Saturday, September 09, 2006

Trading Stocks Under $10 Per Share

I really enjoy trading stocks that are $10 and under. Often they provide the chance to enjoy high percentage gains and, of course, at worst, the risk is limited to what I paid for the stock. In almost all circumstances the real potential loss would be much less than that because I would have an early exit in place in case the stock turned against me. If you read my recent article that dealt with reward to risk ratios, you can see how a less expensive stock might present a great opportunity.

Ordinarily, if you are a fundamental trader you wouldn't be crazy about a cheap stock. Often, they are cheap for a reason, but don't think that the reason is always bad. Many times a cheaper stock won't even have a P/E (price to earnings ratio). When there is no P/E, that means there were no earnings. Remember your middle school math -- anything divided by zero equals zero. There may be an excellent reason why a stock has no earnings. It may have an important product in development and has had to spend revenue and borrowed money on research and development.

Just because a stock is cheap doesn't mean a trader can't make money trading it. Don't confuse a good company with a good stock. Let's look at some truly great companies and see how their stocks have performed over the last couple of years. Merck (MRK), for example, traded around 48 in June of 2004; in early March of 2006 it was around 35. 3M Company (MMM) hit 90 in June of '04 and was below 74 in March of '06. Pfizer (PFE) was over 37 in April 2004 and was $11 lower in March of '06. DuPont (DD) hit 54 in March 2005, but a year later it got down almost to 40. From July of '05 until March '06 Intel (INTC) dropped a full 25%. IBM fell nearly 10 points from December '05 to late February early March of 2006. These are just some examples from the Dow 30 Industrials. Just because it is a good or even great company doesn't necessarily mean the stock will go up.

On the other hand, some cheaper stocks with perhaps lesser fundamentals have provided fantastic returns for investors in the same relative time frame. From January to March 27, 2006, Level 3 Communications (LVLT) enjoyed a 61.5% move from $2.75 to $4.44. Not bad, +$1.69 on a $2.75 stock. QIAO Xing Univ Telephone (XING) moved up 67% from October 2005 to March 2006; a +$3.53 on a $5.25 stock. Cell Genesys Inc. (CEGE) climbed $2.75 from a low in October 2005 to March '06. That was a 58% gain. There are many other examples. Take a look at the history of Finisar Corp (FNSR), a company with fairly high debt, negative earnings, negative net income, negative ROE and negative ROA. From August 2005 until March 2006 the stock more than quadrupled from under $1 to almost $5.

The point is that often the lesser known and cheaper stocks can provide very exciting returns. Traders and investors in these cheaper issues are often "betting on the come." Often the companies with cheaper stocks may have great management and great product; they may be just getting up a head of steam. They need not be ignored by the careful trader or investor.

Since fundamentals may be misleading on the lower priced stocks, I believe they are best traded using technical analysis. I can use Ciena (CIEN) as an example. There was a pretty clear entry on December 23, 2005 after the stock had bounced off the 50 day moving average on strong volume. The high that day was $3.11. Had a trader bought at the high that day ($3.11) and used a close below the 50 day moving average as an exit, he would still be in the trade as of late March (the 27th) with the stock trading around $5.25. So far, the move has shown a 68.8% gain in three months (from December 23, 2005 to March 27, 2006 as I write this article).

High potential percentage gains are one of the things I like about trading lower priced stocks. Another thing I like is that the risk is often small. If I buy a stock for $2.50, that is my maximum risk -- $2.50. Even if the stock dropped to 0 (and I did nothing while that was happening) the most I could lose would be $2.50. Contrast that to something like Cisco (CSCO) that dropped over $14 in a week at the beginning of the bear market or to Google (GOOG) that sometimes has dropped as much as $25 to even $35 in a day! Even under $30 stocks like Intel (INTC) have dropped $2.00 overnight.

I search the $10 and under stocks with a couple of proprietary formulae I have developed. I am always trying to find relatively low risk plays with a potential reward to risk ratio of 2.5:1 or better. Of course, cheaper stocks can be risky. Companies can disappear quickly, but so can their pricier cousins (remember Worldcom, Enron, United Airlines before the bankruptcy). All trading involves risk (so does living life). Each of us needs to know our own risk tolerance, each of us must educate ourselves to understand the risk in any position, each of us must manage our own money and our own risk. That being said, I have found that trading the $10 and under stocks can limit risk and provide a potential for very significant returns.

Bill Kraft, Editor
P.S. Bloggers! Subscribe to my Under $10 Stock Trader Service at and use this link for $50 PER MONTH SAVINGS!.

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Anonymous said...

"Remember your middle school math -- anything divided by zero equals zero."

No, this is not true. Division by zero is undefined. Multiplication by zero results in zero. Back to grade school for you. I must note this is par for the course for a lawyer, to be explaining that for which they only have a glimmer of understanding.

Bill Kraft, said...

Anonymous, you are so right about anything divided by zero and I corrected that misstatement long, long ago. I guess you missed that in your hurry to criticize. I am interested to have you further educate me, however. If I make a dollar a share and have a zero investment to do it, what is the return? At least an old lawyer is still willing to learn.
Bill Kraft