How to Trade Penny Stocks Using Trading Charts
You Can Use Trading Charts to Spot Opportunities
There are two types of analysis in stocks: fundamental and technical. The former is about looking into the operations of the company itself (management, revenues, debts, contracts, lawsuits, etc....). The latter involves finding patterns on the trading chart, and clues to the investor psychology which can be derived from them.
I will discuss technical analysis (TA) with penny stocks here, but you will see that with low-priced shares there are some limitations and risks. There are also plenty of benefits if you know what to look for, as I will discuss below.
Anyone who knows me, or about my story, knows that I am a fundamental analyst first and foremost. This is not to say that there can't be some benefits to a technical review of the trading chart (because there can be), rather that with my own personal approach, I focus on high-quality companies first and foremost, and only then apply TA to the underlying shares.
Thus, in the approach to analysis of my team and I, we only apply technical analysis once we have already uncovered a very high-quality penny stock, in order to identify the best buying and selling ranges for the shares. In fact, with the Leeds Analysis process we've developed, we give 80% of the weight to fundamentals, and only 10% to technicals. (The other 10% involves a review of what we refer to as third Level Analysis - this assesses aspects of any business such as branding, marketing, and product/industry connotations).
In fact, the close linkages between business operations and stocks which perform well have been so striking that I developed the 12 stages to supercharge your small business. Certain aspects of small business success are the same as those which will lead publicly traded companies to excel, and you won't find these on any trading chart.
Regardless, let's assume you want to use the clues from the trading chart to better your investment results. Technical analysis is the way to do it.
I posted an article entitled, "Know When to Buy or Sell Any Stock." This details how to use the relative strength index to see how overbought or oversold shares are, and by extension what that stock's next move in price is going to be.
The relative strength index is one of my favorite technical analysis indicators, as I explained in this video, because it is one of the most reliable for penny stocks. There are others as well, and I'll detail them below, but first I should explain some of my concerns.
Specifically, technical analysis is not as trustworthy with penny stocks as it is with higher-priced shares. This is because any technical analysis (TA) indicator can only be relied upon if there is significant trading volume involved in the formation of the pattern.
Since many penny stocks are barely traded at all, or have very thin activity, TA will often fall apart, even when a very clear pattern appears. For example, you may see that a particular penny stock is showing a bottoming out pattern, but if that move is based on only 1% of total shares traded, then it must be ignored.
The greater the trading activity involved in establishing the technical analysis pattern, the more reliable that set-up. Thus, any TA which is based upon a million shares traded will be more reliable than one which formed from 10,000 shares traded.
This is also why you can know that most significant price moves on low volume will reverse. If a penny stock jumps up 50% but does that on only $1,500 worth of shares traded, then that price will almost certainly drop right back down, and soon.
Some of the Best Technical Analysis for Penny Stocks
The following patterns are some of the ones I've found which seem to be more reliable when it comes to low-volume penny stock shares. After all,when a technical analysis indicator can't be trusted, it becomes useless - or worse, could cost you thousands of dollars if it misleads you.
- Bottoming Out Pattern
This type of pattern emerges after a long, sustained slide in the share price. The trend goes from downward over months, to sideways (usually for a couple weeks).
When this occurs coincidentally with a sudden increase in trading volume, especially if this is in line with an oversold condition, the shares may be about to enter a long, sustained recovery in price. Often, the shares which display a bottoming out pattern will be some of the best long term holds.
- Price Dips
Since penny stocks are often thinly traded, they can have massive price volatility simply because of an imbalance in buy and sell orders. This can lead to shares dipping significantly when sellers outweigh buyers.
You will recognize a price dip pattern when the penny stock suddenly drops but does so on no news and on very low trading volume. The opportunity with price dips is that they usually reverse, and typically within hours, if not minutes.
The way some investors play (and benefit from) price dips, is to be in the right place at the right time. By keeping a buy order on a thinly-traded penny stock, which is significantly below the recent or current price, you may catch any shares which "fall through the cracks."
By this I mean when someone puts a market order to sell, if that trade is much greater than the current line-up of buyers, it may result in some of the shares which are being sold going for significantly lower prices. Your open buy order may get some of these shares.
- Topping Out Pattern
This is similar (only in reverse) to the bottoming out pattern. Shares have climbed for a long time and now appear to be leveling off, or trading sideways.
While this may just be the stock "taking a breather" before resuming the advance, when it appears in a penny stock, coincident with a declining daily trading volume and an overbought condition, the profit takers may be preparing to move in. In other words, shareholders start to sell to capture these new, higher prices, while buying dries up, the end result of which is tumbling share prices.
- Share Consolidation
When the base of shareholders turns over, it can be very good for the penny stock prices. Simply put, newer owners typically have a positive expectation for the investment they just bought, and are much less likely to sell any time soon.
Now combined with all the disenfranchised or frustrated shareholders who are selling their stock, the individuals who are exhausted with the investment or expect it to fall in value, the ownership base slowly goes through a transformation.
When the penny stock's price trades sideways on higher-than-average volume, it could be displaying a consolidation pattern. This is very bullish (positive) for the future direction of the shares.
This is because the investment eventually reaches a tipping point where there are no more sellers looking to get out, and at least 20% of shareholders are relatively new (and therefore unlikely to sell). In such an event, the next move for the penny stock is usually much higher.
- Candlestick Chart Patterns
Every trader should use candlestick charts, which I explain in this video. Unlike the more common line graphs, or open-high-low-close (OHLC) trading charts, candlesticks provide a great deal of additional information about investor psychology.
For example, certain patterns demonstrate that a penny stock's trend is about to reverse, or that prices may fall (or rise) in the coming weeks and days.
You should familiarize yourself with how easy it is to pull up and read a candlestick chart first. Then you can learn about all the great technical patterns which can help you profit; dark cloud cover; outside reversal pattern; Doji; Harami; engulfing; piercing; hammers; more.
For example, if a penny stock seems to be displaying a topping out pattern, other indicators could reaffirm your beliefs. If you see a Doji on the candlestick trading chart it could imply that this is indeed a full topping out and that the shares are due to start sliding lower.
- Gapping Stocks
When shares open higher (or lower) than where they traded the day before, this is known as gapping. For example, if a penny stock closes at $1.50, then opens the next day at $1.95, that represents a gap higher of 45 cents.
I discuss potential gains from penny stocks which gap higher here in this special article I wrote. Basically, any time shares gap higher, it is a very bullish (positive) indicator. At the same time, when shares gap lower, it can be bearish (negative).
Keep in mind that this is one of those technical indicators which could mislead you. There are times, for example, where the penny stock may gap lower, but that just signals the beginning of a capitulation, after which the investment will increase in price significantly. (Once all the sellers are gone, the shares tend to have pretty strong upside).
- Against the Trend
One of the most reliable technical indicators with any type of shares, but one which plays out well with penny stocks specifically, it the positive implications of an investment which holds up under pressure. When the markets drop 4% or 12% or 7%, and the specific industry falls by a lot as well, the shares which hold up the best in price are typically the ones which gain the most once things recover.
For example, if the shares you are watching only fall 1% (or don't fall at all, or even increase in price), while everything around them is sliding lower, that is a very bullish sign. Strength during times of weakness translates into even greater strength during times of recovery.
These are just some of the best (meaning most reliable) technical analysis indicators which work well with penny stocks. There are several others of course, but TA is a massive, bottomless topic, more suited for a full series of heavy books, than a single article.
What is important to understand is that:
- TA is best used in conjunction with high-quality companies, which are already discovered with fundamental analysis
- TA does not work when the stock has low trading volume (the more activity, the more trustworthy the pattern)
- TA does not typically factor in the fundamentals of the company
- TA can be a good tool to spot potential price moves in penny stocks
So, don't rely exclusively on technical analysis, and even if you do, understand that it can often be misleading. You may see what you think is a perfect topping out pattern only to watch the shares continue their climb higher.
Also, keep in mind that no strategy is fool-proof. This is why it is so important to start by Paper Trading, whereby you risk no money, as you learn and develop your own approach to penny stock profits. Start slowly, and you will finish well ahead of all the investors who just dive in, head first!