What is Dilution? Why do Traders lose money because of it?
The Dilution Process
Company files in it's 10-Q that it has issued convertible bonds or warrants that allow but do not require the acquisition of shares in the future, at a predetermined price. Generally, the price granted will be at a much lower price than market value. When a stock price gets pumped and dilution occurs, those who have exercise-able warrants and bonds can then sell their shares at a higher than converted price.
Where is the money going?
The profits after exercising warrants and selling them generally go back to company's investors who received warrants for their original investment or commitment to the company. A lot of the times, company's release BS public reports to jack up a stock's price so they can issue warrants exercisable at a lower price and sell for a profit. For example, Joe has 10000 warrants to purchase stock at $0.02/share but the stock gets pumped to $0.10. Later on, you find out that Joe has exercised those warrants and sold them into the market at a 400% profit, diluting the float and thus contributing to the bearish trend to follow.
How do Diluted Stocks re-attain their Low Float?
A lot of the time, these stocks undergoing dilution accumulate a high float overtime and price per share goes into the sub $0.50/share level because the float is simply too high for bulls to control price. In order to rebalance and prepare these small cap stocks for higher potential to run, the float must be lowered. The float is reduced through "Reverse Splits." Generally after a reverse split, the price continues to drop back to Pre Reverse Split levels but now the float is of a smaller multiple. This allows less momentum to bring up price on less volume, making it easier to re-pump and re-dilute a stock.
What's the best way to trade stocks that are often diluted?
Short. A stock that is undergoing dilution which allows warrants to be exercised for shares at a price below current market prices will drag prices downwards. Those shares can then be sold back into the market, making the float larger and the share structure biased towards bears as there are more shareholders cashing out on buyers and depleting the stock of interested buyers. Often times, these buyers are victims of pump and dumps.
Avoid holding stocks long that are undergoing dilution, there will be no bottom for the most part as shares get sold into them market. Also, stay away from trying to hold stocks undergoing "offerings" to receive cash. Not only are these companies in further debt, they compensate with convertible bonds or warrants which are then converted into shares that dilute the structure.