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Technical Analysis in Penny Stocks (Part 2)

by Peter Leeds

Read all the past Blog entries here

Part 1 of Technical Analysis (TA) for Penny Stocks explained that analysis of a stock's trading chart can often provide clues to future direction of the shares.

However, many of the patterns and set-ups which would work with higher-priced, more heavily traded Blue Chip stocks, will not be reliable when dealing with penny stocks.  
 
telescope chartspenny rolling on chart
 
There are plenty of free web sites which display trading charts, and your discount broker should also give you access to such tools.

We provided a look into the TA patterns which work for penny stocks, specifically:

Trading Volume Spikes or Declines
Penny Stock Support Levels
Penny Stock Resistance Levels
Trends are Your Friends... Sometimes
Price Spikes and Dips
Topping and Bottoming Out Patterns

Now we will delve into 6 other patterns which work well with penny stocks:

 



Consolidation Patterns:

When a penny stock experiences a 'turnover' in shareholders, it can imply an approaching jump in share price.  Basically, the share price seems to be flat lining for weeks, or months.  Current shareholders are selling, while that is being met by buying from new investors.  This buying and selling equilibrium keeps the price in a flat range.

You can see the entire trading pattern formation of a more complex 'cup and handle' here, but for simplicity we'll keep our discussion of consolidation more straight forward.  

The concept is that, during this period of flat trading, discouraged shareholders are unloading their shares, while that supply is being equally met with new investor demand.  
 
This keeps the price relatively unchanged, however the percent of investors who have a long term outlook is increasing.  Since brand new shareholders have optimism about this particular penny stock, and they just recently bought, they are highly unlikely to sell any time soon.

The greater the trading volume during the consolidation period, the better.  If 45% or 70% of shareholders are brand new, and they are less likely to sell - it is almost like taking that percentage of shares off the market.  

Eventually, a tipping point is reached, where anyone who wanted to sell has now done so.  Without the selling, the supply shrinks.  

At that point, any buying whatsoever typically sends prices higher.  Even if buying demand remains at the exact same level as it has been over the entire consolidation period, once the sellers are exhausted, the penny stock's price goes higher.


On Balance Volume:

On Balance Volume (OBV) keeps track of a stock's 'positive' and 'negative' trading volume.  When shares close a day higher in price, that day's trading volume is added to the OBV.  When shares close the day lower in price, that day's trading volume is subtracted from the OBV.

The end result is a tracking line on the trading chart.  Put in the simplest form, the OBV is theorized to predict stock price movements.  If the OBV is strongly higher, the shares are expected to rise in price.  If the OBV line is dropping, the shares may be in for a decrease.

Like all these patterns in Part 1 and Part 2 of Technical Analysis for Penny Stocks, OBV is one of the indicators which is reliable with penny stocks.


Money Flow:

When shares are bought on an 'up' day (whereby the stock is trading higher than the previous day), this is considered positive Money Flow.  When shares are bought on a 'down' day, this is considered negative Money Flow.

Money Flow is measured between 0 and 100.  Theoretically, the higher the value, the more money going into the shares, while declining and lower values are based on money coming out of the shares.

To put it in the most basic terms, Money Flow can be considered to be an 'enthusiasm' index.  When investment dollars are pouring into a company's shares on an 'up' day, this implies that investors are willing to pay a premium to purchase the stock.  When money is coming out of a stock, illustrated by a declining Money Flow indicator, it means investors are selling even on 'down' days, which can be a warning sign for future share prices.


Momentum:

Momentum shows the current share price compared to 12 (usually the default setting) days earlier.  So any day you look at on the momentum chart, the indicator will be displaying the change from 12 days prior to that.

For example, today shows the change from 12 days ago.  If you look back 100 days, it will show the change from 12 days even prior to that, thus the change in the stock from 112 days ago, compared to the stock price 100 days ago. 

Momentum can display the penny stock's trend (as if just looking at the trading chart wasn't enough)!  Momentum typically displays as a pattern of bars across the bottom of a stock's trading chart, one bar for each day. 


Relative Strength (RSI):

The RSI is very subjective in any type of stock, because it is intended to imply whether the shares are overbought or oversold.  Overbought (too much buying) typically precedes a price decline, while oversold  (too much selling) means the shares should go higher.

Most good TA charts will give you the option to display RSI.  When the RSI line dips below 30, the shares are oversold, implying that prices will rise.  And when the RSI line breaks above 70, the shares are considered overbought, implying that the stock is due for a fall.

RSI works equally well with penny stocks as with larger stocks.


Moving Averages:

Moving Averages (MA) are a great way to smooth out the day to day price fluctuations in stocks, so a clear trend can be seen.  They can be especially helpful with very erratic, volatile penny stocks.

For example, a 9 day MA averages the price of the stock over the last 9 days, and displays this as a line which lays right over the trading chart.  

The applications and uses of MAs are quite involved, so we'll just leave you with one example here to keep things short.  If you want to learn more about MAs, there are plenty of online resources.

Many investors will use 2 MAs at the same time, such as both the 9 and 18 day MAs.  The theory is that when the shorter MA (9 day) line crosses above the longer (18 day) line, it indicates a buy signal. 

The penny stock is climbing, which is why the shorter duration line starts rising.  It will take a little while longer for the 18 day MA to catch up, so the shorter duration line crosses above the longer duration line.
  

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