Risk / Reward Analysis on Micro & Low Cap Securities (Penny Stocks)

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1. Overview
2. Catalysts
3. Identifying and Predicting Catalysts
4. Risk
5. Identifying and Predicting Risk
6. Making your Risk Assessment
7. Conclusion
1. Overview: More and more often I find retail traders new to investing drawn to the highly volatile micro cap community. And who can blame them? A three cent increase on a micro-cap security trading at fifty cents per share will net the trader a 6% return. And who am I to judge? I’ve made thousands on the rare occasions I could find a penny stock with low relative risk and imminent catalysts. But that is the trick now isn’t it? Low relative risk and promising future price action. By the end of this entry you will know how to assess risk and reward pursuant to conducting DD on micro-caps so you aren’t blindsided by easily foreseen obstacles on your path to profitability. 
Note: Due Diligence IS NOT looking at the easily found numbers, stats, and price targets combined with all the good news, patents, and life altering medical pipelines that make a security look attractive. While this information is important, particularly for identifying catalysts, in order to be proper DD you must not only look at the possible risks, but estimate risk probability and why. Only then can you estimate when those risks are most likely to come to fruition. In the penny stock world those risks are only a matter of time. Researching by looking at only the good isn’t DD; Its confirmation bias. And confirmation bias leads to bad trades. You must do a risk assessment if you are to complete proper DD!
Change concepts with red paper airplane leading among white

A catalyst is a figurative launching platform that can swing the price action on a security up significantly.

2. Catalysts: If you are looking at a penny stock you were likely lured in by a possible catalyst. Penny Stocks are perhaps the most sensitive securities in the market when it comes to both good and bad news. This is usually because profitability is in question and good news or bad news can have a dramatic effect on how investors view the security. A catalyst is a figurative launching platform that can swing a security significantly higher. Penny stocks with catalysts aren’t hard to find. Day traders and “trading educators” will regularly advertise them after the fact. It is important to note that their interest is not yours. A trader never wants to chase the price action after the catalyst. Penny stocks can dump quicker than they’ve pumped, and often do. You will find out more about this when you get into the risk section of this entry but for now it is important to realize that investing in a penny stock without a probable imminent catalyst is a good way to throw away your money. The question is therefore “how can I find the catalyst before it occurs?”
Note: The overwhelming majority of day traders LOSE MONEY by chasing securities they have no historical knowledge of. This is because they saw a trending security and jumped in WITHOUT assessing the risk. … What? So you know some day traders who claim they aren’t losing money? Have they showed you their annual portfolio balance?
3. Identifying Types of Catalysts: Catalysts include but are not limited to the following:
  • 3a. Good Earnings: If a normal company outperforms revenue and earnings per share (EPS) expectations when they report earnings they are considered to have “beat earnings.” However many microcaps, particularly pharmaceutical companies, have yet to realize profitability. In many cases they have yet to acquire a marketable product altogether. In these scenarios good earnings is often considered if they have enough money to last a while before making another offering again. That is easy enough to assess based on past offering history, although it isn’t the only thing you should look at. You’ll just need to look up the relevant 8-K’s that pertained to offerings and assess based on past earnings (the most recent 10-K’s or 10-Q’s) if they have enough money to last a while. There are certainly other things that could come out during quarterly earnings that may bode poorly for the security. It is therefore also important to see the most recent public relations releases which can also be found in 8-K’s.
    • WARNING!!! Sometimes microcaps trade with some solid momentum before earnings; already pricing in the expected beat before dumping after. Sometime market makers short them hard immediately before earnings only to cover and accumulate before the probable pop. 
  • 3b. Expected Good Earnings: These are earnings where good news is expected which creates a pre-earnings pump. There are a number of scenarios in which traders have reason to expect good earnings on a security. The best way to find them is to look for recent spikes in security price where a public offering was suddenly implemented to raise money. Yes, the security price experienced a sharp decline but that spike in security price did not come out of the blue; there was a catalyst that shot the share price up beforehand which may be reported in more detail during earnings. Once you find the date of the spike look for the catalyst the drove it up in the media or adjoining 8-K. If you do not want to play the earnings  then fine … simply ride the security up until the day of, or the day before, and sell it before earnings are announced. Remember that earnings report dates are among the few times when you know exactly when a company is going to release information. The price will no doubt reflect this. A possible way of finding these pre-earnings plays are to check earnings calendar’s and go one by one searching for penny stock reporting dates. Look for ones with recent good news, recent catalysts, or perhaps an offering that destroyed the momentum of the share price. Remember to do your risk assessment!
    • Note: There are many online earnings calendars. It is important to understand that many of them list when a company is EXPECTED to report earnings, not when they are ACTUALLY reporting earnings. In the absence of clarity ensure the expected earnings date matches the expected earnings date in other calendars. Often it is best to wait until the company announces an earnings date in an 8-K. You can find a list of earnings calendars HERE.
  • 3c. Profitability: If a microcap company is suddenly profitable, or more profitable than expected, there is a solid chance that it will realize an increase in security price. Increased year over year profitability is the number one indicator of a probable increase in security price. You will generally get this information from quarterly or annual earnings reports. You can also assess the most recent quarters cash and debt situation by looking up company data on Yahoo Finance and clicking on the “statistics” section. Assessing profitability can be a tough task. However if you’ve seen their most recent 10-Q you can make assessments based on their market and actions between the last 10-Q and the next. 
  • 3d. Enough Funding to Make it into the Following FY: Penny stocks are penny stocks for a reason. Many microcap companies are operating off of borrowed money or, in some cases, heading toward bankruptcy. Pharmaceutical companies researching novel drugs are particularly in need of shareholder funding to make it to the next stage of development. Companies often update shareholders during quarterly and annual earnings reports on their funding and how long they expect that funding to last. Generally, all things being equal in these types of circumstances, if a company reports that they have enough funding for a year or more, the security price typically increases in the pharmaceutical sector. In order to gauge if a company has enough money to make it to the following FY I recommend looking at their last Pre-14A or DEF-14A. Or perhaps their last 10-K or 10-Q. The most recent document will give you the best information. Through these SEC filings you can usually see their financial estimates and they generally tell you outright how long they can sustain operations on current funding levels. Once you have that information down you look at their offering and fundraising history and check out how often and how recent money was raised since the last time they reported their financials. You’ll also want to review 8-K’s to see if they’ve changed the nature of their operations which could make their cost of operations more expensive. If you assess they have made operations more expensive through further investment/expansion, or, operations will get more expensive as things progress (like they often do in pharmaceutical companies), you can assess that they will need money sooner than originally thought. 
    • ALWAYS REMEMBER! Just because they say they have enough funding into the following year DOES NOT mean they will wait until the following year to raise money! It simply means that an offering is not likely at the current time. A company operating on shareholder credit will need to raise money again! So the possibility is ALWAYS present! The question is therefore one of probability. 
  • 3e. New FDA Trial Filings: When a pharmaceutical company files for FDA approval to begin a new trial, FDA approval to advance a trial, or FDA approval to approve a drug, the security price of the adjoining company generally goes up. For microcap companies the security price skyrockets! It is always best to get in before they are expected to file. You can estimate this by paying close attention to their pipeline, their investor relations page, and SEC Form 8K filings. For additional information you may want to check the FDA calendar, look at clinical trials, or see what they have in Biopharm Catalyst. Don’t forget their twitter feed and Facebook page as well. You may not get on right before they announce but you can get close enough to turn a solid profit. To find out when they will likely file its best to assess current operations and press releases. You can also find forums like StockTwits and Reddit and ask around BUT ALWAYS VERIFY THE INFORMATION! Be careful not to invest in microcaps where the news is already priced in. That may be determined by closely monitoring the price action before hand. You will know if the price is over-pumped. REMEMBER to do your risk assessment! Sometimes companies release offerings soon after announcing FDA filings. 
  • 3f. FDA Advancement: After a pharmaceutical company submits for advancement of their pipeline you will notice a sharp spike in the price of the security; typically followed by a sharp decrease finally resulting in a gapping up a few cents from where it was before. The reason for the increase is the rush of opportunistic penny flippers/chasers rushing in to profit off the momentum. Most will become bag-holders. The decrease is either a result of the shorts coming in as the penny flippers are selling out or market makers closing the spread in hopes of facilitating volatility after the catalyst cools off. Microcap pharmaceutical companies regularly plan offerings around FDA pipeline advancement news (so do your risk assessment). Penny chasing is a horrible way to do business and you will inevitably lose money. To see how close a company is to further advancement you can look at all the aforementioned resources (Biopharm CatalystClinical Trials, or FDA calendar) or seek additional resources here.
  • 3g. FDA Approval: If the FDA approves a drug the share price of a pharmaceutical company generally skyrockets. I say “generally” because this is not always the case. I have seen decreases in share price due to the fact that approval was already priced in. Additionally, sometimes the next step for a pharmaceutical company is to market their drug which requires raising money. However generally the price increases. Once again you can find filing in the aforementioned sites above (Biopharm CatalystClinical Trials, or FDA calendar) or seek additional resources here
    • Note: You should always ask yourself before you invest in a penny pharma if the drug they’re working on has enough demand in the marketplace to justify your risk. If, for example, someone is working on a drug to cure a very rare disease, or perhaps a cure for a common but necessarily untreated ailment, will the drug sell? Additionally, you should look for companies working on other, and perhaps, better drugs. I’ve seen pharmaceutical companies enjoy approval of their drug in one month only to see the share price plummet as another company gets a better quality, better functioning, and cheaper drug or device approved the next. This rendered the former company’s drug or device obsolete. In yet another case I’ve seen the FDA approve a drug only to disapprove their ability to market it as another company was granted exclusivity. 
  • 3h. FDA Fast Track Status Approval: Fast track designation ensures a drugs priority and rapid succession down the pharmaceutical pipeline. No it is not as fast as it seems but when the FDA awards fast track designation the security price does increase. Additionally this creates a scenario where catalysis come more often which mitigates long term bag holding. Fast track status is usually granted for drugs that are in immediate demand in the marketplace for illnesses that have few successful treatments. 
  • 3i. Patent Filing and Approval: When a patent is filed or approved it naturally increases the share price of a security in both circumstances. Patents can be filed in a number of countries but the gold standard is to have a patent approved in the United States. Patent rejection will naturally have the opposite effect. Here is the website to the U.S. Patent Office.
  • 3j. Partnerships: Partnerships can be a wonderful endeavor for a company. Generally, a partnership means someone is coming in with their own money to help advance a product. For the shareholder this typically means less fundraising and share dilution. It can also mean that a big company is coming in to fund research, production, marketing, and distribution of a good or service. There are a number of pharmaceutical companies that have a staff of 10-20 people and must eventually find a partner to help fund, produce, market, and distribute a drug. In many cases no partner means no drug. The partner also generally pays for licensing rights; meaning they pay the company to produce, market, and distribute their intellectual property. A partner often means the share price increases, as someone sees value in the product and are willing to put their own money down for it. There are a number of indicators that a partnership may be imminent. For example, if a pharmaceutical company has developed a drug that has been approved by the FDA, or a drug that’s shown promising results in trials, a partner can be around the corner. Pharmaceutical companies will generally notify their investors if they’re looking for a partner. Sometimes open source leaks in the media can indicate a partner is imminent. However be careful when it comes to rumors. 
  • 3k. A Buyout: Quite often a large company asks itself “Why the hell would I pay for rights to a company’s product when I can just buy them out and sell it myself?” The share price generally skyrockets to whatever price the company agrees to be bought out for. Moreover, if a company rejects a buyout because they consider the offer price is too low, shareholders may enjoy a boost in share price. However, if word is leaked that a buyout offer came in for less than what the share price was trading for, shareholders will see their equity plummet. If the buyout is hostile it is typically bad for shareholders. Generally to prevent an unwanted takeover the sought-after company begins diluting shares and exercising warrants to retain their majority stake. Buyout indicators are similar to searching for indications of a partner.
  • 3l. Insider Buying: If the officers or board members of a company are suddenly buying their own shares in bulk it is a solid indicator that they expect the share price to increase. Particularly if they rarely purchase their own stock like many of the microcap pharmaceutical companies do. Is it illegal for a CEO to trade on insider information? Yes! But let’s face it, they know best when they are going to make offerings, issue warrants, or advocate for a reverse split, and in most cases they aren’t going to buy large quantities of their own stock if they think they’re going to lose money. Be careful not to buy simply because a solitary company officer wants more voting power before a shareholder meeting. To see insider buying reports you can look for your companies SEC Form 4’s  or look for previous insider transactions HERE
  • 3m. A Sudden Change in Market Conditions that Increase Demand for the Company’s Services: Remember when COVID-19 hit and the news ran stories of people buying out Costco supplies, stocking up on Clorox, buying up toilet paper, or buying all the medical face masks? Shortly after word hit the street, the share price of COST, CLX, PG, & 3M began to skyrocket. For the microcap pharma community anyone who mentioned anything to do with some COVID-19 relationship to their drugs, tests, or devices saw increases in some cases up to 500+%! This is an example of market conditions changing the momentum of otherwise un-noteworthy microcap companies. 
  • 3n. New Contracts: A microcap company’s share price generally skyrockets when they receive a contract from a government agency or a large company. Getting a head of the curb on this can be hard but you can certainly profit from the subsequent PR and earnings reports.
  • 3o. Institutional Investment: Large funds and capital management firms are considered “institutional investors.” When they establish or increase their position in a company it is generally viewed as a net positive. However not all capital management firms have a solid reputation for investing in microcap securities. Some buy up shares for the purpose of lending them to shorts for a premium. Some buy in to profit from the spread as market makers. Some regularly assess a security’s potential to have a significant upcoming catalyst, short the hell out of it on low volume, and then slowly buy up shares on the cheap with the intent of making money on the catalyst. To see what institutions are investing in your favored microcap I recommend searching for your ticker on the web and typing the word “fintel.” Then click the ownership tab and click institutional investors. The institutional investment history will appear before you. 

Tip: Institutions can be Solid Indicators of Promising Picks: One of my favorite ways of finding promising penstocks is to look at a few pennies that have plumped and see which institutions are invested in them. Of course not all institutions are equal but some I find are really good at researching and picking microcap companies! Indeed why should I do all the hunting when I can let the institutions narrow my picks for me? All I need to do from there is to research the company, judge if the trade has a high probability of profit, and time my entry. A good way of finding such institutions is to visit secform4.com. Once gain look up companies that pumped on news and see which institutions were expecting it. Remember it isn’t enough to use the institution itself as an indicator, you must research as well!!!

  • 3pActivist Investment: Activist investing is when a wealthy person or firm suddenly decides to buy enough equity in a company to become a board member of said company for the purpose of looking after the shareholders and increasing the share price. There are a number of activist investors out there of different success rates and reputation. To figure out what activist investors are in your favorite microcap you can simply search for your company’s SEC Form 13D filings.
Note on Penny Stock Alert Services: There are a number of penny trading alert services out there that will recommend when to get in and when to get out, but all too often the subscriber is left in the dark as to what is really driving the security. These services are often a waste of money and have more losing recommendations than winners. These trading services spend a great deal of time pumping their recommendations for free after they have alerted their subscribers. You can find a number of them on Twitter and Stocktwits. While I do not recommend blindly listening to these paid pumpers, I do recommend looking at their free alerts on Twitter and Stocktwits. Subscribe to their tweets to see what they’re looking at. They can be a great reference to begin looking for stocks with promising catalysts.

Measuring device concept

4. Risk: If you are not assessing risk you are not doing due diligence. DD without the risk is nothing more than blinded confirmation bias that WILL lead to losses. Those who participate in purchasing a microcap security without first assessing the risk aren’t trading or investing; they’re gambling. Jumping into a security without knowledge of the company’s history or their current financial situation is one of the primary reasons the majority of day-traders lose money. Any day-trader that tells you that the information below is not worth your time if you are in and out of a trade during the same day is not doing you any favors. You will find that if you at minimum assess the information below the night before you decide to purchase a microcap stock you will see much better overall profit than you’ve experienced previously. You will have also likely avoided many imminent pitfalls that you otherwise would have been subject to, had you not completed your risk assessment. Once again, if you are not assessing risk you are not doing DD!
Note on Where to Begin when Searching for Risk: The risk section of the 10-K & 10-Q is perhaps the most important for assessing the possible long term issues faced by the company. Granted, if you are trading in the pennies you aren’t going to be hanging around for long. But these risks are good to know. Not all risks are created equal in the risk section of the 10-K & 10-Q. You must choose which ones are the most important to your analysis. The good news is they practically give you the scenarios that can harm the company; often in order of importance. Items covered in the risk section of the 10-K/Q may include but are not limited to the following: Competition/Competitors, Seasonality, International Relationships, Supply Chain Issues, Expansion Issues, Contractual Issues, Taxes, Foreign Exchange Rates, Challenges to Protecting Intellectual Property, Government Regulation, Product Liability Claims, Litigation, Fraud, and other risks. By assessing the risk factors you can make economic indicators that would result in aggravating critical vulnerabilities and develop a plan that could help you mitigate the effects of these vulnerabilities should they come to fruition. Conversely you can come up with a list of economic indicators that could result in reducing the vulnerabilities and adjust your analysis accordingly. Once again the point is to enable you to act smartly on information, rather than be surprised by it, pursuant to protecting your investment. 
Identifying & Predicting Risk
Vector of a businessman with umbrella resisting protecting himself from falling arrows
Risks are easy to spot if you look for them. Identifying and predicting likely catalysts without doing the same for the possible risks will more often than not land you in hot water. 
5. Identifying and Predicting Risk: Penny stocks are among the riskiest securities on the market. Sure, you can win big. However you can also lose big! The following are a list of questions you should answer before buying in a penny stock lest you lose big:
  • 5a. Offering Risk: How Long can they Operate until they Need to Raise Money?: They will generally tell you how long they expect current operations to last at current levels on their most recent 10-K’s10-Q’s, or DEF -14A’s (look for whichever is the most recent). Find the most recent one and look for how long they expect to operate at current funding levels. Then estimate when they will raise money again. This will prevent bag holding due to offerings. REMEMBER! Just because they expect to operate at current funding levels until Q-1 2021 DOES NOT MEAN they will wait until that date to raise money! As said before you can also estimate their current financial standing by reviewing their last 10k/10Q or DEF-14A and reviewing the offerings since that time. Should give you a good idea. Previous offerings can be reviewed in 8K’s. Moreover Yahoo Finance will often give you a solid snapshot of their financial situation. Simply search for your ticker and then navigate to the “statistics” tab. 
    • Other Considerations: If you’ve done your research and concluded that a company has enough funding for a year, and then the same company releases a new product or starts a new drug trial, you can bet an offering will be coming sooner rather than later than expected. Expanded operations mean increased costs. 
  • 5b. Are there Outstanding Warrants? Check out their warrant history to see how many they issued, at what strike price, and how many were exercised. The left over warrants are a risk. If they are exercised you will experience a dramatic drop in security value. You can usually look for previous warrants both sold and exercised by sorting through their 8K’s. Warrants are generally sold with public/private offerings and have an expiration date of 5 years or so. Researching this will help prevent you from bag-holding due to the exercise of warrants. For example, if a company sold warrants a year ago with a strike of $0.50, and suddenly a catalyst boosts the security price from $0.30 to $1.00, you can likely bet that a warrant will be exercised around the corner. 
    • Note: Quite often institutions will exercise a warrant and buy a new warrant at the same time if they believe a micro cap has promising catalysts. This results in temporarily lowering the price for them to buy up more shares. 
  • 5c. When MUST they be Back in NASDAQ Compliance? If out of compliance they face either delisting or a reverse split. No one will want to be around for either of those. You can find their drop dead compliance date on their DEF 14-A’s and sometimes in other forms. 8-K’s usually announce delisting notices. If there is a shareholder meeting between now and the compliance date, there is usually a vote on the R/S. If that is the case you know you are at least safe until the shareholder meeting. If that is not the case you must attempt to estimate if they plan a R/S in the immediate future. This will help prevent you from bag-holding on a surprise R/S. Remember they need to be above $1.00 for 10 days to a month (depending on the circumstance) to regain compliance.
    • Note on NASDAQ Compliance: On When a security dips below $1 for 30 consecutive days NASDAQ will issues a deficiency notice to the company. Any NASDAQ company receiving a deficiency notice has four business days to file an 8-K form with the SEC or to issue a press release to announce the notice. After receiving a deficiency notice, a company has 180 calendar days to return to compliance. A company warned about its shares’ minimum bid price must achieve a closing price of $1 or more for 10 consecutive trading days during this period. If a company with a minimum market value of $1 million in shares held by non-affiliates satisfies the other listing requirements, it may receive a second “cure period” of 180 calendar days. To receive this, the company must notify Nasdaq of its intent to correct the deficiency. If a company fails to comply with the minimum requirements during the first grace period or any second grace period, Nasdaq will issue a delisting letter to the company. As with the deficiency notice, the company must notify the investing public of the delisting letter within four business days, by filing an 8-K with the SEC. The company then can appeal its delisting to the hearings panel. Your companies last SEC Form DEF 14A or Pre 14A will let you know when they must be back in compliance.
  • 5d. Are Institutions Increasing or Decreasing their Investment?: This one is obvious. Simply type the ticker into google next to the words “institutional investors” or “fintel.” If institutions are selling it usually means there’s a lot of money coming out of that security. It may mean the institution no longer has faith in the company, although, it could just as easily be assumed that the institution has made enough of a profit to move on. Circumstances will dictate what you make of it, but if you did your DD properly, you will know. 
  • 5e. Are Insiders Buying or Selling? Are they doing anything?: Another obvious one. You can find total insider shares on the most recent DEF-14A. You need to ensure that the folks owning the company are buying more shares each year. If not there is likely a reason. You will also want to know how much of a stake insiders have in their own company. A CEO who owns but a few shares (relatively speaking) is likely holding out for better times. You can find insider buying simply by looking for their Form 4’s. Remember that a code (A) on a Form 4 does not mean they’re buying, but rather being awarded stock. You want to see code (P) for “purchase.”
  • 5f. Is my Stock Actively Being Shorted?: You’re going to want to know the short volume, the short interest, the naked short interest, and the shares available to short. You will also want to know if the security is on the REG-SHO Threshold List (indicator of naked short selling by means of failures to deliver). Shorting presents both opportunities and risks for longs and shorts are often creatures of habit. For example, if there is a widely expected catalyst coming up what short is going to want to hold over a weekend? You therefore may make the assessment that a short squeeze may be imminent. Perhaps longs will aggravate the shorts as well, hoping to hop in before a probable catalyst. In these cases where there is high short volume and an imminent catalyst expected the following week, the smart shorts cover before Friday. See HERE for more short data.
    • FYSA The Short Sell Circuit Breaker List:  Many traders are unaware of the Short Sale Circuit Breaker ListSEC REG-SHO RULE 201 is best summarized as when a security drops more than 10% in a single day the “Alternative Uptick Rule is in Effect” for the rest of that day and the following day. That simply means that you cannot sell a security short below market value unless there is first an uptick in price for the rest of the day and the following day. 
    • Note on Shorting Penny Stocks: Many retail trading platforms do not allow shorting of microcap penny stocks. One of the reasons is because it increases the risk for themselves and their customers. They don’t want to lose money on folks who can’t pay for a margin call on a security that skyrocketed 200% in a few seconds. Yet another reason is that microcap penny stocks are few and hard to borrow. The primary culprit of shorting microcap penny stocks are large market makers and investment firms. Market makers involved in a penny stock aren’t necessarily a bad thing. They provide liquidity where there can be little. However the spread can be huge and if they cant provide liquidity at a higher price they will be happy to provide it at a lower one. 
  • 5g. When was their Last “Mixed Shelf” Extension?: Mixed shelf filings are renewed every three years and are nothing to be afraid of. It just gives a company permission to make offerings and sell warrants at will up to a certain amount of shares. Nevertheless retail traders will initially mistake them as a public or private offering which will send the stock into a temporary tailspin. Play this one how you will. You can average down or buy the dip. Weaker securities with no immediate catalysts may not come back up. But for the most part they do. You can see their last mixed shelf extension on the SEC Form S-3.
  • 5h. What is the Penny Flipping Day Trader Footprint?: These are day traders that buy massive amounts of shares on a low float, low volume security and sell for a cent or two higher only to buy a massive number of shares again and sell for a few cents higher … rinse and repeat. These fellas do a lot on low volume to keep a good security stagnant or even increase selling pressure. However, they will benefit you when a catalyst drives up the security price as they all flock to feed like rabid wolves and become future bag holders. They also eat short volume though they can create sell volume of their own as well; particularly at the end of the day. You need them on good days, hate them on stagnant days, and despise them on bad days. You will love them when the security pops and hate them when they sell shortly after. No need to worry. Most of them are losing money. 
  • 5i. How Much Liquidity/Volume?: If there are too few shares and low volume it will increase volatility in both selling and buying and make securities hard to sell or buy. Best to stay away. These are usually easy to spot. Their charts look like building blocks. Securities with moderate volume also may have a market maker increasing liquidity and profiting off the spread. These are easy to spot by the giant walls below and above current value in the level 2 data. 
  • 5j. Are Insider’s Selling?: If insiders of a microcap are selling and they aren’t stepping down, run for the hills. They know something you don’t. Assess each case individually. You can look for insider transactions HERE. Of course, if a major company officer steps down or retires you can bet that too will be reflected negatively in the share price. 
  • 5k. At Risk for Bankruptcy?: Please do yourself a favor. Never invest in a microcap security of a company that is only a microcap due to extreme insolvency issues. Recent examples include McDermott (MDR). The Wall Street Journal among other outlets were reporting rumors of bankruptcy derived from industry insiders well in advance of their eventual bankruptcy. Yet penny chasers ignored them still, opting instead to chase a catalyst of another loan to get them over the next few months. Penny flippers were cursing the WSJ as “propaganda” on internet forums. Finally, a trading freeze was implemented and bankruptcy was announced. When trading finally resumed the security dropped instantaneously from $0.55 to $0.07 with a quickness that I’ve never seen before. Traders were bragging about getting out with a 50-75% loss which, at the time, was indeed something to brag about. As MDR was in debt more to lending institutions than there was shareholder equity in the company, the shareholders lost all but $0.07 where it trades last time I checked in the OTC pink sheets. I understand that all shareholder equity was to be liquidated. The lesson here is simple. There are plenty of microcap securities to invest in. If the catalyst you’re looking for is another loan to stay afloat on an over-leveraged financially insolvent company, you’re risking too much. Stay away from financially insolvent companies!!!
  • 5l. Less than 3 Products/Profit Potential: When a company offers too few primary products it increases the risk. A drug company that is only developing one drug could be destroyed if the FDA rejects their applications. A technology innovator working on new software or hardware would seriously be hurt if someone came out with something better. When there are too few products offered by a company and something catastrophic happens to their product line, it could mean imminent death to shareholder equity. Penny stock shareholders value a company based on profits yet realized. If  potential profitability disappears because a company’s only product is now worthless, so too will stock value. I’ve seen penny stocks crushed over 90% in a matter of seconds in such circumstances.


Businessman hands holding a magnifying glass and analysing the d

Itemizing key data points will help you conceptualize and assess both risk & reward.

6. Making your Risk Assessment: Now that you know how to identify and predict both catalysts & risks its time for you to make your risk assessment. As a rule of thumb you should always underestimate the good and overestimate the bad. Sure things would be rough if you didn’t profit as much as you thought you should. But things would be rougher still if you came out at a serious loss. You should never think in terms of absolutes, but probabilities. Risk and reward yet to be realized comes in three categories: Low, Moderate, and High.

  • 6a. Identify Possible Catalysts: First identify the possible catalysts and when they are likely to happen. A company will usually tell you when they expect to file submissions with the FDA or when they expect to fully market their drug in their earnings call. Moreover companies often grant guidance in their earnings calls. If you are invested in a microcap without having first listened to their last earnings call or read the earnings call transcript, you’re playing with fire. You can usually find these in their investor relations page of their website. If not there you may be able to find it by looking up the ticker in Seeking Alpha and clicking the news tab. I have given you enough information above to help you get the ball rolling on identifying catalysts. In many cases identifying catalysts will come with experience and knowledge of how a particular industry works. 
  • 6b. Identify Possible Risks: When it comes to microcap securities the big three risks are Offerings, Reverse Splits, & Exercised Warrants, although there are others. Nevertheless you will want to list all three of these risks and judge the probability of them happening in the short, medium, and long terms. For many of the cheapest penny stocks these events are a forgone conclusion, its only a matter of time. A company with enough funding to last beyond a year from the current quarter might have a low chance of an offering in the next three months, but that risk will be moderate in the following three months and high in the time thereafter. A company trading over $1 likely wont need to worry about NASDAQ compliance and delisting, but a company trading below $1 will. You will want to know exactly when they will need to be back in compliance by. In that scenario they will either need make a reverse split, or go to the pink sheets where many securities die. Write down and keep track of that compliance date! Finally look up their past offerings and see how many warrants they have out. Ensure you look at the strike and how much was paid for the warrant. When the security hits a certain price the owners of those warrants will want to exercise their right to convert them into shares. Your job is to estimate at what price so you don’t get caught holding the bag later. 
  • 6c. Other Considerations: Your job isn’t over yet. You want to write down important upcoming dates like earnings, expected FDA submissions, shareholders meetings, a time frame of when a reverse split is likely, and when you believe an offering is likely. You will want to dive deeper into their finances, check out their institutional ownership, see what the size of their float is (lower float = higher volatility), come up with a most likely scenario, a most unfortunate scenario, and a best case scenario. You may want to look at analysts predictions and price targets and compare them to yours. You’ll want to see if insiders are buying or selling, or anything at all. You may want to look up the profit potential of their drug if approved, how far along they are on their drug pipelines, and look up past news reports on the company both national and local. You may want to judge on their progress in obtaining a partner, research the probability of their trials ending in success, look at the short data, and most importantly look at the trading history to assess what dumped the stock and what helped the stock. Finally, you will want to know at what price will you want to establish a starter position at, what prices you will average down at, and at what price, or prices, you will sell at. Never go into a penny stock without first having an idea of how you expect to trade it! After all of this, and perhaps more, you will be able to gauge if the risk is worth the reward. 

7. Conclusion: There is no one way to conduct risk/reward analysis. Unless you do, however, you cannot honestly claim that you are doing DD on a security. Following this model, or at least incorporating it into your DD, can go a long way to ensuring that you mitigate risk and maximize profit. It will reduce surprises and place you in a position to act if the trade turns against you. You should always have a good idea what the risk reward profile is on a penny stock before trading. 

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IMPORTANT DISCLAIMER: I am NOT a registered investment adviser, broker dealer, or member of any other association for research providers in any jurisdiction whatsoever and I am NOT qualified to give financial advice. Investing/Trading in securities, particularly microcap securities, is highly speculative and carries and extremely high degree of risk. The information, analysis, and opinions listed above are my own and may not properly reflect the underlying conditions of a company or security. You should do your own Due Diligence. If you trade based on anything I have written YOU ACCEPT FULL RESPONSIBILITY AND LIABILITY for your own trades and actions and hold the author of this publication harmless. If that isn’t clear enough DO NOT TRADE, ACT, OR INVEST, BASED UPON ANYTHING I WRITE OR RECOMMEND. There, we should be solid now. 

9 Comments on “Risk / Reward Analysis on Micro & Low Cap Securities (Penny Stocks)”

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