Knowing the limits of how much to invest in a trade is critical to long-term success and risk management.

 

“Make a Million dollars in one year starting with $5!” Sound ridiculous? Of course it does. Yet that is just what many penny stock newsletters promise. They suggest you can start with a small amount of capital and keep doubling it. They promise that in little time an investor will be a millionaire.

 

But even if all recommendations they give were accurate (that’s a big if) there’s a bigger problem!

milliondollars

To take $100,000 and turn it into $200,000 with a penny stock, one would have to buy many thousands of shares. At $0.20 per share, that’s 500,000 shares. The challenge is that if the average number of shares being traded is just 2.5 million shares in a day, then 500,000 shares represent 20% of the daily volume!

 

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If one unloads 20% of the daily volume, that effectively dumps a huge volume of shares into the market at the same time. This can cause significant fluctuations in the value of a stock. Sell too many shares and it will drive your share values down. Buy too many shares and it will cause your costs to skyrocket.  This is simply an outcome of the supply and demand model which describes how prices vary as a balance of product availability and demand as demonstrated in the chart on the left.  This behavior is true for all stocks, bonds, and ETFs regardless of market capitalization.

 

As a rule of thumb, we recommend capping ownership to no more than 2% of the 30-day average volume of a stock. By limiting an investment in this manner, one ensures that as they buy and sell stocks they won’t artificially influence the value of a stock.

For example, if the 30-day average volume for SPXL is 1.65 million shares, the ownership cap should be no more than 33,000 shares. At the market price of $55.92 a share, one can have up to $1,845,360 invested in the SPXL without having a significant impact on the market.

 

The following steps help one figure out the maximum ownership cap for any stock:

  1. 30 day average daily volume * 2%

  2. If using margin to magnify a 2x leveraged ETF to 3x, multiply Step 1 by 66%. If taking advantage of margin on a standard stock, multiply Step 1 by 50% instead.

  3. Multiply the figure in Step 2 by the value of the stock. This will tell you the maximum $ value of your non-margined cash you can dedicate in any given stock.

 

Of course, if you apply this important and appropriate technique to Penny Stocks, it becomes impossible to become a millionaire overnight because one can only buy or sell so many shares without impacting the market.

Penny stocks are rife with problems including significant manipulation which is why we advocate that investors steer clear of them.

Coming Up Next

 Back | Course 8:  Understanding trading costs and the truth of how they can kill the performance of any strategy.