Low-Priced Stocks: A Golden Opportunity or an Unreasonable Risk?

You can buy a lot of shares of a low-priced stock, and it can double in price quickly. It sounds like a golden opportunity. We’ll take a closer look at some stocks that are trading a low levels and decide if we want to participate.

There are stocks that have always traded at a low price, stocks that were once high and are now low, and stocks that have been delisted because they declared bankruptcy, were caught cooking the books, or just fell under the minimum capitalization requirement for the Exchange. Is it a good company going through a hard time, or a bad company about to disappear? The reward for getting it right can be high, as is the penalty for getting it wrong.

It’s difficult to evaluate some low-priced stocks without being criticized for hindsight, or survivorship bias. Still there is important information we can discover that will help you make a better trading decision in the future.

Case Studies

We’ll look at two companies that have survived some difficult times, Bank of America (BAC) and J C Penny (JCP). Well, we think JCP has survived. We’ll also look at Radio Shack (RSHCQ) and Crumbs (CRMB).  We’re not interested in day trading and most of our readers are investors who would like to hold a position for months rather than days, so we’ll apply a classic 200-day trend to these markets as a way of deciding if it was profitable to trade. It’s likely that we could test each stock and find some particular trend that worked, but that would be overfitting.

The rules for the trend system are (1) buy when the 200-day moving average turns up, (2) sell when the 200-day moving average turns down, (3) only take long positions, (4) each trade size is calculated as $10,000 divided by the entry price, and (5) $8 per trade is applied as the only cost.

J C Penny

Starting with JCP, the left chart below shows the closing price since 1998 and the net PL of the trading system over the same time. The price scale is on the left, showing that it reached over $80 and now sits just under $10. At the far right on that chart, a long position about August 2014 first showed a profit, then a loss.

Note that the recent loss is very large considering the low volatility of prices. In the right chart, the “size,” shown in red, increases as the price declines, so that every trade is intended to have the same risk.

1 jcp

To understand these trades, we need to look at the price volatility, shown below. It may seem counterintuitive, but as prices decline (the bottom scale), volatility increases. What we need to understand is that the absolute size of the price moves increase as the share price increases, but the percentage price move declines slightly. But that is not our real concern. The problem is on the far left, when prices drop to their lows and volatility explodes from 50% to 450%.

Are you rewarded for taking that risk? The net PL in the first chart shows that the system lost money. But this is only one case.

2 jcp vol

Bank of America (BAC)

We all remember that Bank of America suffered badly in the 2008 meltdown, and ended up acquiring Countrywide, which was then the target of lawsuits. Prices dropped from $50 to under $5 in short order. The 200-day trend would have kept us out of that trade and posted only minor losses. The biggest trend profits were made as price recovered in 2011 but all the losses are associated with high volatility. In the lower chart we can show clearly that volatility is highest when prices are lowest, but they rarely translate into trading profits. This is seen best in the early 2000s, and again at the end of the 2008 crisis.

3 bac

The Ultimate Risk

Radio Shack has been on a long downhill slide, but there is always the chance it will recover. We’ve often seen that the demise of a company is exaggerated by the news, otherwise Apple and Best Buy would have been long gone.  We see in the charts below the classic pattern of higher volatility as prices reach new lows in recent months.

4 radio vol

Had we used a 200-day moving average to trade Radio Shack from 1982, we would have had an incredible run of profits, as shown in the lower chart of NAVs below, that is, until recently. Extreme volatility at very low prices would have erased 15 years of gains. Even worse, the stock could go to zero or stop trading.

5. radio nav

Low Prices and Volatility

Even if we netted a gain at very low prices, it would be on high volatility and unreasonable risk. As a general rule, we think that stocks posting volatility (20-day annualized) greater than 50% are a poor risk-reward. Although this value may vary  for individual stocks, avoiding extreme risk seems to be justified in our examples and we believe, in the market as a whole.

© 2015 April KaufmanSignals.com – Low-Priced stocks – All Rights Reserved

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