Timing of Purchases of Penny Stocks of Major Companies such as AIG

Nowdays many stocks of major companies are penny stocks. In this post we review some principles (developed by the Editors of this blog) on how to buy (if ever) penny stocks (which are even more risky than any stock which are already risky).


Principle 1:

Never buy the stock before the bankruptcy news is out. You do this because you want the component in the stock price that relates to the probability of no bankruptcy to be filtered out of the stock.

Therefore you buy the stock only towards the end of the day after the bankruptcy has been announced.

Principle 2:

The price after bankruptcy announcement is interesting. It represents the price of a perpetual call option at strike zero, with however the knoweledge that we now have which is that stock is already in bankruptcy or insovent.

What does then the price roughly represent? Let us look at a simple model. The stock now can either be worthless or worth something with a probability (let's call it q). The price can then be thought of as: 0*(1-q) + q*(X), where X it the price of the stock under the assumption of the stock will not be worthless.

Therefore if we decide to buy the stock, we are essentially buying q*X. Bankruptcy takes time to resolve, and buyers may emerge. In the meaning time, the stock price fluctuates. Therefore if there are any surprises to come, it would be that the probability Q (in Q*X), or its estimation by the market, would rise in value.

The next question is, what could the value of X and Q be? This leads us to principle 3.

Principle 3:

Unlike other penny stocks, we want to focus on stocks that have option chains (such as AIG). This provides valuable information. The reason is that we can calculate from option prices and implied volatilities, the options market estimation of the value of Q.

If we can determine an approximate value of Q(or just some bounds on Q), we can make estimations on X.

The reason we want to calculate X is that our estimated reward is: X-Q*X, which is (1-Q)X. This is very important to understand and internalize.

Principle 4:

Option pricing tells us that the estimation of Q, also depends on the time horizon one takes. This dependence on time is called time skew. It further tells us that the estimation of Q has a large variance compared to the variance of Q.

Principle 5:

A consequence of principle 4 is that we should sell volatility premium in going long the stock. One should therefore sell an ITM put or equivalently buy and write an OTM covered call. In addition one should average once's entry because of changes in the estimation of Q as a function of changes in price (but this aspect is less important if one were to use options in implementing the long stock scenario).

The above have a sublist of principles that I would like to touch upon. As stated above, the complete discussion and coverage of principles will be written in a special report to be given to those who request it. Email address is below. Please put Penny Stock Report in the subject line.

stocksuniversity (at) gmail (dot) com