One of the worst parts about investing in popular stocks such as large caps and small caps is that you are susceptible to market conditions. Over the past couple of days, the market has taken quite the beating and, consequently, many investors’ portfolios dropped significantly. Luckily, this drop did not affect my trading strategy. Of course, the title of this article is facetious, as I always pay attention to market conditions, however, it is intended to prove a bigger point. Certain markets function independently and are not prone to the influence of the larger markets. This is not to say that all penny stocks are uninfluenced by the larger markets, but there are a select few stocks that defy the macro sentiment of the large markets. Why is this? The answer is simple. Some stocks have a cult-like following that pays no attention to larger indices such as the Dow Jones Industrial Average, NASDAQ composite, and S&P 500. Essentially, these are micro-markets that follow their own set of rules. Stocks that fall under this category are traded way differently than main stream stocks. These stocks are not traded by wall street investors who pay attention to the overall condition of the market. They are traded by day traders, gamblers, dreamers, and others who are trying to make fast money (See my post about why “real” investors avoid penny stocks for more info).
So, what was I up to while the rest of the market was panicking about the massive drop? I was trading a company called Triton Distribution Systems (TTDZ). The company has positioned themselves in the medical marijuana industry and has mustered up a lot of hype. I was able to make a nice profit on the stock through intraday trades.
These are the reasons I traded TTDZ on Monday.
- TTDZ is the number one stock on Investors Hub – For those who don’t know, Investors Hub is one of the most popular message boards for discussing OTC stocks. Being a top stock on the site does not guarantee upward momentum, but it provides a crucial element for success: exposure. The TTDZ message board is read by tens of thousands of people. This leads to the stock gaining the exposure it needs to run, and the daily volume of nearly 120 million shares on Monday confirms this. There are many amazing companies that never reach their fair value due to a lack of exposure. Exposure can lead to high volume, and with positive catalysts in play, this can lead to a breakout.
- Positive sentiment – I talk about market sentiment in another post and explain why it is so important. TTDZ had great positive sentiment from a cult-like following that believes the company is going to become a leader in the medical marijuana industry. A stock can run on positive sentiment alone, as proven by TTDZ. TTDZ had no direct catalyst that triggered its movement, but positive sentiment pushed the stock price to new highs. When you have tens of thousands of people reading a message board with mostly positive posts, this can influence new investors to buy shares and drive the price of the stock upwards.
- The charts don’t lie – TTDZ was a great technical play based on the charts. The stock has been in an upward trend for weeks now. Volume sustains itself or increases alongside the share price, which is good, because dollar volume is increasing every day. Last but not least, the stock kept breaking through resistance levels without a problem. There were no “blue sky breakouts” after each break, but instead each new high was followed by a short run and consolidation. The stock continues to test new highs as I write this post.
- Volatility and Liquidity – There were plenty of opportunities to buy and sell TTDZ. The stock would pull back to its lows intraday and set new highs intraday as well. My strategy consisted of buying shares at support levels and selling at resistance levels. The liquidity of this stock made this possible. With roughly 120 million shares traded, it was pretty easy to get buy and sell orders filled.
- Positive catalysts expected – TTDZ shareholders are expecting a variety of positive catalysts in the near future, including financials, a ticker symbol change, and potential dividends. This anticipation builds a strong positive hype as investors believe the price will skyrocket in the future. Had a press release been disseminated the stock could have run even further, as it may do in the future.
Overall, TTDZ was an easy, predictable pick for making some fast profits. My percentage gain was not exceptional, but any gains are good gains. I limited my position size to avoid unnecessary risk. Notice how my rationale states nothing related to the company’s fundamentals. They did not matter in this case. So, what is the point here and why am I adding this example?
TTDZ traders did not care about the market conditions. No one was posting on message boards stating, “the stock is doing well, but the down market may takes its toll.” These traders do not care about the larger markets. As long as they are making money, they are happy. These aren’t wall street investors and they have a completely different mentality. It may seem naive to base trading decisions off of the posts on a message board, but when you think about the psychology of trading, it can make more sense. People are influenced by what they read, and their trades often reflect this. Of course, I had other reasons for entering the stock, as mentioned above.
A lot of other stocks on my watch list took a hit, but I avoided trading those stocks. The goal is to find stocks that fluctuate independently from the main markets on days when the market is down. By finding these stocks, you can protect yourself from drops in the market.
One of the most difficult decisions to make when you go long on a stock is when to sell. This decision becomes even more difficult when a stock is breaking out and there is no top in sight. A lot of investors will tell you to plan when you want to get in and out of a stock. If it is your goal to make 20% profits, you should exit the stock when you are up 20%. I don’t fully agree with this strategy as you can often sell yourself short when you take this approach. The strategy is safe, which is good, but sometimes it is too safe. If safety is your main focus, you should utilize this strategy, however, safety and penny stocks are antonymous. A lot of the times, your profit goal is an arbitrary number. Unless you have mastered the markets and know that your stock will drop after reaching 20% gains, you may want to pay closer attention to the price movement. So, when should you take profits?
There is no “one-size-fits-all” answer to this question. Not every trade will be the same. You should watch the price action closely, and pay very close attention to a level 2 screen if you can. Here are a few reasons I will sell:
The stock is nearing a known resistance level
A resistance level is a stock’s top price based on historical price action. This is the level where more sellers enter the market and less buyers are present. If I am playing the volatility of a stock, and it is nearing a known resistance level, I will usually sell to lock in profits. I make exceptions to this rule when there is a specific catalyst that I believe will help the stock break through the level of resistance. Quite frequently, stocks trade in a cyclical fashion until a catalyst prompts them to do otherwise. For these kinds of stocks, it is my goal to buy at support levels and sell at resistance levels. You may sell yourself short every now and then, but you can’t complain if your taking profits.
A Negative Catalyst Is Approaching
If I believe a stock has a negative catalyst in its near future, I will sell just to be safe. A negative catalyst is anything that damages positive investor sentiment. This can be anything from bad earnings to a bad company update. Often times, penny stock traders are overly optimistic and they ignore the negativity surrounding their stock because they are blinded by greed. A negative catalyst doesn’t have to be directly negative. Instead, it can be the absence of an expected positive catalyst. For example, if a company’s earnings are due within the week, many investors may get overexcited and push the stock price up. If I don’t believe that the earnings will justify the run up, I will sell my shares. Sometimes, a huge company event is expected, such as an exceptionally large business deal. Penny stock traders will push the stock price up in anticipation of the deal, and some will forget that the deal is not a sure thing. I will sell my position when I believe that the stock has overextended itself. Selling in anticipation of bad news can cost you profits, but it can also keep you safe from large drops. Penny stock markets are extremely volatile so a safe strategy is crucial to your survival.
Investors are Getting Bored
In another post, I discuss the importance of investor sentiment. When a stock trades sideways for a long time, penny stock traders get bored. A lot of penny stock traders are day traders that play many different stock picks. When a penny stock is not exciting, these traders may exit their position to play other picks. When many investors exit a stock, a price drop is inevitable. If a stock was recently promoted by a newsletter, it is even more prone to this trend.
The Stock Goes from Undervalued to Overvalued
One of my trading strategies is to find undervalued penny stocks with strong fundamentals. They are rare in penny stock markets, but they are definitely there. I use the market cap, company financials, and a few other factors as the basis for my valuation. When I find these companies, I will load up on shares when I believe the company is undervalued. These kinds of stocks are prone to breakouts. Sometimes these breakouts can cause the stock to go from undervalued to overvalued. In these cases, I will sell because the stock did exactly what I wanted it to. I bought the stock because it was undervalued. Once it becomes overvalued, I have no reason to hold it anymore. I use market cap as the basis for valuation during runs, however, as discussed in this post, market cap does not always matter.
A Large Seller Enters the Market
This rationale applies mostly to intraday trades. If I plan to hold a stock for days or weeks, I will probably not utilize this strategy. That being said, the strategy is incredibly simple. When a stock is breaking out, it can sometimes hit what traders call a “wall.” A wall is simply a large sell order on the ask. If a stock is running and someone tries to unload shares that account for a good percentage of the daily trading volume, I will sell exit my position. For example, let’s say a stock trades about 20,000,000 shares each day. The stock opens at $0.05 and runs to $0.06. At $0.06, there is a seller that tries to unload 1-2 million shares (5-10% of the daily trading volume). At this point, buyers are not able to break through the wall on the ask and the stock trades sideways for a bit. I will sell my shares, as will other traders. This causes the price to drop, meaning it is a good time to get out. The rationale being that getting past this wall doesn’t seem viable. This means that the price will either trade sideways or go down; both of which give me no reason to hold my shares.
I’d Prefer My Current Profits to Smaller Profits or Losses
When stocks are breaking out, it can be very difficult to know how high the stock will run. It is even more difficult when a stock is setting new highs and no resistance level is in sight. This is when traders get greedy. It is important to remember that stocks will not run forever, and unless you are playing a long term pick, you will need to take profits at one point or another. I’ll start taking profits when I have a considerable gain. It’s better to take a smaller profit than to lose all of your gains. Here is a fictional example. Let’s say you buy 10,000 shares of a stock at $3. The stock starts to run and breaks through it’s 52-week high at $4 and upward momentum is still strong. As the stock approaches $5, I will start to minimize my position in case a new resistance level is formed. For this example, let’s say I sell 5000 shares at $5. The stock continues to run and approaches $6. At this point the upward momentum begins to fade. Now, I will sell my remaining shares. Sure, the stock could run to $7, $8, $9, $10, or further, but is it worth risking your gains? It is better to lock in sizable gains, especially when a drop is possible. You need to avoid the “I could have made “x amount” if I held” mentality. Which would you regret more: taking a nice profit, or losing all of your gains? Keep in mind that the numbers above are completely fictional. When I am actually playing a pick, I will play very close attention to the level 2 price action to see how the market reacts to new price levels and make trades accordingly.
These are just a few of the reasons I will take profits on a stock. Some of the reasons can also be applied to taking small losses. Keep in mind, that these rules are all speculative and you should pay close attention to the price action. Level 2 analysis is crucial in my opinion. These strategies will not work for every trade, however, they have helped me with a lot of my trades. Don’t think of these strategies as “rules.” Think of them as ideas to contemplate when considering an exit.
Making money in the stock market is all about being able to predict future trends. If you believe a stock price will go up, you go long (buy). If you believe a stock price will go down, you short the stock. The process is as simple as that, however, predicting price movements is not as easy as it sounds. If it were, everyone would make millions in the stock market. So, how does one predict the future price action of a stock? Chances are, if you asked 10 different investors you would get 10 different answers. Some will tell you to look at the company’s fundamentals and growth strategy. Others will tell you to do a sector analysis and make predictions accordingly. Some may even tell you to look at technical indicators such as the RSI, exponential moving averages, MACD, etc. So, who is right?
To put it simply, anyone who is making money is right. There is not one single way to be profitable in the stock market. Some people trade solely off of charts and make millions, while others trade solely off of company fundamentals and also make millions. Any strategy that makes money is a good strategy. That being said, I use somewhat of a unique strategy when I trade penny stocks. My strategy encompasses elements of all different strategies and aggregates them into a simple, easy-to use metric. I refer to this metric as “market sentiment.” This strategy is intended for penny stock markets, however, it could probably be applied to larger markets as well. So, what is market sentiment and why is it so important?
Market sentiment is very basic and very complex at the same time. Basically, market sentiment depicts how the majority of people feel about a certain stock at a given time. If the majority of people think the stock will go up, there is a strong positive market sentiment. If the majority of people think the stock will drop, then there is a negative market sentiment. Keep in mind that your opinions on the stock do not matter if they conflict with the majority of people. When people think a stock will go up (positive sentiment), they will put in a lot of buy orders. If people think the stock will go down (negative sentiment), they will put in a lot of sell orders. Essentially, this is somewhat of a self-fulfilling prophecy. The initial buy and sell orders on a given day can trigger even more buy or sell orders when people panic/rejoice at the price movement. By now, the concept should be clear. Positive sentiment drives the price up and negative sentiment drives the price down. This probably seems very obvious, so you should begin wondering how to gauge market sentiment.
First of all, gauging market sentiment is no easy task. In no way do I want to simplify the complexity behind trying to understand how an entire market feels about a stock. That being said, it is definitely doable, especially in penny stocks. Penny stocks are unique in the aspect that a lot of them are thinly traded (at least when compared to larger companies). This means that there is usually a small group of people trading the stock, which makes it easier to gauge the market sentiment. If a stock valued at a few cents trades 20 million shares a day, this means that 200 traders buying/selling in units of 100,000 shares could account for the entire trading volume. Of course, this number can be much higher or much lower, but you get the point. Gauging the sentiment of 200 traders is a lot easier than gauging the sentiment of thousands of traders for more popular companies. Additionally, penny stock day traders tend to be more vocal about their opinions on a stock. Understanding the market sentiment does not happen overnight nor does it happen intraday. Understanding the sentiment surrounding a stock can take days, weeks, and even months. Here is how I do it:
First things first, I like to find a stock that appeals to me. I make sure the stock has enough daily volume and investor interest to run when given the chance. Through a combination of fundamental and technical analysis, I create a watchlist of a few stocks at a time. As days go by, I watch how the stock trades. I pinpoint key support and resistance levels and start thinking of a good buy-in point. I also like to see how the stock reacts to different catalysts. What happens when news is released? Is anticipation building over an upcoming event? How does the market react to large sell orders? Watching the price action relative to different catalysts can be extremely insightful. However, if you want to truly understand market sentiment, you need to be more thorough. Focus on the psychology behind each of these moves. Luckily, penny stock traders tend to be very vocal about their opinions and even their actual buy/sell orders. Read message boards like Investors Hub. Browse Twitter, or use a tool like StockTwits. Check Facebook, LinkedIn, and other sites. You can never be too thorough. Read what people are saying and analyze it. After you believe you have done a thorough analysis, determine whether the market sentiment is positive or negative. You should also determine the strength of the sentiment. If the sentiment is strongly positive, the stock may move upwards in a day. If the sentiment is just slightly positive, it may take a few days to move, as the market will wait from confirmation from other traders. You will also want to make sure the stock has enough volume to move. This means you will want a lot of people to be talking about the stock, and not just a small group of loyal followers. Do not let your personal biases get in the way. Here is an example:
Awhile back, I traded a stock called PVEC. The company released a press release about a future dividend that would essentially give investors “free money” (Read the PR if you are interested in the details). I had never heard of PVEC before reading this article, and I had very little time to do research on the company. Instead, I analyzed the market sentiment surrounding the stock. People were raving about this new press release that offered investors free money. There was a strong positive sentiment surrounding the stock. Although there was some skepticism regarding the legitimacy of the dividend, this offer was too good for investors to refuse. So, after thoroughly analyzing the investor sentiment, I placed an order to buy shares at .0005/share. This was a Friday and I knew that the news would spread on the weekend. Did I believe the news? Not in the least bit. Did that matter? Not in the least bit. When I placed my order I knew almost nothing about the company, but that didn’t matter. What I did know was that there would be buying pressure on Monday and I could make a quick profit. Needless to say, on Monday, the stock ran up as investors lined up to collect their “free money.” I sold into the morning spike at a price of .0009/share for an incredibly easy gain of 80%. The validity of the news didn’t matter for this play, nor did the company’s fundamentals, the charts, or any technical indicator. All that mattered was market sentiment.
Market sentiment is an aggregation of every trader’s strategy. It accounts for fundamental traders, technical traders, momentum traders, etc. This is why it is futile to argue about trading strategies with different traders. If all of the chart traders believe a stock price will go down, and all of the fundamental traders believe it will go up, one group is inevitably wrong. As someone who trades on market sentiment, you just need to be able to pinpoint which group represents the majority. You want to find stocks where there is a strong sentiment. If 80% of people believe a stock will go up and 20% believe it won’t, there is a good chance the stock can run. Whereas if 60% of people believe a stock price will go up and 40% believe it won’t, the stock may not move because the naysayers will have a larger voice.
Overall, this strategy has helped me make a lot of money. That being said, my analyses are not correct every time, and this is not a fool proof method. There is no such thing as a fool proof method in the stock market. Trading based on market sentiment should be viewed as a tool that gives you a competitive advantage. Of course, this tool requires that you step back from the overall market, and develop an unbiased point of view. People who get emotionally involved in their stock picks will have a difficult time gauging market sentiment. You need to remain calm and analyze the situation apathetically. As always, I recommend testing all new strategies with paper trading so you can get the hang of them.
Market cap is short for market capitalization, and this number portrays a company’s valuation as determined by share holders. The number is calculated by multiplying the number of outstanding shares by the share price. The implications of the market cap are much different for bigger stocks than they are for penny stocks. After trading penny stocks for some time now, here are my thoughts on market cap.
Why Market Cap Matters
A company’s market cap is important because it represents the valuation of a company. If the market cap is $100 million, than the company is valued at $100 million. As a diligent investor, I always look at the market cap to see if I believe that it accurately reflects the company’s true value. Since I also invest in, build, and sell my own private companies, I have a basic understanding of what a company should be valued at. So, if a company is valued at $100 million dollars, I have to ask myself whether or not I would pay that price for the company in a private transaction. More often than not, when researching penny stocks, the answer is no. Companies with zero revenues are often valued at millions of dollars. Unless the company is in the biotech industry, or some other field where revenues come later in the business life cycle, this makes absolutely no sense. Contrarily, some companies are valued at only a few million dollars when they already have a few million dollars in revenues/profits. When I am trading based on market cap, I look for companies that are undervalued and avoid companies that are overvalued. This tactic has helped me find some undervalued companies at their bottom prices. Some of these companies eventually run 1000-2000% in a matter of weeks. By looking for undervalued companies, you can gain a competitive edge by investing in these companies before the rest of the market catches on to the true value. You can also avoid investing in overvalued companies that are due for a crash. Keep in mind, that a companies market cap, be it overvalued or undervalued, will not always dictate the future price action, which is why I will be discussing why market cap does not matter.
Why Market Cap Does Not Matter
When I started investing in penny stocks, I assigned a lot of weight to the market cap of a company. I would avoid overvalued companies, and buy into undervalued companies. Considering that my investing roots are planted in small cap and large cap stocks, this seemed like a sound strategy. I was always baffled when the market would allow terrible companies to reach multimillion dollar market caps. Eventually, I realized that a company’s true value is not as important in penny stocks.
Most people are not “investing” in these companies, they are just trading them. When price action shifts upward, new investors jump on board. When stocks are breaking out, no one is taking the time to look at the market cap to ensure that the company remains properly valued. This is most apparent in the runs of marijuana stocks during early 2014. Penny stock traders sent marijuana stocks surging by 1000-2000% without thinking twice about the market cap. These investors didn’t care that the companies had no revenue or anything to justify their new market caps. They saw a hot sector and they played it accordingly.
On the opposite end of the spectrum, I have found quite a few undervalued companies that never reached their full potential. Some of these companies had revenues and product inventories that exceeded the value of their market cap, yet the companies never experienced any breakouts because there was no hype surrounding them. Simply put, penny stock traders go where the hype is. They follow the price action. If an undervalued company trades sideways for months, there is not much incentive to invest in it.
Looking at a company’s market cap is part of doing thorough due diligence, whether the market appreciates the company’s true value or not. Personally, I try to find undervalued companies that may be prone to a future breakout. I either invest in these companies or add them to my watch list. When these companies run, I increase my positions significantly. In this aspect, I use a market cap as somewhat of a safety net. If you buy into an overvalued company that starts to run, you are exposing yourself to a lot of risk. At one point, investors and traders could get bored and the stock could return to its true value. If you buy into an undervalued company during a breakout, you have a lot less risk, as the breakout may be responsible for taking the company to its true value. Of course, nothing is ever certain in investing, especially in penny stock markets, but strategies like this have helped me experience some great gains.
For those who don’t know, “averaging down” is when you buy a position in a stock at a lower price than you initially bought it for. So, if you took an initial position of 1000 shares in a stock at a price of $5, and later purchased another 1000 shares when the stock dropped to $4, you would be averaging down to $4.50/share. Many investors have different views on averaging down. Some think that it is a great way to get cheaper shares in a company you believe in, while some think that you are buying into a stock when the momentum is against you. I agree with both arguments and utilize a hybrid strategy.
First things first, you need to know how your stock trades. Stock price movements are largely controlled by the public sentiment surrounding the stock. This is why stocks can run on a press release or mere speculation. If you follow a stock for awhile, you should begin to develop an understanding of the sentiment surrounding the stock. When public sentiment is positive, the stock will rise. When public sentiment is negative, the stock will drop. I’ll go into how you can gauge public sentiment in a different post.
So, let’s get to the averaging down strategy. It’s nothing complex or revolutionary, but it does help me save a lot of money. When I recognize that there is negative sentiment surrounding a stock, I realize that the price will not move upwards. At the very best, the price will move sideways. When a stock is trading sideways, all it takes is one large seller to panic the market and create a breakdown. At these times, I will sell all or some of my current position for a small gain or small loss. I will then repurchase all or some of my position in the stock when it reaches new bottoms.
Let’s take the example I gave earlier where you purchase 1000 shares of a stock at $5. The stock may be trading in a range of $5-$5.50 for a few days without any signs of a spike in share prices. Without any catalysts, the stock will move not move up, and sideways action can test investor confidence. Whenever I see investor sentiment shifting, I plan to start averaging down. If I catch on to the drop early, I will sell for a small gain in the lows of the range at around $5-$5.20. If I don’t catch on soon enough, I will sell for a small loss between $4.50-$5. When the stock drops back down to $4 (let’s assume this is the bottom), I will repurchase my position.
Compare this to a standard “averaging down” tactic:
Standard Averaging Down Strategy –
Buy 1000 Shares at $5 > Stock drops to $4 > Buy 1000 Shares at $4.
You now own 2000 shares. Assuming the price stays at $4, your loss is $1000 until price movement shifts upward.
My Strategy when I catch on to a drop early (Best case scenario):
Buy 1000 shares at $5 > Sell shares at $5.20 ($200 profit) > Price drops to $4 > Buy 2000 Shares at $4.
You now own 2000 shares. Assuming the price stays at $4, your profit is $200 until price movement shifts upward.
My Strategy when I catch on the drop in realtime (“Worst” case scenario):
Buy 1000 shares at $5 > Stock starts dropping > Sell at $4.50 ($500 loss) > Price drops to $4 > Buy 2000 shares at $4
You now own 2000 shares. Assuming the price stays at $4, your loss is $500 until price movement shifts upward.
Standard Averaging Down Strategy = $1000 Loss
My Strategy (Best Case Scenario) = $200 gain
My Strategy (Worst Case Scenario) = $500 loss
By utilizing my strategy, I can cut losses and even take some gains. Of course, these numbers are fictional, and getting orders filled doesn’t always work as well in practice as it does in theory, but the concept remains the same. Why hold onto a stock as its dropping when you can buy back your exact position for a cheaper price? The key to making this strategy work is to have some sort of foresight into the stock’s price.
Other things to note:
- A more experienced trader may want to consider shorting the stock on the way down to profit from the drop.
- If the stock is dropping based on a catalyst other than public sentiment, you may want to reconsider your reentry.
- Only re-enter the stock if you believe it will move back up again. This works better for people who are truly long on a stock but don’t want short term volatility to hurt their portfolio.
- Look for bottoms. An ideal re-entry is at the stock bottom. This strategy can still help if you don’t find the exact bottom, but buying at the bottom is much better.