The 5 phase Trade : Lesson 1

/The 5 phase Trade : Lesson 1

Trading the Spec Stocks

 Background

 

During the Gold Boom of late 1979 and 1980 most of my energy was consumed by trading the very speculative end of the market – the “penny dreadful” stocks that were generally trading at less than ten cents. There were dozens of new floats with an issue price of ten or twenty cents that started trading at twenty or forty cents. It was easy pickings and so easy to make a good dollar, but did I learn anything?

 

The short answer is a resounding NO!

 

I came out of that particular boom with money but very little knowledge of how to trade profitably in all markets. At the end of it I had no trading plan, and no idea how to trade the downturn and subsequent bear market. Most of the companies that were floated at that time do not exist now and were probably non-existent only a couple of years later.

Within a very short space of time these companies were a heartbeat from either a capital raising or bankruptcy. I’d be rather surprised if any of them ever turned over a profit, let alone grew into a Top 100 company. A year or two after any boom it is interesting to see how many of these companies remain listed and how many fade into oblivion.

That same process has been repeated several times. The 1986 boom followed by the 1987 crash, the Telco boom and crash and of course the 2006/7 boom and subsequent global financial crisis. The upshot of these experiences is twofold:

 

1) You must have a very detailed plan.

2) There is a time and a place for trading the spec stocks.

 

Hopefully you will be able to translate my experience and knowledge into a trading plan that suits you.

 

Over the years I have refined my approach to trading these stocks.

Initially, my trading was a pure gamble – it paid well in the boom but was not sustainable in bear markets. Slowly but surely I have developed a clearly defined method of trading these stocks. I now trade these stocks profitably, with low risk and without losing sleep. Fortunately computers and the internet have given us tools that we could not dream about a mere twenty years ago.

 

  

Definition – What is a spec stock?

 

Investopedia de_ nes a spec stock as: “A stock with a high degree of

risk. A speculative stock may o_ er the possibility of substantial returns

to compensate for its higher risk pro_ le. Speculative stocks are favoured

by speculators and investors because of their high-reward, high-risk

characteristics. Such stocks usually have a very low share price. A necessary

condition for investing in speculative stocks is a high tolerance for risk. This

means an investor in a speculative stock should be prepared for the possibility

of losing the full amount invested if the stock price goes down to zero”.

 

So, according to Investopedia we have high risk and potentially high return. The trick to trading the spec stocks is to minimise the risk, then we are left with the potential for high returns. Trading the cheap spec stocks with low risk is the whole objective of this book.

My definition of a spec stock is based purely on price. I consider that any stock currently priced below fifty cents is a speculative stock. This is a very broad statement and clearly other experts will have different definitions. On the ASX there are stocks within this price range that have a sound business, produce dividends, are well managed and are anything but speculative. Despite this, when looking for a spec stock to trade I will always limit my price parameters to those stocks below the fifty cent level. Some companies are operating in a more speculative industry than others. I would define any junior oil explorer as highly speculative.

 

Volume is the key!

 

On Balance Volume is a running total of volume. Most software applications have the on balance indicator in their toolbox. It shows whether volume is fl owing into or out of a stock. When the stock price closes higher than the previous close, all of the day’s volume is considered buying volume. When the security closes lower than the previous close, all of the day’s volume is considered selling volume.

 

Why Trade Speculative Stocks

Leverage

 I prefer to trade the speculative end of the market as these stocks offer me tremendous leverage. A small price movement from 4 cents to 6 cents gives a 50% return. I find that trading with a sound plan, limited risk and the ability to earn large returns in a short space of time is far less stressful than trading with leveraged trading instruments.

Traders will often look towards using derivative products to supply leverage. Many leveraged instruments are shamelessly promoted to a sometimes gullible public who are led to believe that the key to great wealth lies in unravelling the secrets of these instruments.

Leverage comes with great risk, as it magnifies both profit and losses.

A move of ten percent can wipe out one hundred percent of your deposit.

I find that the spec stocks supply enough leverage without the use of derivatives.

 

Company Capital Structure

 

Market Capitalisation

Usually referred to as the “market cap”, this is a measure of the company’s total value and is calculated by multiplying the current market price by the number of outstanding shares. As a rough guide companies fall into the following categories:

 

Mega Cap:                   Market cap of $200 billion and greater

Big/Large Cap:             $10 billion to $200 billion

Mid Cap:                      $2 billion to $10 billion

Small Cap:                   $300 million to $2 billion

Micro Cap:                 $50 million to $300 million

Nano Cap:                  Under $50 million

 

Issued Capital

 

“Issued Cap” is the number of shares that have been issued by the company. When trading the spec stocks I look for a company where the

Directors have a sizeable shareholding, preferably purchased on the open market. I also look for a stock with low Issued Capital. My upper limit is 1 billion shares on issue. When prices start to increase the masses commence buying. I want the amount of available stock to be scarce. This will help price climb even higher and faster.

Volume

 

Volume is often talked about, but at times not interpreted correctly, or investigated thoroughly enough. Trading volume is important as it is a measure of emotion. High volume with rising prices is very bullish, whereas high volume, accompanied by falling price, is very bearish. Without exception the experts will tell the newcomer that they should only trade stocks that are highly liquid, meaning stocks that have a lot of daily trading volume.

 

Once again, I have a different view. I am not concerned by a lack of volume when entering a stock. I am only interested in getting the volume that I require. I do however want a lot of trading volume when I sell the stock. Picture a real estate scenario where you want to buy a house at auction and, lo and behold, you are the only buyer that turns up; this would be a dream come true. The chances are that you will buy the house at a price far lower than if 20 interested buyers turn up.

 

Now put the boot on the other foot. You want to sell the house. You would be desperately hoping that 50 very interested buyer’s turn up for the big day. In short, you really only need big volumes when you are selling stock. If your analysis is right and your plan is activated correctly, you will have the required volume when you need it. If you are wrong however, and buyers are scarce when you NEED to sell, it can be very costly.

 

Summary

 

1) Spec stocks are generally those under 50c

2) Always use OBV to ensure buyers are in control

3) I prefer issued cap less than 1 billion

4) You must have a written trading plan