Return of the Cheapies -- Stocks Priced at Less Than $10

When I first began trading, I almost always played lower-priced stocks (less than $10) because these were the stocks that attracted daytraders.

I traded 1,000 shares and primarily looked for news events that would draw daytraders. Everything was delayed -- news, quotes and executions. Slowly, things began to get faster and faster, and now everything is real-time. I was able to squeeze tremendous profits out of these cheap stocks by understanding the psychology that made daytraders enter and exit stocks. In early 1999 I noticed that daytraders started to migrate away from the cheaper stocks and to the larger, faster-moving stocks.

As daytraders moved, so did I, and I continued to profit by learning the psychology of traders in the larger stocks. Recently, though, I have been seeing more and more daytraders move back to the smaller stocks. Ahh, the good old days are coming back.

Why do I like cheap stocks so much? Well, a large majority of the traders who are active today have never consistently played these stocks, but the reasons behind their entries and exits remain the same. Until these traders gain experience playing these lower-priced stocks, it is easy to beat them to the punch, as they don't fully understand this group yet. Sounds unfair, but when I trade, I don't trade stocks -- I trade traders and profit from their overreactions, slow responses and unfamiliarity with certain patterns.

It's a bit like learning to play tennis on a grass court all your life, moving to hard courts and then returning to the familiar grass courts against opponents who have never played on them. The balls bounce in strange ways and sometimes act completely contrary to what is expected. Cheap stocks are no different.

Here are some of my observations concerning these stocks. With cheap stocks, I trade at least 1,000 shares and try to keep my stops within 12 cents. Exits are different. I exit cheapies on the way up, much earlier than I do higher-priced stocks, while there is still buying. Remember, I am playing daytraders, so I need to beat them to the punch and if I delay, I lose.

Not always, but a good percentage of the time, cheapies tend to move up from the open. When cheapies move down from the open, I watch for the first uptick, then enter. If the premarket shows large upward momentum and I feel the potential is good, I will enter premarket with a 20-cent stop. Just as with a tennis ball on a grass court, small stocks tend to go contrary to what is expected and catch many traders off guard. By knowing this, you can beat them in and out of the trades. Here are a few examples.

On Monday, June 11, I was watching the overall premarket action, which was fairly negative. Due to this, I expected the general market action to trend down. However, I was watching three "cheapie" stocks in the premarket that were all showing positive momentum just prior to the open -- dELiA*s(DLIA Quote - Cramer on DLIA - Stock Picks), Intuitive Surgical(ISRG Quote - Cramer on ISRG - Stock Picks) and Worldgate (WGAT Quote - Cramer on WGAT - Stock Picks). I decided to concentrate on these as the trend for cheap stocks is to climb at the open, regardless of general market conditions.

You can see from the Nasdaq chart above that the negative action in the premarket was a good warning flag of what happened that day. This negative action had many traders confused when many of the cheapies started to take off; when the traders attempted to trade them, they entered the trade late. Because I was expecting this, I beat them to the punch at the open.

As you can see from the chart above, dELiA*s opened at $6.01 and climbed right at the open until 10:01 a.m. EDT to $6.89. Due to the vertical climb, this was the proper exit point for an easy 0.80-point gain. This is a good example of the perfect play on small stocks.

Intuitive Surgical was another great example. It opened up at $9.15 and climbed all day long to a high of $11.00, but the exit point was at 11:48 a.m. EDT when it faltered and it looked as if it was going to reverse when it hit $10.25 for a bit more than a one-point gain.

Worldgate was next. It opened up at $5.46 and took off from the open, eventually climbing to $6.95, but the proper exit point was at the first reversal at 9:42 a.m. EDT when it hit $6.25, for a little less than a 0.75-point profit.

Looking at the charts, hindsight will tell you I could have ridden out these dips, but those momentary dips could have just as easily been complete reversals. Remember, I am trying to get in and out before the masses realize they missed their exit points and begin to panic.

The key to successful trading is to track patterns that repeat, learn how the traders you are up against will react and beat them to the punch. And last but not least, trade traders, not stocks, because after all, that is who is making the stocks react in the way they do. Keep an eye on those cheapie stocks -- they're back once again!