As a Darvas System trader, I typically avoid “penny stocks.” (I define “penny stocks” as low-priced stocks, anything under $10.)
The reason for this avoidance is that low-priced stocks are more easily manipulated and often swing wildly.
Following a trend is much easier when price action remains fairly stable. In such conditions, you’re able to avoid getting whipsawed out of positions during “normal” pullbacks.
However, you can use a trend-following method like the Darvas System to profit with penny stocks. It’s riskier and rarer, but every so often a penny stock comes along that would have worked perfectly with Nicolas Darvas’ method.
One such recent trade is Pizza Inn; ticker-symbol: PZZI.
This stock has spent most of the last two years trading in the $2 range. But this past summer, earnings began to explode for PZZI and the stock surged to a high of $3.54.
PZZI then spent the next three months working on a decent Rounded Base.
On October 17th, this stock broke out in a big way as it surged more than 10% on incredible volume (see the chart attached to this article).
The stock then built a nearly ideal Darvas Box, with $5.00 as its top, before breaking out again.
As it stands on November 17th, one month after its breakout, PZZI is up a cool 58%. Not bad for a single month in shaky market conditions.
When you see gains like this, it’s easy to get lured into the world of penny stocks. But you must recognize that these stocks can fall just as quickly as they climb.
And that’s where the big danger lies. When penny stocks fall, they fall hard.
You need to identify proper support levels and adjust your stops appropriately, just as you would with any stock. But with penny stocks, you also must be fully prepared to get lousier fills when you exit. Exiting a position ten cents below your stop order isn’t a big deal with a $40 stock, but with a $2 stock, you’re talking about leaving 5% of your profit on the table. That can add up quickly.
If you’re going to trade penny stocks with the Darvas System, know this going in: your individual trades ARE more likely to fail than succeed due to their erratic nature. You WILL get stopped out more frequently and with larger spreads.
Therefore, if you decide to implement the Darvas System with penny stocks, make sure you adjust your expectations and risk levels. Trade penny stocks with smaller positions and be prepared mentally for more breakout failures than you’re used to dealing with.
It’s not easy and it certainly isn’t for everyone, but every so often a stock like PZZI comes along and makes a trend trader reconsider penny stocks.
UPDATE: Almost on cue, PZZI showcased the risks of fast-moving penny stocks. By the end of the Thursday, November 17th session (the day this article was published), PZZI had dropped 10.9% during a market selloff. It doesn’t mean PZZI is finished, but it serves as a good reminder that penny stocks move extremely fast, in both directions. Be aware of this fact before you start trading them.
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