Blog : 5 Ways to Survive Economic Turmoil

1. Buy the Rumor, Sell the Fact

2. Investor Sentiment

3. Limiting Losses

4. When to Sell

5. Be Wary of Averaging Down

BUY THE RUMOR, SELL THE FACT

Have you ever wondered why a stock falls sharply in price right after it achieves a major milestone? You've probably seen companies drop significantly in price on the heels of an FDA clearance, strong financial results, or gaining a much anticipated patent grant.

Sirius Radio is one that comes to mind, with it's shares dropping over 90% since they were finally given approval to merge with XM, after attempting to gain approval for years.

There's an expression in the stock market that says, "buy the rumor, sell the fact." The idea is simple. When there's an outstanding rumor about an upcoming event for a company, investors buy in, thus pushing share prices higher. Once the event itself is actually realized, the share price loses that upward buying pressure, and the stock drops in value.

For example, ABC Inc. is likely to get FDA approval for their new drug. The upcoming ruling is widely expected, and many investors buy in, speculating that the announcement will send the shares skyward. This starts pushing the stock price up.

Once the actually FDA approval is officially granted, the shares don't spike much higher since the speculators had already run the share price up so much. Now that the announcement is out, many of those same speculators start cashing out, putting a great deal of selling pressure on the stock.

The following events are some examples of what might drive buying interest:

• impending patent award
• expected strong financial results
• new major customer or contract win that is widely anticipated
• upcoming release of a new version of their technology
• anticipated FDA clearance

Any such widely anticipated event would gradually push share prices higher. The stock would gradually increase, higher and higher, until the underlying event finally came to pass. Then speculative buying vaporizes, sellers come out of the woodwork, and shares start their descent.

For this effect to actually occur, the rumor or event needs to be:

• widely known
• growing in probability
• noteworthy (potential for a major impact)
• nearing the date it is expected to occur

"Buy the rumor, sell the fact," plays out again and again on the markets. It's certainly not the exception, but rather the rule. Keeping this in mind will help you identify penny stocks that may trend upward, allowing you to ride the shares up for profits. Just make sure to escape your position before they come crashing back down to earth, and more realistic valuations. In other words, buy the rumor, sell the fact.

INVESTOR SENTIMENT

The current investor sentiment refers to how optimistic (or pessimistic) the majority of investors are feeling. In other words, what beliefs and expectations do the majority of people have at the current time.

If everyone thinks the stock market is about to crash, that represents highly negative investor sentiment. If the world seems to be stampeding to throw their money into stocks, and even your great-grandmother is phoning you with her latest stock pick (similar to the Dot-Com bubble days), then that's highly optimistic sentiment.

Now, here's the important part - Investor sentiment is a contrarian indicator.

The greater the percentage of people that are optimistic, and the more optimistic those people are, the more likely the market will drop or crash. If everybody expects shares in ABC Inc. to go up, they are highly likely to go down. If 90% of investors believe that XYZ Corp. shares are going to collapse, then those same shares are probably going to go higher.

This mainly happens because people act on their beliefs. Traders buy into stocks they expect to go higher, and that buying pressure pushes the shares up. When everybody thinks that the same stock will increase in price, they buy. Once they've all bought, that buying demand disappears, and the shares are usually overvalued and due for a fall.

The same holds true in reverse. When the stock market crashes, and everybody is running for the exits, the mob mentality selling drives the prices lower. Eventually the last panicking investor has sold.

At that point, anyone you talk to will have a highly negative outlook about investments. That's when negative sentiment has reached it's peak, and therefore traders are most likely to be wrong. There aren't any more sellers, because everyone's sold. They all still believe there is even more downside. Really all that's left are highly undervalued companies that are about to increase in price.

Use investor sentiment to your advantage. It takes a lot of courage to buy when everyone else is selling, but the harder that becomes for you, the more likely that you are making the right move.

LIMITING LOSSES

The reasons to limit losses are obvious. Of course, don't forget opportunity costs. If you put $1,000 dollars into a stock that goes down 20%, not only did you lose two hundred dollars, but you also lost any potential gains you could have made if that same $1,000 had been invested elsewhere.

Whenever you commit money to one place, you're not only committing to where the money will be, you're committing to where the money won't be.

There are many ways to limit losses when trading penny stocks:

• Get strong, fundamentally solid companies in the first place by doing Leeds Analysis. Finding the best companies and paying bargain prices for them is the first step to limiting your losses

• Position Sizing is a very important concept. I discuss Position Sizing in detail in our special report, "Pennies to Fortunes."

• Paper trading will help you learn the ropes, while discovering how to dodge the easily avoidable mistakes. (See my blog or "The Straight Facts About Penny Stocks")
  

• Diversification is a great way to limit your losses. You can diversify by industry, by market, geography, market cap or even the dollar amounts you put per stock.

• Avoid emotional decisions. Don't fall in love with a company, it's just business.

• Use stop losses. You may find that your broker, especially if you're trading penny stocks, is not very friendly about allowing stop losses. In such a case, simply keep track of your intended stop loss in your head, so that if your stock falls to a certain point, no matter what, you liquidate your position. This prevents further downside from an investment that may be heading towards zero.
  

• Look for penny stocks with good trading volume. This will help you limit your losses, since you can liquidate your position easily and quickly if required. Good trading volume also demonstrates that the penny stock is more widely followed, and therefore more likely to have strong investor interest.

• Take some profit off the table over time. That way you are proactively limiting any potential losses.

• Limit orders are an excellent way to curtail your losses. Avoid market orders.
  

• Trade on the better markets. There are a lot of problems with the Pink Sheet market. You'll generally get better penny stock companies, with better reporting requirements, enforcement, regulations, and trading volume, on stock exchanges like the OTC-BB (Over the Counter Bulletin Board), NASDAQ, AMEX, and NYSE.

Overall, the very best way to limit losses is never purchase any penny stock until you feel absolutely comfortable with it. Know why you are investing in this company. Understand where you expect the share price to go, and how fast. Be clear about why the penny stock company is going to do well. Know at what point you want to take your profits. Take full responsibility for whatever happens, and don't buy unless you feel very confident and comfortable with your decision.

WHEN TO SELL

Knowing when to sell is one of the most overlooked aspects of investing. I'm a believer that you set up your future profit or loss when you buy (by getting in at a great price). However, I understand that the sell decision can really have a major impact on the results of the trade.

Now remember, we're dealing in penny stocks. We use Leeds Analysis to uncover companies that we expect to multiply many times over in price. Less experienced traders seem to forget this, as they cash out for 50% and 100% gains, only to see the shares keep on ramping up.

For a 25 cent penny stock to go to $5.00, and absolutely change your life, it first has to go to 50 cents, then 75 cents, then $1.00, and so on. You can rest assured that there will be investors gladly taking their profits each step of the way, only to miss out on the big score.

The other end of the spectrum involves being greedy, and not taking a good profit when it presents itself. You're up 100%, but you wait to see if your penny stock could go even higher. Then, as the shares drop back to earth, you kick yourself, wondering why you didn't cash out.

So how do you know when to sell, and when to hang on? How do you know when you should exit a losing penny stock position and take losses? Assuming you are in a position to either hold or sell, the right move may become more clear by considering the following:

• Trading Activity - Spikes and drop-offs in volume will give you clues as to whether a climbing price is running out of steam, or a trend is reversing, or the penny stock is poised for a big jump.


• Technical Trend - Refer to the Leeds Analysis sections Current Trend, Trend Reversal, Resistance, Support, Topping Out, and the rest of the technical analysis indicators detailed in The Straight Facts About Penny Stocks.  Each of these provides you with clues to understand what is happening with the share price, and what to expect from this penny stock going forward.


• Original Reasoning - Why did you buy the shares in the first place? Do those reasons still apply? Have the company's prospects improved or declined? If the penny stock is executing well on their business plan, then it may make more sense to have patience. If many things have changed since you originally got involved, you should revisit the idea of owning the shares.

Consider this - if you just found out about this penny stock company today, would you buy into it at these prices? Even better, forget everything you know about the company, and perform Leeds Analysis from square one. Put the company through the Leeds Analysis ringer, looking for both warning signs and opportunity.

BE WARY OF AVERAGING DOWN

Averaging Down means buying more shares of a stock you already own, if the price has dropped since you originally bought it. This tactic lowers your average price paid per share, but increases your exposure.

For example, you buy 2,000 shares at $2.00, and weeks later the stock drops to $1.00. If you buy another 2,000 shares at $1.00, your average price per share for the 4,000 units is now $1.50.

In other words, if the shares make it back to $1.50, you are breaking even overall. (However, you now have an additional $2,000 invested.)

I have personally seen people average all the way down, with three or four or five new buy orders over months or years. They lost their shirts on stocks like Nortel and some of the Internet high-flyers.

Most times investors average down to make up for a bad trading decision. This can get pretty ugly when a penny stock is nose-diving towards zero, as they throw good money after bad.

I don't support the concept of Averaging Down. When I trade, I'm much more likely to 'Average Up.' I'll acquire more shares as the penny stock price climbs, and the momentum of the company rises. The increasing share price is a confirmation of the research success, and the company's progress, rather than a profit-taking opportunity.

NEXT STEPS

Hopefully applying some or all of the concepts detailed here will benefit your penny stock trading results. You can learn even more about all the ideas mentioned by visiting my free online book, The Straight Facts About Penny Stocks, or reviewing my penny stock blog entries.

As always, we greatly appreciate your business, and remain committed to bringing you the absolute best in penny stock picks.