How to minimize risks when buying speculative stocks

High-flying speculative stocks are once again in play. These are typically little-known stocks that become active and go up sharply because of rumors that something exciting will happen, making them very profitable in the future. Most of the time though, these stocks drop as fast as they rise because rumors don’t materialize or actual profits do not meet expectations.

We generally advise investors to stay away from speculative stocks. Although potential returns can be big, risks are equally huge. However, for those who still want to buy them, here are some tips on how to minimize risks:

Plan your trade and trade your plan.

When buying speculative stocks, you need to have a plan on where to sell or cut losses in case your trade doesn’t go your way. You could use the 50-day moving average or other technical indicators as your cut-loss level. Most importantly, don’t be emotional and make sure to follow your plan when prices hit your cut-loss level. Otherwise, you could risk owning a stock that will be worthless in the future.

Limit the size of your trade. While it is tempting to bet a huge amount when buying speculative stocks, make sure to limit your size to only a small amount. Remember that speculative stocks are very volatile, both on the way up and on the way down. Buyers also tend to disappear when prices are going down, making it difficult to exit a large position.

One method to determine the size of your exposure to speculative stocks is to base it on the amount that you are willing to lose in case you are wrong. This can be an absolute amount or a certain percentage of your portfolio. For example, if you have a P1-million portfolio and are willing to lose 3 percent or P30,000 in case you are wrong, compute for the number of shares that you can buy assuming that the stock hits your cut-loss level. In case the stock goes down, your loss is limited to P30,000 and bulk of your capital is still intact.

Don’t buy on weakness or average down. Fundamental analysts like me usually get excited when blue chips like SM or Ayala go down because we view this as an opportunity to buy these gems at a bargain. However, the same is not true for speculative stocks. As discussed earlier, speculative stocks go up because of rumors. Unfortunately, the price of these speculative stocks will stay weak if these rumors fail to materialize or don’t meet expectations, making you stuck with a worthless stock.

Buy on rumor, sell on news. As mentioned earlier, speculative stocks go up because of rumors that something exciting will happen. Moreover, there is usually a rumored valuation or profit that analysts still can’t validate because of the absence of information. However, once the rumor comes true, excitement dies down because there’s nothing to look forward to anymore. Also, if prices went up because of a new business (such as a new mine site), execution risk comes into play and it usually takes several years before profits materialize. Because of this, the price of the stock will most likely go down, making it wise for the owners of speculative stocks to sell on news.

Can you still justify valuations? Because of excitement, there are times when valuations of speculative stocks reach absurd levels, making them even more expensive than other more established names that are already generating the rumored profits. When this happens, it’s time to sell the stock and stay away because it will be impossible for the stock to sustain its current price over the long term.

With these five tips, we hope that you can minimize potential losses when buying speculative stocks.