I couldn’t believe my good fortune. It was my first day investing with real money at a proprietary trading firm. I had just completed an intensive training course and spent weeks on a stock market simulator with pretend money.#-ad_banner-#

A quick primer: Proprietary trading companies hire traders to trade the firm’s money for a split of the profits. Some require traders to post a risk deposit to cover any potential losses. Others don’t require a deposit, but traders take less of the profit because the firm assumes more risk.

My first trade was on a small $7 stock that showed all the signs of one about to explode on the upside. I purchased the maximum number of shares that the firm permitted and set my stop loss — and to my amazement, the price took off to the upside. By the end of the trading day, I had banked a $2,500 profit after splitting with the firm.

Not bad for the first day on the job, I thought. My phone rang — it was the managing director of the firm requesting my immediate presence in his office. I hadn’t met him, but I thought that surely he wanted to congratulate me on a great day, or maybe even give me a promotion!

As I entered his office, however, I could quickly tell by his face that he wasn’t happy with me. He explained that it was against company policy to trade stocks under $10 due to their inherent volatility and high risk.

“But,” I stammered, “I made a killing for myself and the firm today — how can this be a bad thing?” 

He explained that another trader at the firm had done the same thing but shorted the stock instead and taken a big loss. The director went on to say that stocks trading under $10 were simply too risky, that my success was nothing but luck, and that if I ever did it again I would be fired.

Although I never again traded a sub-$10 stock with the firm’s money, I disagree with the managing director about the extreme risk of such stocks.

While risk certainly exists with low-priced shares, the risk is no greater than with any other investment as long as these low-priced stocks are chosen with care. The corresponding upside of low-priced stocks more than compensates for their inherent volatility, as smaller stocks are much more likely than their larger brethren to double or more. In addition, investors can buy more shares of low-priced stocks, potentially magnifying their returns.

If you read my recent article on legal insider trading, you’re aware of the power of tracking insider sales and purchases. Applied to small stocks, this tactic can be devastatingly effective. The inherent volatility of low-price shares, combined with insiders committed to making a series of insider transactions, can radically affect the share price.

One of the most interesting small stock insider activity stories right now is biotech MannKind (Nasdaq: MNKD), which is something of a study in contradictions. There have been 38 insider transactions over the past 12 months: 10 buys and 28 sales. 

Ironically, TheStreet.com reported that executives were selling shares on the same day that the company was advising investors to remain confident in its leading product, Alfrezza. An experimental fast-acting inhaled insulin product, Alfrezza obtained controversial results from its Phase III studies, which prompted the executive selling and led to the company’s attempts at damage control.

Despite the selling by top-level executives, the No. 1 stockholder in the company remains its founder and CEO Alfred Mann, with more than half the shares. Mann is bullish on the shares and is convinced the Phase III results were positive despite the controversy, so investors are faced with the dilemma of weighing Mann’s bullishness against the executive selling. MannKind has also long been a rumored potential takeover target, possibly by Pfizer (NYSE: PFE).

When the fundamental picture and insider activity record are in conflict, I turn to the technical picture to break through the confusion. A look at MannKind’s daily chart shows shares sold off from a high of near $8.50 in August to a low near $4.50 this month. Price has correspondingly bounced from the lows and found resistance near $5.50.

Risks to Consider: Like all investments, small stocks are inherently risky. Even in cases of heavy insider buying, high risk remains. The rule to always use stop-loss orders and position size properly is even more crucial when investing in small-dollar stocks.

Action to Take –> Shares of MNKD are currently supported by an upward-sloping 200-day simple moving average in the $5 area. This chart looks bullish to me, but I’d wait for a breakout close above the $5.50 resistance level before entering. If shares break above $6, I expect a retest of the highs in the $8.50 range within nine months, a potential gain of nearly 42%.

P.S. I’m not a market technician, but I’ve seen enough charts in my day to know when a pattern is shaping up to be… interesting. I encourage you to check out my colleague Amber Hestla’s presentation to learn more about what the dreaded “Triple Top” could mean for your portfolio in the coming weeks.