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Penny Stock Basics

How Debt Impacts A Stock’s Volatility

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Written by Timothy Sykes
Updated 1/13/2023 6 min read

God bless these new trading challenge students and their guest posts…this is a good one on debt basics:

Debt is one of the few things that can turn a profitable company into a bust. Heavily debt laden companies can immediately see a falling share price if earnings shrink, or if the company cannot turn to profit within a few quarters. When the debt incurred fails to return more than the cost and interest expense of the debt it becomes a serious burden on the company. Earnings periods can be an ideal time to play on negative prospects for a company in the long-term. You can open and close a trade in a matter of days or weeks.

ALU 1-year chart

You can see on the Alcatel-Lucent chart that a big gap down occurred in July. The entire downward trend, and particularly the steep falls last year were due to posting losses as well as debt maturities that were years away hanging over them. Shorting the stock would have been extremely profitable back then. Playing the credit agreement news would have been a quick long trade that made money. Companies that are undergoing strife and uncertainty present opportunities on both sides of the market.

Debt is the focus here, but when screening for stocks make sure to use a market cap you are comfortable with. I would avoid using a limitation such as negative earnings, because you are looking for companies walking a fine line that might have their luck change. Once debt-laden companies are identified they should be judged individually, and if you keep up with the news you will probably recognize ones that are worth watching. These normally have issues like flat revenue, deteriorating margins, etc. but not necessarily losses.

1. Debt-to-Equity Ratio
The debt-to-equity ratio measures if a company has more debt than equity. For some companies that is normal, such as manufacturers. For technology companies it can tend to be lower unless the company has been on an acquisition frenzy. The higher the ratio the more debt the company has relative to its worth, and anything over 1 means that it owes more than it’s worth. Think about underwater mortgages, because it is a similar concept. The lower the ratio the less debt there is compared to the size of the company.

You do not want to cast the net too narrowly when looking at the ratio. When using a screener you can try 0.75 and above, though if you really want to look for distressed companies you can increase this to the 0.90 range. Just remember to check its peers to figure out what is a good ratio for the industry.

2. Long-Term Debt
This is not really a metric, and it is somewhat incorporated into the debt-to-equity ratio. However, long-term debt is so important enough that it warrants close attention. It is a good idea to look at long-term debt to see if there is a lot of it on the horizon. The debt-to-equity ratio incorporates all kinds of debt, but long-term debt is the kind that becomes problematic since it is due so much later. The situation of the company when it incurred those debts might be drastically different from the present, or the future period when that debt is due.

It is also useful to look at long-term debt compared to current cash. A company might be debt heavy but if most of its assets are cash, then long-term debt is less of an issue since it can push back the day of reckoning.

A company like LDK might incur a huge debt to expand, but that is rare. LDK was another fantastic short that could have been seen coming, because the company had insane amounts of debt and was in the weakening solar market. LDK might be getting some government help to deal with their debt problems, but it remains to be seen if this will have a positive effect on the stock. Going with call options might be safer than buying the stock.

Most companies incur debts over time that accumulate to become scary numbers on balance sheets. A large cash position can push back the pain, though if the company is posting big losses it might not be enough. There is no proper screener amount for this number. You would look at this balance sheet item individually once you have narrowed down a list.

3. Current Ratio
The current ratio incorporates both cash and short-term debt. It is supposed to be a quick ratio that determines if a company can meet its current liabilities with its current assets. Any number over 1 means that the company does not have a liquidity problem. This metric is not about solvency. A company can have many assets, but if it is not very liquid it might have trouble paying some obligations. It is like if you only had solid gold and had an electric bill due in the next two days. Your gold is valuable, but could you get top dollar in two days?

When looking in a screener you probably want to go with companies that have a ratio less than 1.25. The ratios can get very high, for example ATVI has a ratio around 3 because of its solid cash position. The current ratio can be a tricky one because even extremely healthy companies can have one below 1, because cash might come in right when its needed for payments, but is not sitting the balance sheet. However, if you are also looking for high debt companies, then it should narrow the field.

Additional Details
If the screeners return too many results to sort through you can tweak the parameters a bit. The final filter you can add if necessary is to use one of the many revenue growth measures and choose less than 3%. This will show companies that are having a hard time growing top line revenue. I would not focus on earnings, because companies can save or even grow earnings by boosting margins through cutbacks, but this cannot continue for long. Look at revenue growth for a few quarters to establish a trend, not just the most recent.

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Timothy Sykes

Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading $12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More

* Results are not typical and will vary from person to person. Making money trading stocks takes time, dedication, and hard work. There are inherent risks involved with investing in the stock market, including the loss of your investment. Past performance in the market is not indicative of future results. Any investment is at your own risk. See Terms of Service here

The available research on day trading suggests that most active traders lose money. Fees and overtrading are major contributors to these losses.

A 2000 study called “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” evaluated 66,465 U.S. households that held stocks from 1991 to 1996. The households that traded most averaged an 11.4% annual return during a period where the overall market gained 17.9%. These lower returns were attributed to overconfidence.

A 2014 paper (revised 2019) titled “Learning Fast or Slow?” analyzed the complete transaction history of the Taiwan Stock Exchange between 1992 and 2006. It looked at the ongoing performance of day traders in this sample, and found that 97% of day traders can expect to lose money from trading, and more than 90% of all day trading volume can be traced to investors who predictably lose money. Additionally, it tied the behavior of gamblers and drivers who get more speeding tickets to overtrading, and cited studies showing that legalized gambling has an inverse effect on trading volume.

A 2019 research study (revised 2020) called “Day Trading for a Living?” observed 19,646 Brazilian futures contract traders who started day trading from 2013 to 2015, and recorded two years of their trading activity. The study authors found that 97% of traders with more than 300 days actively trading lost money, and only 1.1% earned more than the Brazilian minimum wage ($16 USD per day). They hypothesized that the greater returns shown in previous studies did not differentiate between frequent day traders and those who traded rarely, and that more frequent trading activity decreases the chance of profitability.

These studies show the wide variance of the available data on day trading profitability. One thing that seems clear from the research is that most day traders lose money .

Millionaire Media 66 W Flagler St. Ste. 900 Miami, FL 33130 United States (888) 878-3621 This is for information purposes only as Millionaire Media LLC nor Timothy Sykes is registered as a securities broker-dealer or an investment adviser. No information herein is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security or fund. Millionaire Media LLC and Timothy Sykes cannot and does not assess, verify or guarantee the adequacy, accuracy or completeness of any information, the suitability or profitability of any particular investment, or the potential value of any investment or informational source. The reader bears responsibility for his/her own investment research and decisions, should seek the advice of a qualified securities professional before making any investment, and investigate and fully understand any and all risks before investing. Millionaire Media LLC and Timothy Sykes in no way warrants the solvency, financial condition, or investment advisability of any of the securities mentioned in communications or websites. In addition, Millionaire Media LLC and Timothy Sykes accepts no liability whatsoever for any direct or consequential loss arising from any use of this information. This information is not intended to be used as the sole basis of any investment decision, nor should it be construed as advice designed to meet the investment needs of any particular investor. Past performance is not necessarily indicative of future returns.

Citations for Disclaimer

Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: “Day Trading for a Living?”

Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance and Zhang, Ke, Learning Fast or Slow? (May 28, 2019). Forthcoming: Review of Asset Pricing Studies, Available at SSRN: “https://ssrn.com/abstract=2535636”

Chague, Fernando and De-Losso, Rodrigo and Giovannetti, Bruno, Day Trading for a Living? (June 11, 2020). Available at SSRN: “https://ssrn.com/abstract=3423101”