beginners corner

Penny Stocks: I’ll Have the Salad

You’re out for dinner in your favorite restaurant. The waiter hands you a menu and you immediately focus in on the salad column looking for a healthy meal. Hmmm….broiled salmon on the house salad….looks good. As you continue to study your choices you notice the young couple sitting at the table to your right. Piled in front of him is a creation that appears to be a burger super-duper deluxe. You make the assumption that the burger itself is somewhere north of the conglomeration of French fries and east of the mountain of onion rings. Yes, you think to yourself, that’s probably where it is. Your eyes now wander to the girlfriend sitting across from the hidden burger. Evidently she didn’t want to order a full meal… perhaps it was a first date. Instead she opted for the brownie supreme drizzled in strawberry sauce topped with a mountain of whipped cream. Most of her dessert was on her plate but some of it was projecting from her chin anticipating a soft landing on her freshly pressed jeans. “This must be heaven”, her expression suggested.

You now re-think the salad because, much like Pavlov’s dog” your mouth is salivating from the scene to your right. “I worked hard this week”, you think to yourself. “The kids were out of control and I still have to go home to them” you further justify. There is a  tug-of-war of Olympic proportions going on in your brain: Do what you know is right or acquiesce to temptation. Just then the waiter places a piece of paper on the young couple’s table. You wonder: “Is it the check or a referral to the local cardiologist”?

The waiter now turns to you, pen in hand. “I’ll have the _____________” (you know who you are!).

Much like the temptation of the burger deluxe and the brownie supreme, many stock investors are tantalized by the thought of cashing in on penny stocks. We are constantly being inundated with information about the $0.20 stock “ready to explode”. This past week, the BCI site has also had a few inquiries about these securities so I thought it prudent to write this article to help arm our BCI community with the appropriate information.

Definition:

Here are the qualities most investors define a “penny stock” to have:

  • Trade at a low price (under $5 to some, under $1 to others)
  • Low market capitalization (# outstanding shares x price); usually under $500M
  • Highly speculative due to lack of liquidity (low trading volume)
  • Large bid-ask spreads
  • Little or no analyst following
  • Difficult to obtain corporate information
  • Limited disclosure
  • Trade over the counter through OTCBB and pink sheets, not on national exchanges

Risks:

  • Manipulation– As these securities are often traded by a single brokerage firm or a small group of firms, artificial buying and promoting can drive up the stock price concealing the real value of the company. A buyer who enters a position will then watch the price decline when the firms start dumping their falsely inflated shares. This is called “pump and dump”.
  • Immediate loss due to wide bid-ask spread– If we buy that stock at the “ask” of $0.20 while the “bid” is at $0.10, our shares must double to break even.
  • Brokerage overcharge– These firms selling penny stocks will “mark-up” the price they paid for the shares, sometimes as much as 100%.
  • Lack of available information– Many of these companies do not file quarterly and annual reports making it impossible to compute the real value of the company.
  • Cannot sell the stock– The low liquidity will sometimes make it impossible to sell and the brokerage company may insist in a trade for another penny stock it promotes.

What to look out for:

  • Hot stock tip– This can be promoted via the internet, TV, cold calling and emails. In many cases the promoters will be the big winners and we will provide those profits.
  • Promises of being insured by the SIPC (Securities Investor Protection Corp)– The SIPC does NOT insure against securities fraud or devaluation of an investment.
  • Brokerage licensing– Appropriate licensing and registration still does NOT protect us from fraud. It’s all up to us.
  • Bankrupt companies– These companies usually trade in fractions of a penny and will have 5-letter ticker symbols associated with them.
  • Erratic trading activity– May be difficult to find a buyer when you are ready to sell.

So most penny stocks are fraudulent companies?

This is NOT true. Not every company that trades for pennies should be considered fraudulent. Many are new companies just starting out hoping to become the next Apple Computer. They aspire to one day trade on the major exchanges. The challenge from our perspective is to find these gems hidden in a field of uncertainty. Once we do, the hope is that the company will actually succeed.

Conclusion:

Purchasing penny stock is enticing like the burger super deluxe. However, there are a plethora of risks that we face when pursuing these securities and we must understand and negotiate our way through these challenges before investing our hard-earned money. This site is fortunate to have tens of thousands of visits each month so I am sure that some of you have been successful with this strategy and I congratulate you for that. For most retail investors I say “buyer beware”. For me…I’ll have the salad.

Market tone:

This past week’s economic reports suggest that the economy is recovering enough to prevent another recession but not enough to overcome the unemployment issue:

  • The September unemployment rate remained at 9.1%, lower than anticipated
  • 103,000 jobs were created; 60,000 were projected
  • Job increases for July and August were revised upward
  • Consumer debt fell for the first time in 10 months, suggesting caution about borrowing
  • Construction activity rose 1.4% in August after declining by that same amount in July
  • Factory orders fell by 0.2% in August, however, orders for core capital goods rose 0.9% a positive for business spending
  • The index of manufacturing activity increased more than expected to 51.6

For the week, the S&P 500 increased by 2.1% for a year-to-date return of (-) 6.7%, including dividends

Last week a chart was created that showed both the VIX and the S&P 500 were located at the bearish end of recent trading ranges. We looked to see a bullish bounce off these support levels this past week and that’s exactly what we got. The chart below shows a recovering VIX and a rebounding S&P 500:

Market tone 9-30-11 and 10-7-11

On this week’s chart (10-7-11) you will note a declining VIX (green field on top) and an accelerating S&P 500 (yellow field on bottom). Both parameters for our evaluation of market tone continue to move in the recent trading range and a definitive trend is yet to be established.

Summary:

IBD: Market in correction

BCI: Neutral but fully invested favoring in-the-money strikes. We are looking for a bullish technical breakout of the above parameters before taking a more aggressive posture.

My best to the BCI community,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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28 Responses to “Penny Stocks: I’ll Have the Salad”

  1. admin October 8, 2011 2:19 pm #

    Premium members:

    Two new flow charts have been uploaded to your premium site. Login and look in the “resources/downloads” section for “Flow Chart- Fundamental Analysis” and “Flow Chart- Technical Analysis”.

    We will be adding more flow charts in the near future.

    Alan and the BCI team

  2. Barry B October 8, 2011 10:54 pm #

    Premium Members,

    The Weekly Report has been uploaded to the Premium Member website.

    Barry and The BCI Team

  3. Aaron October 9, 2011 6:13 am #

    Alan,

    What kind of return should we be looking for if we used an in the money strike option for this months options. With only 2 weeks left should the 2-4 percent be cut in half to 1-2 percent?

    Thank you.

    Aaron

  4. admin October 9, 2011 9:34 am #

    Aaron,

    The decline on option value is not in a direct relationship with time to expiration. That is because time value erosion is greater the closer we get to expiration Friday. It starts off slowly and then increases rapidly. With 2 weeks remaining in this 5-week contract, our goals would be slightly less than half of our original 2-4% per month although in some cases we MAY be able to achieve a 2%, 2-week return for an in-the-money strike. Below is a graph of the time value erosion of a 1-month option showing the enhanced time value erosion as we approach the end of the contract cycle.

    Alan

  5. FrankK October 9, 2011 10:17 am #

    Last Thurs on the bus from NYC at about 3 PM I got rid of some “dead money” – bought back the option – sold the stock and bought another covered called from the premium list. All this from my smart phone. Thank you Alan for all your help.

  6. Aaron October 9, 2011 12:18 pm #

    Thanks a lot Alan for your response. Could you gave an example from this week’s premium list of a stock you may consider (I know its not a recommendation).

    Aaron

  7. Fred October 9, 2011 2:40 pm #

    Alan,

    Great article. Informative and entertaining.

  8. admin October 9, 2011 5:46 pm #

    Aaron (#6),

    Given the following parameters:

    1- Choose a stock from the premium watch list
    2- Sell an October, 2011 option
    3- Try to achieve close to a 2%, 2-week return
    4- Sell an in-the-money strike to acquire additional downside protection

    Let’s look at QCOR:

    As of market close on Friday, here are the calculations:

    Buy 100 x QCOR @ $30.46
    Sell 1 x October $29 call @ $ 2.25
    Time value = $0.79
    Intrinsic value = $1.46
    ROO = 79/2900 = 2.7%, 2-week return
    Downside protection (of the ROO) = 146/3146= 4.6%

    This means that our 2.7%, 2-week return is guaranteed as long as the share value does not decline by more than 4.6% in the next 2 weeks. These figures can change when the market opens on Monday but were available to us on late Friday.

    This just an example and not necessarily a recommendation.

    Alan

  9. Barry B October 9, 2011 9:59 pm #

    Following up on Alan’s comment, re: QCOR…QCOR hit the top of it’s Bol Band…so it is a good time to sell calls.

    Barry

  10. Steve October 9, 2011 11:42 pm #

    DSW is another stock on the list that gives a 2 percent return with protection and my wife loves that store!

  11. Jaime October 10, 2011 9:26 am #

    Hi Alan!,

    I wanna say thank you for all yours videos on youtube, we have learned a lot of each one. I was thinking and I have a question of naked writting calls and puts.

    Is it possible to sell a naked call option and make a lot lot of money?

    An example: Friday 21 october 2011 is the expirarion day,

    AAPL, if I sell 1000 contracts call options of apple with strike price of 510 USD (Bid: 0.05 usd), I will earn a premium of 5000 usd, if the stock price dont rise up at 510 Usd at expiration day. So I will keep the premium price.

    Am I right in this?

    What If I sell 10000 contracts; I will earn 50,000 usd, I’m right???

    Thanks a lot for your reply.

    Best Regards,
    Jaime

  12. admin October 10, 2011 9:31 am #

    Jaime,

    I love when our members think outside the box. Your concept is interesting in that you can generate a huge cash return for selling an option that is highly UNLIKELY to be exercised. It seems almost too good to be true. The hang-up here is the margin requirement. You will be required to have a certain amount of cash in your account when making a trade of this nature. This can be calculated on a margin calculator as shown in the screenshot below you can see a requirement of over $37M for 10K contracts. That would eliminate most retail investors. (Click on the screenshot to enlarge and use the backarrow to return to the blog).

    In addition, we, as average retail investors, would need special approval to trade naked options and most of us would not be approved for such trading and that’s probably a good thing.

    As a general rule, if something seems too good to be true, it probably is.

    Keep up the good work.

    Alan

  13. Dave October 10, 2011 12:04 pm #

    Alan,

    Where can I access the margin calculator you showed in #12?

    Thanks.

    Dave

  14. admin October 10, 2011 1:22 pm #

    Dave,

    Here is the link to the CBOE margin calculator I used in comment # 12:

    http://www.cboe.com/tradtool/mcalc/default.aspx

    Alan

  15. Fred October 10, 2011 5:03 pm #

    Alan,

    How would you evaluate today’s trading action in terms of the trading range breakout you mention in this weeks article?

    Fred

  16. admin October 11, 2011 4:25 am #

    Fred,

    Monday was an outstanding day for the market as France and Germany pledged to strengthen European banks. However, it did not represent a technical breakout. Also, because of the holiday trading volume was light @ 3.8B. We are still in the trading range I displayed in this week’s blog article but at the bullish ends. Let’s see if the upcoming earnings season can propel the market to a bullish technical breakout. Below is an updated chart with the red arrows pointing to the current positions within the recent trading range.

    Alan

  17. Get Smart October 11, 2011 8:08 am #

    Hi Alan,

    Thanks for the great article.

    I am new to options. In your book, Cashing in on covered calls, Chapter 11, Exit strategies, there is no mention exit strategy for stock. As we have heard, the risk in covered calls is in the stock. What happens if the value of the stock suddenly drops 40% or 50%, is there a stop lost?

    I have ordered your second book, Exit strategies for covered call writing, will this be explained in this book?

  18. admin October 11, 2011 2:23 pm #

    Get Smart,

    My second book will go into much greater detail regarding exit strategy execution. In particular I have set up a 20%/10% guideline for closing the short option position. At that point you can choose from a series of choices like rolling down, rolling out, “hitting a double” and others. These are explained in detail with examples in the book.

    Selling the stock is one of those choices and I base my decision on technical analysis of the chart and price performance compared to the overall market. If your stock is down but less than the overall market, I am more likley to hold on to it. If it has dropped in price but still above the moving average I am also likly to hold the stock. Some of our members use an 8% – 10% stop loss rule but I base my decisions on the above factors. If a stock gaps down 40% – 50% as you suggest, a stop loss will not help. If a stock declines gradually over time you will have already taken action if you follow the guidelines of my system.

    Thanks for the great question.

    Alan

  19. Barbara October 11, 2011 6:45 pm #

    Hit my first double today. Very exciting. Bought 300 QQQ for 56.22 and sold the oct. 54 options for 3.60. Profit on time value is 414. Bought back the option for .75 and sold it again today for 2.70 for another 585 profit and still plenty of protection. Thanks Alan!

  20. admin October 12, 2011 10:17 am #

    DSW:

    Reported an outstanding 2nd quarter earnings report in late August with revenues up 15% and earnings 26% ahead of estimates. Over the past 4 quarters DSW has boasted a 9.4% average bullish earnings surprise with a 13% growth projection.

    Cash stands @ $351M and total debt @ $203M. Our premium report shows an industry segment rank of “A” and a dividend yield of 1.20%.

    Check to see if this equity deserves a place on your watch list.

    Alan

  21. Steve M. October 12, 2011 11:27 am #

    Alan,

    Is there a minimum price a stock must be to be eligible to have options? I assume most penny stocks would not qualify?

    Thank you.

    Steve

  22. admin October 12, 2011 3:36 pm #

    Steve,

    NEW options listings are not approved for stocks trading under $7.50. You are right that most penny stocks will not have options for this reason and others like market capitalization, trading volume, and not trading on national excahnges among others.

    Alan

  23. Lori October 13, 2011 6:45 am #

    Alan,

    Is there any issue with using ETFs during earnings season when some of the stocks in the fund are reporting during that option period?

    Thanks.

    Lori

  24. admin October 13, 2011 2:32 pm #

    Lori,

    Because we are dealing with a basket of stocks earnings reports are NOT a factor with ETFs. Some may surprise positively, others negatively and some will meet expectations. It does not present the risk as when we own individual stocks.

    One of the reasons we started including the weekly ETF report for premium members was to assist in adequate security eligibility during earnings season.

    Alan

  25. admin October 13, 2011 4:58 pm #

    Premium members:

    This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site.

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    Not a premium member? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  26. admin October 14, 2011 9:55 am #

    Expiration Friday Video:

    With the market surging the past week, many of us have sold options that are now in-the-money (lower than market value of the stock). As a result, we may consider rolling our options as one exit strategy choice. The BCI team has therefore highlighted the “Rolling Strategies Video” on the homepage of this blog and will leave it there until October options expire. As always make sure earnings report dates are watched. Premium members will note that the ER dates are separated by broken black lines in the report according to contract month. We hope you find this useful:

    https://www.thebluecollarinvestor.com/

    Alan and theBCI team

  27. Brian October 14, 2011 2:21 pm #

    Alan,

    One of the stocks on this weeks list is QCOR. If you bought the stock today and sold the 34 option (at the money) you can get better than 2% in 1 week. Do you consider this a good investment?

    Thanks for your help.

    Brian

  28. admin October 14, 2011 3:17 pm #

    Brian,

    I would consider this investment when I have the confidence of an uptrending or bullish market. Right now the market has been uptrending but still in an overall trading range. If the stock declines in value be prepared to act quickly as there is little time for exit strategy execution.

    The reason for the great return is that you are selling an at-the-money strike which generates the highest INITIAL return but offers no protection of that return. Of course, your total position breakeven is the cost minus the premium. It also tells us that the market is anticipating some volatility with this equity from now until expiration Friday.

    Great stock, great return, a bit risky. Depends on your personal risk tolerance.

    Alan

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