May 13, 2008
ARE YOU BLIND SEC I am fed up with your bull, WHERE IS MY DAMN MONEY I WANT MY NAKED SHORT MONEY NOW, DARN IT June 22, 2004, was another good day for CMKM Diamond Inc. More than 3.2 billion shares of company stock were traded. On the same day, less than 1.7 billion shares traded on the Nasdaq and 1.4 billion on the New York Stock Exchange. CMKM had traded more shares that day than the NYSE and Nasdaq combined Just a few days earlier, on June 16, the stock had traded more than 4.2 billion shares. Market interest in the little company from Saskatchewan spotlighted a phenomenon in the making: the rapidly growing popularity of penny stocks.
Going Ballistic
In 1994, the Over-the-Counter Bulletin Board (OTCBB) traded a total of 3.02 billion shares, just 4.5% of the numbers traded on the Nasdaq and New York Stock Exchange. By 2003, annual OTCBB volume had soared to 267.4 billion shares, an incredible 8900% increase, and equaled 63% of the Nasdaq and 78% of the NYSE share volumes (Nasdaq volume surpassed NYSE volume in 1993). It was a phenomenal growth story. At that rate it wouldn't be long before the OTCBB was trading the same number of shares as its larger brothers.
Figure 1 – Over-the-Counter Bulletin Board (OTCBB) volumes from 1990 to 2004 (est).
Chasing the Establishment
Figure 2 – Volumes for the Nasdaq and OTCBB. OTCBB volume grew 8900 percent between 1993 and 2003, eclipsing both the Nasdaq (638 percent) and NYSE (512 percent) volume increases by a wide margin.
Volumes on the Pink Sheets (where CMKM Diamonds traded) have grown even faster. In 1998, roughly 9 billion shares traded, and by 2003, volumes had soared to 187.5 billion--an incredible increase of more than 2000% in just five years. In 2004, Pink Sheet volumes were set to surpass 700 billion, blowing past both the OTCBB and Nasdaq, thanks in part to companies like CMKM.
Figure 3 – Meteoric rise in trading volumes on the Pink Sheets.
Pennies for Dollars
However, there is a big difference when dollar volumes of the various exchanges are compared. In 2003, volume for the OTCBB was an average of 1,060,949,618 shares per day, and average daily dollar volume was $159,551,840. That's an average price of $0.15 per share. The average 2003 share price on the Pink Sheets was $0.14. By contrast, in the same year, the average daily share price on the Nasdaq was $16.61 and the average daily share price on the NYSE was $27.50.
Consider this: in 2003 and 2004, shares in CMKM traded between 0.002 and 0.0001 cents. At 0.0001 cents per share, a million shares cost you $100. If you were lucky enough to catch a ride when the stock moved to 0.005 cents, which it did on occasion, and if there were enough buyers to get you out of your position, you would make a cool $4,900 profit.
Figure 4 – OTCCB (purple) and Pink Sheet (pink) volumes compared.
However, if you were on the wrong side of the trade and bought at 0.005 cents, you would see your $100 dwindle to just $2 when the stock dropped back down to 0.0001 cents. And if you had a $20,000 position at 0.0001 cents you would have to sell 200 million shares to get out. In the sub-penny abyss, a few thousand dollars of buying or selling can significantly sway share values.
A company like CMKM is simply not the place to entrust any money you can't afford to lose. It hasn't filed any reports with the Security and Exchange Commission (SEC) since March 2003, and obtaining reliable corporate information is a challenge at best. But how many stock values fluctuate 5000% or more in a day?
Growing Pains
Mike Ser of data provider Alphatrade.com said in an interview that the company has witnessed exponential growth in subscribers for penny stock data provided by the Pink Sheets and OTCBB. Alphatrade is one of a limited number of providers of both level I and II penny stock data. (Level II is necessary for those who want to watch market maker activity and follow trades as they occur, giving traders an in-depth indication of market strength or weakness.)
One of the problems with this exponential rise in popularity occurs in tracking share volumes. The Pink Sheets and OTCBB are limited by binary reporting systems that 'max out' at 4.295 billion shares, and the largest number a binary system can display is 32 digits. If it reports volumes larger than that, the data gets distorted. Counters either revert back to zero or provide incorrect volume data. Only a new reporting system could rectify this problem.
Carl Giangrasso of the Pink Sheets commented that this distortion is due to the variety of sources supplying raw data. The problem began to emerge in 2003 with the rising popularity and commensurate volumes of penny stocks--and all data providers are in the same boat. Fortunately, this only affects extreme volume sub-penny stocks.
The Pink Sheets has come a long way since the days of the "penny dreadfuls" and written reports, Giangrasso says. It now provides an electronic quotation system and a facility for market markers to electronically execute orders.
Finding a Method in the Penny Mayhem
How does one trade penny stocks? Are there any techniques that work best? Technical analysis that uses indicators and statistics to forecast price movements is one possible approach. But due to the novelty of the penny phenomenon, technicians have not had the time to build a strategy--assuming anyone is interested in doing so. As far as analyzing sub-penny stocks, it would require a new system for charting and monitoring to determine the significance of a 0.0001-cent move, and there is no telling whether or not it would work. Trading these types of stocks is like throwing darts. Place your order and hope you hit the bull's-eye.
Stocks trading for less than $5 have, for the most part, been shunned by the technical analysis community. Volumes of less than 400,000 to 500,000 shares a day make analysis unreliable and liquidity a challenge for trading any size. But as volumes explode, this problem will be mitigated. Will technical charting techniques work on a stock trading at $0.20 with an average volume of 1 million shares per day? As long as trading is not concentrated in the hands of a few and mass-market psychology is dominant, there is no reason why charting techniques shouldn't work.
An accomplished trader himself, Ser says that news and rumors are the major forces driving penny stock price movement. Online message boards and chatrooms play a significant part, and press releases have the potential to cause large price swings. Traditional charting methods just don't work.
Ser's favored trading technique involves getting to know the stock and how it responds to news and rumors. The greater the buzz on the street, the more potential there is for a large price move. Level II tells him how many market makers are involved and how they are working the stock. This is reflected in how much stock is trading at various price levels and who is buying or selling. It helps determine which direction the stock may be heading.
For stocks in the $1 - $5 range, technical analysis begins to make sense when there is sufficient volume, Ser says. He likes to see at least 400,000 to 500,000 shares trade per day, but that depends on whether the stock has a tight price spread. However, it is possible to make money on wider spreads buying at the bid and selling at the ask for a small profit, but that is a riskier strategy.
Ser has spoken with a number of traders who don't have a lot of money to trade ($500- $1,000), and they say they like penny stocks because they can take much larger position sizes than on the larger exchanges. But it's a different strategy, more akin to gambling than investing or trading. As you do when you go to Las Vegas, take only as much money as you are willing to lose. When it's gone, you go home.
The final group of penny players are amateur investors who have not heard of level II and are buying to hold in hopes that the stock makes a big discovery, Ser says. But while an investment in the vast majority of penny stocks will never hit a home run, it's fun to dream.
Conclusion
Trading penny stocks is certainly not for all investors. But it might be just right for those who are looking for something off the well-worn investment or trading paths. Just don't bet too much on it.
by Matt Blackman, (Contact Author Biography)
Matt Blackman, the host of TradeSystemGuru.com, is a technical trader, author, keynote speaker and regular contributor to a number of trading publications and investment/trading websites in North America and Europe. He also writes a weekly market letter.