Friday, May 13, 2011
Why Short Term Trading Penny Stocks Is A Bad Idea
Search Google for penny stock and you will be deluged with sites promoting the active, short term trading of penny stocks. This attracts people due to the greed factor (the promise of huge % returns in short time) , the "I don't have much money" factor, and lastly the knowledge (or lack of) factor. All these sites prey on these three aspects to get people to sign up to day trade penny stocks or at least try to. Most of the time, their version of day trading is holding for a few days, rather than only go in and out the same exact day.
Now not all of these sites are bad. There are a few that are in it for the longer haul, really trying to find the diamond in the rough. The only issue that is never talked about is the true rarity of that happening. I do not have exact stats, but I would guess for every 1000 penny stocks, maybe less than 5 or 6 ever build up to a real company and get listed on a regular exchange. What is a regular exchange? Nasdaq NMS, Nasdaq small cap, or NYSE. The rest go to 0. It may take some time, but it happens - maybe a few get taken over or merge but rarely is it a huge boon to shareholders. Its usually a take under at some point. What most people eventually figure out, is that short term trading penny names rarely leads to any kind of substantial profits for anyone but the people who are issued stock to sell for free.
Penny stocks are usually Bullitin Board or more likely Pink Sheet Stocks (read 99% chance of scam/fraud) - the fact that the company is not even regulated nor required to publish financials that are audited on the pink sheets, and the double combination of the pump schemes to hype stocks so the company can sell shares to earn money (them and their buddies) makes it a huge game of musical chairs. You can always buy penny stocks (market order, please!) but you will have a hard time selling them. The market makers do not want this junk on the books either, unless they have orders to buy it and they can make money reselling the stock at a higher price. So they are very happy to have people who want to learn about trading try their hand at penny stocks.
Think about one aspect for a second - the primary way regular companies go public is: 1 - Have a great idea for a business, 2 - incorporate, find partners, build business some, 3 - if its going well, raise capital with private placement OR VC depending on the industry, 4 - expand further, grow margins and get profitable or very close to it with a well defined plan, 5 - plan to go public OR sell/merge company with a bigger competitor. Now contrast this to the way most penny stocks are capitalized: 1. Think of a business idea, 2 - buy a shell company (listed on pink sheets, but no business or revenues, you buy the name and the other stuff from someone), 3 - formulate a business plan, talk with brokers about getting the word out about your company, 4 - issue press releases about your business (usually whatever is hot at the time is a magnet "to do" stuff), issue shares to pay consultants to pump stock, issue shares to pay yourself a salary, issue shares for rent, issue shares for equipment, issue shares to maybe hire someone (all of which get dumped into the pump scheme designed to keep volume in the stock), .... and on and on. You should notice a difference between the 2 by now. One is a bona fide business from the get go, the other is basically a concept reversed into a public shell, with everything else as an afterthought. That does not mean ALL are like that, but a large percent are or do a majority of those things.
If that did not deter you from trying to day trading penny stocks, lets look at the capitalization issue. A lot of penny names have 10s of BILLIONS of shares outstanding, I personally have seen as many as 800 billion outstanding. So lets take a lower number, but prob average of 5 billion shares outstanding for company XXYY. Also, lets assume the stock is trading at 0.002 per share (penny stocks can trade as low as 0.0001 that is the lowest increment before 0). But we are giving XXYY the benefit of the doubt. Lets see what the market cap is on XXYY. 5bil x .002 = 10 million bucks market cap. This is common. Even at .0002 its 1 million market cap for something that no one would probably even buy for 50k. The company has 0 revenues (or very little at all), and is basically like saying your home based business with a big idea is worth 10mil - prob not even worth 10,000.00 with no sales. Think about it. If you actually had 10mil, would you give it to a company that has no products, has a unique concept and is working on a business plan? Hell no, not a chance. Even if a company was profitable, the general rule is a low multiple x earnings for last 12 months OR revenues, depending on the sector. This company has no earnings and no revenues or even a product. Its pure hype. So if the business makes 2 mil a year (profit, not revenues) you MIGHT pay 10mil for that biz. The hype is always so compelling - turn 2k into 1million bucks etc IF it works and IF it goes up bla bla bla, I can short term trading and make money.
The real driver of any company is only 2 factors: Earnings per share OR what another company would pay to take that business over. Lets see what it would take for company XXYY to earn .10 per share, then we will be super generous and let it trade at a 100 PE ratio so its a 10 dollar stock. That would be considered a home run in anyone's book, whether learn about trading or not. To earn 0.10 per share, the company NET PROFIT would have to be $50,000,000 - now lets be generous again, hugely, and say XXYY is in the software business and gets the same margins as MSFT (Microsoft) of 80%. This would mean their revenues are about $70,000,00.00 with no expenses at all. Most of the time, the entire market for the good or service these companies are in, assuming 100% market share and no competition is not even that big. How many people go from a concept to 70mil in revenues? Very, very few. Most cannot even get product sales much before they implode.
Usually people think they can outsmart the pump and get in early and out before its done, meaning they realize its a scam but the gambling mentality just keeps them trying it. This might work 1 or 2 times, but keep it up you will eventually lose every penny you put into your account as you get trapped in the stocks for 20,30,50% losses when it does not work.
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