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 stock's investment chart, and using trends and other clues to read into how traders might be thinking about them.
There are many benefits of using technical analysis (TA) on penny stocks, but you will see that with such low-priced shares there are also some limits and risks.
- Fundamental and technical are two types of stock analysis, but the latter may be a better method when it comes to penny stocks.
- Technical analysis doesn't always work when the stock has low trading volume; the more activity a stock has, the more you can trust the pattern.
- Patterns you should look for include bottoming out, price dips, topping out, share consolidation, candlestick, gapping, and going against the trend.
Basic TA Patterns and Terms
If you observe an investment or a market over a long span of time, you'll be able to see certain trends. There is no shortage of charts, graphs, and statistics that come from people observing patterns, and such tools can be of great use if you want to conduct a technical analysis (TA). In short, TA is an attempt to identify these trends, which come in many forms.
An upside trend is a steady increase in pricing, whether for a single stock or a full market. By the same token, a downside trend is a steady decrease in pricing.
A sideways trend is a sign that the supply and demand of a given stock are balanced. It reveals no changes in pricing trends. This is viewed as a horizontal straight line across the graph.
A moving average is an average price for a given stock, as calculated each day. Since prices change daily, the average will change (thus the term "moving," as it moves across a timeline). This results in a more precise picture of the price of a penny stock than you would get from a simple average price over a given time-frame.
The support level is the price level at which there is enough market demand to keep a stock price from dropping. At the other end of the scale is the resistance level, which is the highest price a stock can reach at which prices can rise no more.
Breakout occurs when a pricing trend "breaks" through a resistance line, and breakdown is when a pricing trend "breaks" through a line of support.
The thoughts and feelings of traders can have an effect on a stock's demand, which in turn affects its pricing. This is also called "market sentiment" when used in a broad fashion, and at times it can be strong enough to cause breakout or breakdown price levels.
How to Conduct Your Own Technical Analysis
Once you have found a stock you wish to watch, look for the performance chart, or try to find the data needed to make the chart on your own. As you graph or assess how the stock performs over time, you can 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 shown by the lines on the graph that trend up or down. To spot resistance and support lines, connect the highest peaks by drawing straight lines between them. You can do the same for the lowest troughs as well.
When you do this, you'll see the resistance and support level lines, and be able to spot when a stock price "breaks through" one of them.
After making note of your resistance and support levels, look for and watch the volume of trade for the stocks you have chosen. When prices and volume increase or decrease at the same rate, it is more likely to be a trend. If they move in contrast to each other, there might be reversal coming soon.
The Best TA Methods for Penny Stocks
Some patterns appear to be more reliable when it comes to low-volume penny stock shares:
- Bottoming Out Pattern: This type of pattern shows up after a long, steady slide in the share price. The trend goes from downward over months, to sideways, often for a couple of weeks. When this happens at the same time as a sudden increase in trading volume, it means that the shares may be about to enter a long, steady 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 traders play 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 that is well below the recent or current price. You may be able to catch any shares that "fall through the cracks."
- Topping Out Pattern: This is much like the bottoming out pattern but in reverse. Watch for shares that have climbed for a long time and now appear to be leveling off, or trading sideways. If this appears to happen close to a decline in daily trading volume, traders 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 tend to have high hopes for the stock 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 display a pattern of a much higher price.
- Candlestick Chart Patterns: Unlike the more common line graphs, or open-high-low-close (OHLC) trading charts, certain patterns mean that a penny stock's trend is about to reverse, or that prices may fall (or rise) in the coming weeks and days. Some common candlestick patterns that you may come across include 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 instance, if a penny stock closes at $1.50, then opens the next day at $1.95, it leaves a gap of 45 cents.
- Against the Trend: This pattern plays out very well with penny stocks. If you come across a stock that goes against the grain, so to speak, and performs in a way that differs from the rest, it can be a good sign that the stock will hold up well under pressure. When the markets suffer a major drop, the shares which hold up the best in price are typically the ones that gain the most once the market recovers.
Ground Rules for Using TA with Penny Stocks
If you are new to trading penny stocks, many of the methods can seem strange, or like too much to think about at once. To keep things simple, there are a few basic tenets to keep in mind when using TA to assess penny stocks:
- TA methods are best used with high-quality companies, which have been vetted with fundamental analysis.
- TA methods do not work when the stock has low trading volume. (The more active a stock is, the more data it creates, and the more you can trust its patterns.)
- TA does not often factor in the fundamentals of the company.
- TA can be a good tool to spot and predict price moves in penny stocks.
Paper trading (with no money) can be a great way to practice as you learn and form your own approach to penny stock profits. Start slowly, and you will finish well ahead of the traders who dive in, wallet first.
Be aware that technical analysis can often mislead traders who don't have a sense of the full context. You should not rely only on TA methods, and those alone, when choosing stocks to buy or sell. For instance, you may see what you think is a perfect topping out pattern only to watch the shares continue their climb higher.
Of course, no strategy is foolproof, and TA is not a path to quick riches, but if you can use it as a tool, you can invest in penny stocks with more knowledge and better outcomes, and get a step ahead of other traders.