Chapter Three: Common Investment Types – Penny Stocks 101

This is a surprisingly complicated question, so I’m going to break things down so that you can understand this concept from the bottom up.

Stocks begin when a company offers shares to raise capital for operations. The company sells percentage ownership stakes to their investors. which are known as shares. The price of these shares is determined by supply and demand, which I’ll get into in a second.

Here’s an example… XYZ Company sells 2 million shares at $10 dollars a share. They raise $20 million dollars. Now, these 2 million shares begin trading at $10 dollars a share. This is known as the stock price, which is nothing more than a public price at which buyers and sellers swap shares.

As you probably already know, a stock’s price can change.

Here’s an example… One of XYZ Company’s original buyers sees that more people are getting interested in the stock, so he tries to sell his 1,000 shares at $11 dollars a share. A buyer who wants to get in—hoping the stock will go even higher in the future—submits an order to buy 1,000 shares at $11 dollars a share. The order is executed, and the stock’s price has now changed.

Think about it like an auction on eBay. The more bids there are, the higher the price the auction will be. If you have a hot item, obviously the price is going to go up. But there are also people watching from the sidelines who are waiting for the right price to bid. Everyone has different expectations about how the stock will perform in the future.

As a result, stock prices are based on expectations. Since different people have different expectations about the same stock and company, they’re willing to pay different stock prices. Now, remember, expectations can change. Everything from company and industry news to rumors and flat-out lies can influence stock prices, which is why these expectations are constantly changing.

When you’re constantly changing expectations, it gets hard to correctly predict future prices. That’s why so many people lose money trading stocks. But simply being aware that everyone has different expectations can save you a lot of worrying.

This is a really fun subject. If you didn’t take micro or macroeconomics in school (or, if you slept through those classes like I did), supply and demand is basically just stock price changes, depending on how many buyers and sellers there are.

It’s very simple. When there are more buyers than sellers, the stock prices rise to attract more sellers. When there are more sellers than buyers, stock prices fall to attract more buyers. Price is always changing based on supply and demand.

Here’s an example… Our fictional XYZ Company now has 10 sellers and 3 buyers at $10 dollars a share. Since there are more sellers, 3 of the 10 sellers immediately sell their shares to the interested buyers, but that still leaves seven sellers without any buyers.

Unfortunately, at this point, the only buyers are at $9 dollars a share. So the stock price has to drop to $9 dollars to accommodate those seven remaining sellers. The sellers sell their shares to the buyers at the new lower price and the now $9 stock price awaits further buyers and sellers. Fun, right?

Now, it’s time to really start having some fun. Everyone loves to judge stocks based on how the companies are doing. And while I agree that the companies themselves are an important piece of the puzzle, it’s just not the whole picture when you’re dealing with penny stocks.

When you’re talking about fundamentals, you’re judging a stock based on the actual company’s business—meaning, their revenue, profits, losses, and expectations going forward. This information is usually used for investing and valuation purposes. The following are a few of the terms you’ll hear discussed most frequently when it comes to fundamentals:

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  Revenues

  Revenue is the money received by a company for its goods or services. Very simple. Profits and losses are very different. This is the positive or negative game from an operation after subtracting expenses.

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  Earnings Per Share(eps)

  This is a company’s profits divided by the total number of shares outstanding. It’s funstuff to read about, but I’m not going to go into detail here. For now, just understand that this term exists and that it influences penny stocks.

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  price/earnings (p/e) ratio

  Everyone loves talking about the P/E ratio. This is the stock’s price divided by its earnings, which is often used to determine how expensive the stock is. Again, I’m not going to go into a whole P/E lesson because that would take up this entire guide, but understand what a P/E is and Google it. Have fun.

Technicals and technical analysis are a whole different ballgame. In this case, you’re judging a stock based on its price action and chart patterns. Forget about what the company does—you’re judging the stock price (which is what you’re actually buying). Long-term investors rarely use this information, and there really isn’t much mainstream acceptance for trading based on technicals.

So when I say, “Focus on the charts and ignore the company” a lot of people are going to get up in arms. But for penny stock trading, it’s very important that you understand technicals. I’m not going to give you a whole crazy technical background, because that would turn this into a 200-page guide, instead of something you can read quickly to get your feet wet (although you can learn more about this as one of my millionaire trading challenge students if you’re interested).

Instead, I’m going to give you a very basic technical analysis lesson, but I encourage you to read as many books on the subject as you can—just remember not to let it get too complicated, experience teaches me that simple technical analysis works best. You really have to know your basic technical analysis before you start playing penny stocks. There’s a lot of complex technicals out there, but I stick to the basics.

Moving Averages

Moving averages are basically the average price of a stock over different time periods (for example, 50 day, 200 day, etc). If a stock is trading over the 50 and 200 day moving average, then it’s considered bullish because it’s got momentum. The stock is probably going up. If it’s trading below it or if it cracks below it, it’s very bearish.

Breakouts And Breakdowns

These terms refer to a stock that breaks through previous resistance to the upside or support on the downside. If a stock’s 200 day moving average was $3 dollars a share or the 1-year high is $3 a share and it just hit $3.25 a share, it’s experiencing a breakout.

Resistance

Resistance occurs when a stock’s price settles in an area where sellers usually emerge, preventing any further price increase. If a stock is trading at, let’s say $10 dollars a share, resistance at the $12 dollars a share price point would be demonstrated by a lot of sellers wanting to sell their shares right around $12 dollars. If, for some reason, the stock breaks through $12 dollars in a short period of time, it’s considered a breakout as it broke through the resistance.

Support

Support is the same kind of thing, except it’s on the downside. The stock is at $12 dollars again but the support is at $12 dollars (I’ll show you some chart examples later). If it breaks below that $12 dollar support foor, it’s pretty bearish. It should be able to hold support if the stock was going to move higher, but since it cracked through, it’s considered very bearish.

These words might sound confusing now, but stick with me. I’m going to use them again and again throughout this guide, so if you pay attention here and study more about technical analysis on your own time, you’ll soon be able to understand them and use them as you start trading penny stocks.