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 investment chart, and clues to investor thinking which can be derived from them.
There are benefits of using technical analysis (TA) on penny stocks, but you will see that with low-priced shares there are some limitations and risks.
- While there are two types of stock analysis--fundamental and technical--technical may have more benefit when it comes to penny stocks.
- Technical analysis doesn't work when the stock has low trading volume; the more activity, the more trustworthy the pattern.
- Patterns you should look for include bottoming out, price dips, topping out, share consolidation, candlestick, gapping, and going against the trend.
Technical Analysis Terms
When an investment or market is observed over time, trends can be identified. Charts, graphs, and statistics created from these observations are used when conducting a technical analysis (TA). TA is an attempt to identify these trends—which are labeled upside, downside, or sideways.
An upside trend is generally a continuous increase in pricing for a market or investment. Conversely, a downside trend is a continuous decrease in pricing.
A sideways trend is an indication that that supply and demand are relatively equal, revealing no changes in pricing trends. This is viewed as generally a horizontal straight line across the graph.
A moving average is an average price for a given investment, calculated every day. Since prices change daily, the average will change (thus the term move, it moves across a timeline). This results in a more accurate picture of the average price of an investment than a simple average price over a given time-frame.
The support level represents enough market demand that an investment price is kept from dropping. Opposing the supporting level is the resistance level, the highest price achieved at which prices can rise no more.
Market sentiment (thoughts and feelings of investors, which influences demand—in turn, this influences pricing) then causes breakout or breakdown price levels. Breakout is when a pricing trend "breaks" through a resistance line, and breakdown is when a pricing trend "breaks" through a line of support.
Once you have identified an investment you wish to watch, try to either find the performance chart or data to make the chart yourself. As you graph or analyze the performance of the stock over time, use a spreadsheet or financial program to help you define the trend line if you don't know how to calculate it yourself.
You'll be able to spot the upsides or downsides fairly quickly, as they are simply indicated by the graph lines generally trending up or down. To spot resistance and support lines, connect the highest peaks together with straight lines, and the lowest troughs together.
When you do this, you'll see the resistance and support level lines, and be able to spot when an investment "breaks through" one of them.
After identifying your resistance and support levels, look for and watch the volume of trade for the investments you have chosen. When prices and volume increase or decrease together, it is more likely to be a trend. If they are opposite in relation to each other, there might be reversal on the horizon.
Some of the Best Technical Analysis for Penny Stocks
There are some patterns that have been identified which appear to be more reliable when it comes to low-volume penny stock shares:
- 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 of weeks). When this coincides with a sudden increase in trading volume 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: The way some investors play (and benefit from) price dips, is to be in the right place at the right time. Try to keep a buy order on a thinly-traded penny stock significantly below the recent or current price. You may catch any shares which "fall through the cracks."
- 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. If this appears to be coincident with a declining daily trading volume, investors are going to begin selling and prices will begin to tumble.
- 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. When the penny stock's price trades sideways on higher-than-average volume, it could be displaying a pattern of a possible higher price.
- Candlestick Chart Patterns: Unlike the more common line graphs, or open-high-low-close (OHLC) trading charts, 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. Some popular candlestick patterns are dark cloud cover, outside reversal pattern, Doji, Harami, engulfing, piercing, and hammers.
- 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 re-opens the next day at $1.95, it represents a gap of 45 cents.
- Against the Trend: This pattern plays out well with penny stocks specifically, demonstrating the positive implications of an investment holding up under pressure. When the markets drop significantly, the shares which hold up the best in price are typically the ones that gain the most once the market recovers.
Concepts of the Most Benefit to You
Basically, some ideas to keep in mind are:
- 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
Remember that relying exclusively on technical analysis is not a method to quick riches. You should 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.
There is no strategy that is foolproof. This is why it is so important to start by paper trading (no money) as you learn and develop your own approach to penny stock profits. Start slowly, and you will finish well ahead of the investors who dive in, wallet first.