Microcap Rules of the Road

Microcap stocks are fun, but you have to be careful. Many of the microcap and penny stock sites are paid stock promoters masquerading as analysts or stock pickers. That means they show you a stock because they were paid cash, stock or both to do it. Websites and alert services that tout stocks for pay are not showing you true investments or momentum plays, except by accident. But don't be too cynical about promotional sites - the stock touts can be a terrific source of leads on momentum plays about to happen. Read our analytical reports and check out for yourself the companies we feature. Be sure to check out our Momentum Punchlist.

The Basics

Money Management.  Don't put too much of your trading deck (available stock investment fund) into microcap stocks, especially until you've gotten your sea legs and can read the trail reliably on small stocks. For that matter, don't put all your microcap trading deck into one stock. We advise traders to only put the "butter and egg" money into microcaps - this is the little bit of extra cash country folks used to make on the side from selling butter and eggs to city folks. Don't put your retirement into microcaps. Stocks can go up or down and you need to have a plan in either case.

1)  Set a stop:  Always set a stop price on the stock you buy, even if it is a mental stop and not a stop limit order. Know in advance where you are going to get out if the stock moves against you. The stop can be based on support, yesterday's low, whatever. Just pick a stop that makes sense. If the stock moves up, move the stop up, too (known as a trailing stop). Not having a stop is asking for bad decisions when the crunch time comes.

2)  Plan the trade:  Really smart money management is to have an idea of where you will get out as the stock moves up. Will you sell half when the stock doubles? On microcap momentum plays, avoiding losses is job one. Money management is too big a subject to cover here, but plan the trade and trade the plan. Money management discipline will over time make you consistent money and consistently avoid or minimize losses.

Picking Microcap Stocks.  There are two kinds, and only two kinds, that you want:

1)  Investment Plays - meaning stocks you actually are willing to hold for the medium to long term because they are undervalued and hold the promise of generating big gains in the future. Here are the characteristics it must have in order to qualify as an investment play (no exceptions):

• undervalued and trading way under any reasonable P/E (current or forward earnings) for the industry
• trading at the low end of its trading range for a period of several months to a year
• its business makes sense, isn't a fad and will likely be around in 5 years
• revenues are strong and growing
• it is now or soon to be profitable
• management is experienced in this business and is top notch.

2)  Momentum Plays - meaning a stock whose price is moving up on extraordinary or at least unusually high trading volume. You don't care if it's a crap stock or not, or if it is moving solely because of scumbag promoters, and you only care that is moving n-o-w and you want a piece of the action? Fine, but observe the money management rules here and cut this kind of stock no slack. Pick one on the way up and watch it closely. Momentum plays go up like a bottle rocket, and often come down the same way. When the momentum dries up, get out. Period. (You can always get back in if it surges again, but stop'n'start stocks move that way because of manipulation, usually, so be careful with them)

TIP: if you're getting tout emails from several different stock promotion websites on a stock and it's a crap stock, it is a good momentum candidate. But wait for definite movement before you jump on that bandwagon! To be a momentum play, price and volume both have to surge! Don't jump the gun; wait for confimation that momentum is developing. Like fireworks, a lot of stock promotions are very short lived and soon fizzle out. Better to not get in at the bottom than to buy a loser. Be sure to check out our Momentum Punchlist.

Look for the Volume.  The real confirmation of movement and direction on a momentum play is volume. But market makers and other traders can play a lot of games with microcaps. They can move prices at will on many stocks. They can also "paint the tape," which means to create the appearance of volume with phoney "wash" sales among cronies. We'd rather see lots of smaller trades than a few big pieces moving. Think about it: if you had to create an illusion of 200,000 shares trading, would you do it with 2,000-share or 20,000-share blocks? It don't mean a thing if it ain't got that swing, so ignore price advances that occur on low volume or a few large block trades. Avoid stocks that only trade a few thousand shares a day - how will you ever get out?

TIP:  If you are serious about trading, get a Level II service so you can get good Time & Sales data to see trades, and you can see where the market makers are bidding and offering the shares.

Look for Retail Firms.  Level I only gives you real-time quotes and sales. You're going to get a Level II service, right? Good! Among many other things, a Level II lets you see how many market makers there are, who is buying and selling, and whether there are retail firms in the market. You want to see retail firms making a market, particularly on the bid and ask. Retail firms are brokerage firms with real stock brokers and retail customers, as opposed to the large wholesale firms that never really make a market in a stock. If the market makers are mostly wholesalers, and especially if the wholesalers are the bid and ask, be careful, because stocks without retail market makers really have no spine and can drop like a rock.

Look for "Fill" Resistance.  We don't like market orders, because you can get screwed quickly. To be fair, only a market order guarantees that your order is filled, but getting screwed is a poor tradeoff for knowing you'll get a fill. We use limit orders to buy and sell. If you put in a limit order and the stock is hard to buy at that price, it is going higher in the short term. If you can buy lots of stock at your limit, hmmm, it is not about to move. If it is hard to sell, it is going down, so consider getting out of the position. If it is easy to sell, it is safe for the time being, because market makers are willing to buy it - but the time to sell is when the market wants it! That is, always sell into strength.

Be Prepared

Watch the Boards.  If you are interested in a stock, hit a couple of the discussion boards and see what kind of activity and interest the stock is generating. Stocks about to moving or already moving frequently will have a lot of touting posts by paid promoters. There may also be posts discussing recent filings or press releases. We like Raging Bull.com. We don't like the Yahoo! boards because of the way they're organized and b/c they're just not much help, but you might like them better than we do. CNET allows you to do a search by symbol of the Raging Bull, Yahoo!, Motley Fool and Silicon Investor boards at one time. While not as large as RagingBull, check out the InvestorsHub boards, too - hard-core tout boards.

Get Access to Good Charts and Data. This is important if you're going to trade stocks. The following are not recommendations as such, just our thoughts and experience.

Charts and OTCBB Data. While most finance portals will give you OTCBB quotes, not many services have good information on OTCBB stocks. BigCharts has good charts and has good data on OTCBB movers (select Bulletin Board on the stock screener, then you can look for movement by price, volume, etc.). DailyStocks also has good data on OTCBB movers, but sometimes the pages don't work.

Level I and II.  If you are serious about playing microcaps, you have to have this. Level I is real-time streaming quotations and sales. Level II shows you the actual market maker bids and sizes. For Level I and II service, we really like Money.net and QuoteMedia - cheap and reliable, and portfolio and charts are good. QuoteMedia is the same thing, much cheaper.

Alert Service.  We mean a real stock price alert service, not a stock tout service. You put in a stock symbol and target price (up or down), and you will get an email alert if the stock hits it. If you have a Level II, they all come with an alert service. If you don't have Level II, MarketWatch and many other websites offer free memberships that include an alert service, but delayed 15-20 minutes. If a momentum stock moves, you need to know it. Never buy a momentum stock without setting an alert.

Technical Analysis.  Learn the rudiments of technical analysis. A good source of technical education is ClearStation. Unfortunately, T/A is of limited help in trading microcaps that are not regulary traded. They can trade 400,000 shares today, 20,000 tomorrow. And if the microcap is manipulated or being promoted, the technicals are only good for identifying momentum and the apex point (where it goes over the cliff). Pay special attention to the chart and volume histogram - we like an hourly chart for most of the momentum plays with a 10-period moving average. The MACD is helpful on momentum plays, too. When the moving average is violated and the MACD goes negative, get ready to jump.

Discipline, Discipline, Discipline

Greed is Bad; Take the Money!  There's an old microcap saying: they go up in dimes and come down in dollars. Forget Gordon Gekko. Greed gets you killed on momentum stock plays, because on these stocks when the party is over, it's over. Sooner or later, volume will dry up on these plays and the price can go back to where it started, or lower. If it doubles, sell off half your position - now you're risk free. If it runs to a triple, you only have to sell a third to be risk free. For that matter, why are you sitting on a momentum play double or triple? It's okay to take a ride, but get your risk capital back first!! You will rarely buy at the bottom and sell at the top. ACCEPT THIS, please! When momentum plays tip over, they decline fast. If you hold on too long, you are going to watch gains evaporate and turn into losses.

TIP:  You only sit on gains on investment plays, but even on investment plays, sell a little when you are ahead to avoid a potential loss.

Don't Chase a Loss.  If you called it wrong or it gaps down on you, get out. Period. Traders don't get purple hearts, so don't take a bullet. Momentum plays always come back down. Always. Watch for the pullback and be ready to act. If it drops on you, never buy more to average down, because your average basis will still be higher than the current market. Losses are a part of trading. If you chase losses, you'll turn small losses into big ones.

Don't Buy the Open.  Like many other traders, I am not a fan of buying in the first 30 minutes after the open. Never buy in the first half hour. This goes for big stocks, too, actually. Be ready to sell if the stock gaps up or moves up strongly on the open, since this is like candy from heaven. But don't buy the open. Wait to see what happens. What if the stock doesn't trade in the first half hour? Easy. Treat the first half hour after trading starts as the open.

Don't Buy on Broker Tips!!  This one is about as basic as it gets. Sometimes (not always), when a broker recommends a microcap, it is either because his employer is peddling shares of the stock, or the broker is helping someone unload the shares and needs a buyer (you). If your stockbroker recommends a microcap stock, look at the stock carefully for yourself. The broker will almost always use the pitch that the stock is about to move up. In our experience, they rarely do. Wait until you see the movement.

It's Hard to Go Broke Taking a Profit.  Babe Ruth was both the home run and strike out king. Didn't he die broke? Be like Joltin' Joe and live on doubles and triples. A profit is good, and there is nothing wrong with base hits! If a stock gaps up, don't be afraid to take a profit - you can always get back in, you know.

Avoid the Pinkers.  There is almost no excuse to buy a pink sheet stock. It is hard to get good real time quotes or data, even for retail brokerage firms. Brokers hate them and almost no retail firm will make a market in them, so there is no liquidity (except for the Enron-type stocks that once were big board and fell to the pinks), the information available sucks, the companies rarely file reports with the SEC, and their financial information is nonexistent... why on earth would you want one? They're like a roach motel, you can go in, but you can't go out.