I Recommend These Three Precautions

• July 21, 2003
• Rob Hanna

Since the run-up began in March, we’ve seen a large
number of low-priced stocks that have made terrific moves. Stocks like CNQR,
TRAD, RATE, CHINA, ORCC and others have broken out of bases at very low levels
and gone on to terrific gains. For smaller investors who are especially agile,
stocks like these can offer solid opportunities.  At the same time they are also
fraught with dangers.  While low-priced stocks have the ability to run-up
extremely fast, they also have the ability to drop even faster. 

 

Pure
World
(
PURW |
Quote |
Chart |
News |
PowerRating) provided an example of this
recently. In April, PURW sprang to life and moved from about 60 cents to $3.50
in just a few short weeks, nearly a six-fold price increase. From May to the
beginning of July PURW formed a base between $2.50 and $3.63. The December and
March quarters showed significant increases in both revenues and earnings. The
average daily volume of the stock had increased from about 4000 shares a day to
40,000 shares a day. This huge increase in volume is normally a positive sign
and shows that a small stock is likely attracting some institutional
sponsorship.

 

 

On July 8 PURW broke out of its
trading range on convincing volume and ran up over 20%.  It then wiggled back
and forth for the next 6 days. On July 17, around 3pm earnings were released.
The release was not well received by investors, and within 20 minutes the stock
had lost over 50% of its value.  If you weren’t paying attention, and didn’t
have a stop-order in place, then your position took a huge hit.  The chance of
this happening in a higher-priced, more liquid stock is extremely remote, but
when you trade in illiquid, low-priced stocks you really need to be on your
toes.

 

If you decide you want to try
and catch the next RATE or CHINA, then I would suggest taking the following
precautions:

1. Trade with a reduced position
   size. The easiest way to do this is to determine where your stop level would
   be and then calculate how much you would be able to purchase and still keep
   portfolio risk to an acceptable level. Make sure to allow for significant
   slippage.  If you normally risk 1%-2% of you portfolio on your positions, you
   should reduce this number at least by half.  If your normal position size is
   8-10%, you may find that your position sizes in these kind of stock is closer
   to 2-3%.  That’s OK.  As new bases are built, and more institutional interest
   is generated in the stock, you can build on your position with fresh
   breakouts.

    

2. Lock in profits. Many times
   you might get a quick pop of 20%-30% or more. Take a piece off the table.  If
   it continues to rocket upwards, take a little more off the table.  Once you’ve
   locked in some profits, any potential reversal won’t hurt so much.

    

3. Manage your stops
   closely. This is crucial.  Hopefully you land a few big gains. Don’t let them
   get wiped out with a few big losses.  Keep your losses small and you should be
   fine.

The bounce that we saw in the
indices on Friday was unable to follow through today.  The S&P 500 looks to be
testing its 50-day moving average, and the NASDAQ is starting to close in on
that line as well.  The S&P hasn’t really tested this line since the end of
March. If the 50-day moving average fails to hold, the 960-965 level I mentioned
last week looms large.  This area represents the August 2002 high, which was
broken in the beginning of June.  It also represents the July 1 pullback lows,
and the 23.6% fib retracement of the March — July move in the index. 

A close below this level would complete a double-top formation and would likely
lead to a deeper correction.  For longs, I’d look to keep position size a little
light and focus on only the best setups until the market starts showing signs of
accumulation.  I’d also look to find some solid short candidates in case the
market does end up breaking down.

 

Best of luck with your trading,

Rob Hanna

robhanna@rcn.com