Pendulum Theory and Hot Stocks

I want to talk to you about “pendulum theory.” Pendulum theory is an old theory we developed on Wall Street when a bunch of us market makers would gather after hours for refreshment devoid of solid food. (Liver damage was an occupational hazard of market makers as these scholarly discussions would start about a half an hour after the market closed and last generally until the bar closed.)

Pendulum theory says that the more the stock swings one way, the more it will swing the other. If the stock goes too far up, it will go too far down.

On the other hand, there are many quiet stocks out there that do not swing much at all but mostly these are not penny stocks. If these quiet stocks do not swing much one way they will not swing much the other way.

The underlying workability of this theory is that stocks have certain financial and structural factors that determine they way they move.

Small companies are generally more volatile than large ones because a smaller amount of buying, or a smaller amount of news, will move the stock more.

If there is a relatively small amount of stock in public hands, that is a small amount of “float,” the stock will tend to swing more violently as the amount of supply that can slow any buying that comes in to the stock is less. (Note that the float can change over time from additions from people selling stock under Rule 144 or other sources.)

If the company has earnings and its value is determined largely on those earnings and a small profit margin, any expansion in the profit margin will produce a relatively large change in earings and therefore price. For example, one company has a profit margin of 1% and another has a profit margin of 10%. If both increase their profit margins by 1%, the first company has doubled its earnings but the second only has a 10% increase.

In the case of penny stocks, their price is often determined by how much effort and attention is put into informing the investing public. The old adage “stocks are not bought, they are sold” applies. That is, there are not many people out there looking over small companies to buy the stock. Rather, companies have to work hard to get people to buy their stock.

Another determining factor in stock volatility is the presence of possible news. If the company, like many of the companies we discuss here, is awaiting a deal, news many send the stock moving fast.

Finally, an attack by predatory short sellers can increase volatility.

Another aspect of pendulum theory is momentum. Momentum simply means that penny stocks in general, and reverse merger stocks in particular, when in motion tend to stay in motion. They are one way streets for some period of time, until the pendulum turns.

With a volatile stock, the pendulum moves up “too far,” and then too far down in, then too far up. A stock may then start to be less and less volatile as time when on. Thus, there may be less and less momentum in stock movements.

This is typical of some of these stocks, momentum causes them to go too far and they are very volatile and treacherous to trade. But it makes for more fun and sometimes more profits. Travel at your own risk! As always, we tell you that this is risky investing, do not use more money than you can afford to lose, and do your own homework. Please include in your analysis some idea of the float and other factors that will affect the volatility of the stock. You can find more data in my books, How to Find a Home Run Stock and How to Pick Hot Reverse Merger Penny Stocks.

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