Why Penny Stock Sellers Are Deceiving You

When I was in college, in order to force myself to make it through the most lethargically boring classes in my curriculum, I would sit in the back with my laptop open, and a webpage loaded with my brokerage account. I’d usually try to make few trades a day... and considered myself to be a real “day trader.” I thought by doing that, I could surely retire by the time I was thirty.

I was so naïve. But, sometimes I got really lucky.

One day I bought a call option on Goldcorp, inc. (GG). Buying a stock option is a highly speculative form of investing. Options have two purposes: protection, and speculation. This trade was pure speculation. Really nothing more than gambling. Most investors that deal in options are behaving like pure gamblers—and at the time, I was too.

The price of stock option moves like a tidal wave—it can swing hundreds of percent up in a single day—or go straight to zero. Buying options can be like riding a sickening roller coaster all day long… you often get to the puke point fairly quickly. Using our tidal wave analogy… you can be riding gains high one day, and get crushed to death the next.

The price of an option moves in relation to the stock price—but incredibly magnified. If the price of a stock increases by, say 5% in one day, the option price may increase by 150% or more—more than doubling your investment. Sounds awesome, right?

That’s actually what happened with my GG purchase. I bought the option at the market close one day, and two days later I opened my brokerage account. My GG call option was sitting on a 150% gain. I sold immediately and patted myself on the back. Apparently, I was a stock market genius.

I thought to myself, “Man, a guy could get rich like this if he did it every day.” Was I right?

What would my return be over the course of a year if I did that every day? What about over 5 years?

Annualized Returns--the Best Way to Compare Potential Investments

The answer to this question is the essence of an annualized return. It’s the method we use to compare investment returns.

For the particular stroke of luck I mentioned above, I calculated my annual gain would be around 1,890,000%. Who wouldn’t want to brag about a return like that? After all, anyone with these kinds of regular returns should be a billionaire in no time, right?

The concept of annualized gain is simple. Let’s say we make an investment and it returns 10% in one month. If we did this same trade 12 times over the course of the year, our total return would be 120%. Easy math, right?

You can get a little more technical with this and compound your returns. So, $100 invested after one month, returning 10%, becomes $110. If we take that $110 and return another 10% in month two, it becomes $121. Do that 12 times, and we arrive at an ending account balance of roughly $314. A return of 214%. Not too shabby.

Generally, viewing returns within the annualized lens is useful, but be cautious.

It’s useful because I can take any investment I have, across any asset class, and by using annualized returns, I can gauge and compare potential investment opportunities. It is particularly helpful if I have a time frame in mind for when I expect to see a particular return.

For example, if I make 15% in three months, for a 60% annualized gain, that’s better than 15% over 4 months, for a 45% annualized gain. I typically skip the compounding effect, because the numbers tend to become absurd, and realistically speaking, my money will never be tied up 100% of the time as implied by the compounding.

But as I implied, annualized returns are not always very useful. Clearly, if I come to you saying that over the past month, I have averaged annualized gains of almost two million percent per trade, you’re going to call me a liar, a cheat, and a fraud. Quoting numbers like this is going to create ridiculous and unrealistic expectations. It may not be impossible, but it is certainly improbable.

Never let me or anyone else sell you on a particular trading strategy based solely on annualized gains. Having an interesting trading strategy or setup, and using short-term, annualized gains to sell the strategy is, in my opinion, misleading, overstated, and deceitful.

But, as a general rule, I will quote annualized gains to put things in perspective or to compare opportunities. And, I think it’s wise for you to do it too on your own.

When Not to Use Annualized Returns Basis

So, when will should you not quote annualized gains?

If the return sounds completely absurd or unrealistic. I’ll probably say something like “140% return in just 3 months” and leave it at that instead of quoting a return of 560%
If the term of the trade is short-term, and thus would result in absurd annualized return figures. The shorter the term of the trade, the more usefulness of the method is diluted

Making an annualized gain of 1.89 million percent in two days doesn’t make you a super trader, it doesn’t make you a genius, it doesn’t make you a billionaire overnight—and quoting numbers like that to brag or sell something just makes you look like an idiot, and erodes credibility.

One trader I like to follow says, “You can’t ‘eat’ annualized returns.” In other words, quoting them doesn’t put any money into your trading account. You can’t pay for vacation with them, buy lunch, or retire before you’re thirty.

PS. Above I mentioned a bit about stock options. Using options can be an extremely lucrative strategy—if you do it right. If not, you are more than likely to lose a lot of money.

Live long and invest,

Jeremiah