Low Priced, Dollar and Penny Stocks

As you may have noticed, most of my trading involves higher priced stocks - many are over $100/share and I have no qualms with regularly trading stocks such as BIDU/GOOG, which are 200 and 500 dollar stocks. I am also a buy-side investor (I prefer going long rather than short selling).

When I started trading years ago, I learned many a lesson by attempting to trade penny stocks, dollar stocks or other names which were around the $5 level. Now I'm not saying that you can't make money off these names, but there are some intrinsic qualities of these names that make them surprisingly dangerous, regardless of their low price.

1. Low Priced stocks attract poorly capitalized traders and often lure them into accumulating large positions. Basically the crowd consists of a fairly large number of "lottery ticket" buyers, hoping to double or triple or quadruple their money in short order. "Its only 2 dollars! How much could I possibly lose?" or "It's only 2 dollars, if it only goes up 2 dollars I've doubled my money!". So when the novice trader begins by buying 500 shares of a 2 dollar stock for $1000, they quickly double their bet when it falls to $1.90. When it rises back to 2 dollars, they suddenly feel that their position was in fact too small, and they buy another 1000 shares. Before you know it, you have a position of 5000 shares of a $2 stock, and every dime loses you $500.
1b. In fact, low priced stocks which have come down from higher levels are generally held by "bagholders" who have accumulated the stock with each downward move, further exacerbating the fact that it is a crowd of unhappy investors.
2. Low priced stocks are in fact much more volatile than high priced stocks. Consider this: when a $2 stock drops to $1.90, it has in fact dropped 5%. The seemingly "small" drop of 10 cents, can wipe out 5% of any investment within 1 day. Comparatively, it is the equivalent of a $200 stock dropping to $190. And to imagine that they drop and rise by 10 cents or more, several times a day, and within a matter of minutes! Combined with the fact that many traders are holding large accumulated positions and it's a recipe for disaster.
3. Low Priced stocks are easily manipulated. It doesn't take much capital to actually account for the entire day's volume in a dollar stock. Many $2 stocks have total daily volumes averaging 1 million shares. Which means that any boiler room or manipulative fund with $2 million in capital can effectively control that day's share volume.
4. Very few dollar stocks ever break out of their range and truly demonstrate "lottery ticket"-like gains. One in a thousand? Scoring a 10 bagger is not the goal of trading. You simply cannot rely upon that for your living. What about the other 1000 stocks that never go anywhere, and in fact disappear into oblivion? Many of these names end up being delisted and or end up in bankruptcy.
5. Low Priced stocks are low for a reason. They are simply unloved and should essentially be viewed that way. If we have been in a bull market for the last 6 years and your favorite stock is still at $3.50 .... need I explain further? Basically if we've been in a bull market for 6 years, a strong stock better be expensive by now. We haven't seen many stock splits in a while either.


So what do we do with low priced stocks?
1. If you want to participate in the "lottery" - View them as long term options contracts. ie. Biotech companies. Only invest what you don't need, don't consider them as trades.
2. View every large move with suspicion
3. They are better treated as short selling targets
4. simply avoid them?

Once again, as a disclaimer, I'm sure there are great traders who only trade these stocks and they do well. I would venture to say that these traders are extremely skilled and experienced. I would also bet that they are most likely NOT purely long biased.

Instead, I urge traders to move decimals when viewing stock prices. When GOOG moves from $565 to $550, (During times of volatility), it essentially is the same as a $5.65 stock moving to $5.50 (which happens in a matter of minutes or hours). Depending on how you look at it, GOOG is the safer trade! Ie. Google at $550 can be viewed as a $5.50 stock, if it makes you feel better, you simply adjust the number of shares you would purchase. The difference is that GOOG is actually a valued company in the eyes of shareholders, and has much more favorable ratios when compared to the "beloved" dollar stocks. High priced stocks are generally owned by a happy and content crowd - as a majority of holders are most likely profitable during the course of the stock's rise. They actually hope for dips as opportunities to accumulate more. And they won't disappear into oblivion any time soon.