I affectionately refer to stocks under 5 dollars as lottery tickets. This is more of a blanket statement and may not apply to every stock under 5 dollars, but the majority of the times this is the case. You maybe thinking, well the risk involved in stocks is the same whether it’s a $50 stock or a $5 dollar stock. Again, partially true. A stock like Sprint has billions of dollars in market capitalization and was trading below $5 dollars in 2012.
Let me further explain my definition of “too risky”. To me risk has very little to do with the price of the stock and speaks more to the volatility of the security. The volatility of a stock speaks to how wildly the stock will swing from one price extreme to another. When most people trade stocks under $5 dollars they fail to include this in the equation.
Why is volatility important to you? Let’s say you invested $10,000 into a stock trading at $4.80 and over the next 3 months the stock drops to a low of $2.40. You would have just loss 50% of your money. Now in the stocks under 5 dollars world, this could be completely acceptable, because maybe the stock ran up from .25 cents to over 5 dollars and is now having a simple 50% retracement from the highs.
Should you sell at this point? Probably not, but you would need to have the capital and the belief system to know you are right in order to sit through such a deep correction. Without these two, the market will likely press you until you submit.
Not to be all doom and gloom, so what about the times when the market gives you exactly what you want and the stock shoots up 400%. Will you be able to reap the benefits of this entire move? Will you know when to pull the trigger to exit such a profitable trade. In all of these charts that show a stock sky rocketing to the moon, there are very few traders who actually make money on the move.
Let me make this real for you based on one of my actual trades from 2013. I purchased RVLT at $2.66 on 9/3/2013. My target was $4.50 to $5.00. This represented a possible 70% return on the low end. As you can imagine when I was looking at the chart, all I could see was the potential dollars to the upside.
Well of course the market could not make this so easy. After entering the position on 9/3/2013, I was quickly stopped out at $2.27, as my max pain point loss of 10% was exceeded. Now I went at the position with a smaller amount of money, so the 15% loss wasn’t huge in dollar figures which is another reason why I let it run against me so much. No sooner did I exit the position, did it rally over $3 dollars, only to pullback again to a low of $2.22 towards the latter part of September. After this minor pullback RVLT had a number of rallies and slight pullbacks all the way to my target region of $4.71.
As you look at the chart, you can see the moves were sharp and unless you are prepared for the level of volatility, achieving the large gains on penny stocks is very difficult. The bottom line is you have to truly accept the risk involved with trading penny stocks and be prepared to sit through the sharp corrections until your ultimate price targets are hit. Short of taking this approach, you are likely to face a number of headaches trading most volatile stocks under 5 dollars.