eliminate your preconceptions of how you believe a stock will act and utilize a more concrete strategy. Refer to your trading rules and let them guide you through the trade.
Today, I was faced with a situation where I didn’t take my own advice. This ended up costing me a lot of money, however, I learned a lot from this trade. Earlier in the morning, a stock called HDY (Hyperdynamics Corporation) popped up on my stock screener. Hyperdynamics Corporation had released news that a force majeure had been lifted from their contract with Tullow, meaning that HDY’s petroleum operations may be able to continue in the Republic of Guinea. From a fundamental standpoint, this didn’t seem like huge news to me, but I added it to my watch list for the day and waited for the perfect technical setup.
That setup came around 12:15 PM (market hours) when the stock broke through a key resistance level.
A large part of my intraday trading strategy is trading ascending triangle chart patterns. I use other indicators as well as some fundamental analysis, however, anytime I see an ascending triangle chart pattern, I become interested in the stock. That being said, HPJ was already up 81.2% on the day and I didn’t believe the news was good enough to justify the run. Because of that, I refrained from trading this perfect setup and carried on with my trading. As you probably guessed, the stock continued to run throughout the day with very little resistance. HDY made it all the way to around $4.12 from the breakout trigger at $2.70. So, by now, the chart must be overextended, right? Wrong.
Around 3:15 PM (market hours), another perfect ascending triangle was formed and the stock was ready to breakout yet again. By this point, I wasn’t even considering trading the stock considering it was up over 176% on the day. I assumed there would be some strong selling towards the close as people locked in their gains from a nice intraday run. Once again, common sense failed me. HDY was setting up another ascending triangle pattern and when it broke the $4.12 resistance, the stock ran from $4.12 to as high as $4.56 making the gain for the day 206%. The stock eventually pulled back to $4.44 at closing, however, that price would still provide for a nice intraday gain from the $4.12 breakout point
So, what exactly is my point here and why am I going into so much detail about a trade I didn’t even execute?
The point is to always challenge your unsubstantiated beliefs about the market. Always ask why and see if you have a solid rationale. Stocks won’t always have parabolic movement like HDJ, but it is important to have a solid reason as to why you don’t believe a stock will go higher. Here are some examples of good and bad rationale:
Wrong Approach:
Q: Stock ABC is up over 80% on the day but the technical setup is perfect. Should I try to buy the breakout?
Nahh, it’s already up too much on the day. I doubt it can go higher.
Q: Why not?
It’s just up too much, so I doubt traders will push the price up further.
Q: Why not? (…and this goes on forever)
Right Approach
Q: Stock ABC is up over 80% on the day but the technical setup is perfect. Should I try to buy the breakout?
Well, the intraday setup is perfect, however, the stock is approaching a long term resistance level that it has struggled to break in the past. Volume is fading a bit and the stock keeps falling below the 10-day EMA. The nearest support level is 50% below the current price, so the risk/reward ratio is not very appealing.
Notice that both of the responses come to the same conclusion, however, one provides solid rationale and the other doesn’t. Understanding why you are or are not placing a trade is crucial, as it will help you survive in the long run. Even if the fictional stock from the above example were to breakout, if you stuck to your trading rules it would be more difficult to regret not purchasing the stock. Sticking to your trading rules can cost you profits sometimes, however, they will save you from losses a lot of the time.
For today’s trade on HDY, I had no solid rationale behind my decision. Around the time of the first breakout, HDJ had just crossed above the 10-Day EMA (another indicator I use), volume was picking up, and an intraday resistance level was broken. The chart was screaming “BUY!” but I replaced my trading rules with common sense. The market doesn’t always reward common sense, so you need to be prepared. HDY ran about 200% today. Did the company really become 3 times more valuable today than it was yesterday? Probably not. Did the market care? Obviously not. Never underestimate how much a stock can run. Stick to your trading strategy and rules and react accordingly. In regards to HDY, I should have placed my order at the breakout level and then monitored the stock closely. If the stock dropped and I was wrong about the breakout, I could cut my losses quick and move on. If the stock kept moving the way I wanted it to, I would hold it until I believed it was a good time to sell; simple as that.
