Penny stocks: Too fast, too furious

If you think high volume means there's hidden value in low-flying stocks, think again.

By Katie Benner, writer-reporter

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NEW YORK (Fortune) -- Even though Citigroup shares dropped below a dollar Thursday, volume appeared healthy as 577 million shares changed hands.

Other blue chips like Hewlett Packard (HPQ, Fortune 500) and Johnson & Johnson (JNJ, Fortune 500) traded between 20 million and 30 million shares, while the average trading volume per Dow component hit 250 million.

Citi (C, Fortune 500) wasn't the only blue-chip-turned-penny-stock that traded at outsized volumes - 283 million shares of Bank of America (BAC, Fortune 500) traded hands, closing near $3; and volume for AIG (AIG, Fortune 500), which closed at 35 cents, hit 62 million.

But before you think that active trading in stocks trading so low means there's value there, think again. The flurry of activity is more likely the thrashings of a badly wounded company than the stirring of a firm rising from the dead.

"For the most part, what you're seeing is active traders making a few bucks in these names," says Michael Lewitt, president of Harch Capital Management. "It's sort of like gambling or playing craps."

Lewitt and other money managers describe this is an "option value situation," meaning that traders don't need to put a lot of capital at risk to make a return. If AIG goes to 50 cents from 35 cents and you can get your money off the table, you've made a 43% gain and risked very little capital.

Markets have always attracted investors who trade penny stocks to make quick money on their volatility. But now they're sweeping into shares that traditional buy-and-hold investors dominated for decades, a change that shows just how much this market has shifted radically in a short period of time.

"The volume reflects that people are piling in to buy for the trade, knowing that those stocks are highly volatile," says Lewitt. "But these companies have negative net works and their capital base, even at Bank of America, has been or will be wiped out. Few people believe they're turnarounds. They're treating them like companies that will need to be restructured."

Active traders in AIG, Bank of America, and Citi are betting that further government intervention (or even just news thereof), is a factor that could give these stocks a short pop, says Barry Ritholtz, the director of equity research at Fusion IQ, an independent quantitative research firm.

"AIG has gone up 300% at times on a politically-driven bounce," says Ritholtz. "All you need is for someone to come on TV and say that a government is about to intervene, and the stock will move."

Ritholtz says institutional money is another contributor to active trading in these names. There is still massive institutional ownership for these names, and they can only sell so much at a time.

"If you're a big owner, you can't just dump millions of shares because you can't find the buyer for that much," he says. "So you could also be seeing a steady stream of selling."

It's a bad situation for institutional money, and only good for the few day traders who manage to get the timing right on these names. In short - it's just the kind of situation the average investor wants to avoid. To top of page

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