Blog : Technical Analysis in Penny Stocks (Part 1)

We've long explained that Technical Analysis (TA) has serious limitations when it comes to penny stocks.  Below we illustrate exactly why the patterns are typically unreliable, and show you the few TA set-ups which actually work.

 

 

 

Technical Analysis is the study of the trading chart in order to surmise clues as to future direction of stock prices.  For example, certain TA patterns usually show up over the weeks or months leading to a price pop, or decline.  In larger stocks or indexes, Technical Analysis can be pretty reliable.  Unfortunately only certain set ups can be trusted with penny stocks.

The main reason for unreliable Technical Analysis is low trading volume.  The greater the shareholder turnover, or trading volume creating the TA pattern, the more trustworthy that pattern will be.  In other words, if you think you see a Technical Analysis set up, but it is on only 1% of shares traded, or a few thousand shares, the stock will almost certainly not act as expected from a TA standpoint. 

The second reason Technical Analysis is not as reliable with penny stocks is that their price drivers are different.  Penny stocks trade based on speculation and potential, while larger blue chip companies move due to fundamentals and operational results.  For example, a trend will hold up to a much greater degree with some $167 per share corporation than in a tiny 42 cent penny stock.  The smaller something is, the less energy required to move it.

The good news is that there are some Technical Analysis patterns in penny stocks which can really help you spot great trading opportunities.  For more on any of this, pick up a copy of, "Penny Stocks for Dummies," or to get the benefit of Technical Analysis and findings from the Peter Leeds team, simply get their world-famous penny stock picks now!  (For only $19!)

Often a sudden surge in trading volume will increase the reliability of a Technical Analysis pattern.  Just as a price move on very low volume (a few thousand shares) is typically reversed the next day, when a penny stock's price moves on much greater than average volume, the direction of that move will usually be sustainable.

The same holds true in reverse.  When shares spike higher on massive trading volume, but then that trading activity suddenly starts decreasing, the shares very often drop back towards their original price.

 

This is one of the most reliable Technical Analysis patterns in penny stocks.  Whether due to investor psychology around certain numbers, corporate share buybacks, or the impact even individual buyers can have on thinly-traded stocks, you will often see support levels in penny stocks.

For example, even very volatile shares may flat line near support, or never decrease below $1, or $2.50, or even $0.25.  The most reliable set-ups are when the support level is 'tested' on numerous occasions, whereby the stock has fallen towards support.  If the shares bounce higher whenever that specific price is approached, (and even better you see an increase in trading volume at the same time), then the support price is more likely to hold up.

 

 

Just like Support Levels in penny stocks, there are Resistance Levels.  These are simply the opposite - prices where buying demand is not great enough, or selling supply is so significant, that the shares are held below a certain point.

Again, these Resistance Levels typically center around psychologically significant values, such as $1.00 or $2.50.  Often, with thinly-traded penny stocks, it just takes one or two investors looking to unload their shares at specific price points to keep the penny stock down.  And just like Support Levels, the most trust-worthy Resistance Levels have been tested more than once, and trading volume increased while the share price fell away from that price.

It might look like a trend, but it often is not one.  Shares are most likely to continue in the exact same direction they are already moving.  However, only trust the trend if the trading volume (and therefore the shareholder turnover) is great enough.

So, how much is enough when it comes to trading volume?  You want to see a significant shareholder turnover of more than 5% during the trend, but the greater that percentage, the better.

Here's a ridiculous example to explain the point.  Picture a penny stock with only 100 shares total, which looks to be in an uptrend.  If the first day saw trading volume of only 2 shares, and the first week saw a total of 6 shares, then MAYBE the trend is legitimate, but can almost certainly NOT yet be trusted.  However, if week 2 sees 12 shares trade hands, then week 3 sees another 11, and the penny stock had been in an uptrend the entire time, you could reliably expect the trend to continue and the shares to keep climbing.

Keep in mind that trends can be downward or sideways as well.  In addition, it is just as important to identify when a trend is breaking down, as to discover the trend in the first place.  You can learn all about this in Chapter 12 of Penny Stocks for Dummies.

 

Price spikes and price dips are much more common in penny stocks than larger blue-chip investments.  The trading activity in thinly-traded equities often leads to significant price moves for technical reasons on very low volume.  Among the smallest stocks, one seller dumping 3,000 shares might drive the price down by 20% or more.

Assuming there are no significant fundamental reasons behind the trade (which would typically incite much more significant trading volume), then it can be viewed as a potential buying opportunity.  The same holds true in reverse, when a penny stock might spike for technical, rather than fundamental, reasons.

 

 

This is one of the Technical Analysis patterns which holds true with both penny stocks and multibillion dollar blue chips as well.  Put simply, when a long, sustain uptrend seems to meet up with a Resistance Level, and trading volume is falling off, this may indicate the shares have 'run out of steam.'  The ratio of down days to up days increases.  This is typically when shareholders may consider moving on.

The same rules apply to Bottoming Out patterns.  These represent wonderful buying opportunities, and the reversal of the down-trend into an up-trend can be quite profitable. For those interested in more details about Topping Out and Bottoming Out patterns, see Chapter 12 of Penny Stocks for Dummies.

In part 2 of Technical Analysis for Penny Stocks, we explain:

 

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