Trading penny stocks is a risky business. There are two main types of analysis in stock trading: Fundamental analysis and technical analysis. When it comes to penny stocks, neither are particularly reliable. There is often very little accurate financial data publicly available to do fundamental analysis, and these stocks are often the target of coordinated campaigns to pump up their price as part of a pump-and-dump scheme.
Even technical analysis is limited and often faulty due to the extremely low trading volumes. Reliable patterns only emerge when there is enough activity to fill them out. It must be stressed that a pattern formed on the basis of 10,000 or even 100,000 traded shares will be much less reliable than one based on a million shares or more.
With those caveats, it is still possible to identify patterns when trading penny stocks. There are two primary ways to evaluate penny stocks: a line graph or a candlestick chart; most traders choose candlestick charts, although some prefer the absence of clutter in a line graph. Which one you choose is a matter of personal preference.
Because penny stocks are traded at such low volumes, it’s better to focus on simple patterns. The following three patterns are easy to identify and, due to their simplicity, may also be more reliable than more complicated ones.
- Topping out
This happens after a price has consistently climbed over a period of time and then suddenly levels off and may even trade sideways for a while. Although this could simply be a pause, if the topping out pattern is accompanied by a decrease in volume, it is generally interpreted as a sell signal.
- Bottoming out
This is the opposite of the topping out pattern. Typically, the decline takes place over a period of weeks or months and is followed by a period of sideways trading lasting up to a week or two. When this pattern appears, along with an uptick in volume, the stock has entered an oversold position. This often precedes a quick recovery and thus represents a buy signal.
- Price dips
This is a bit more difficult to spot given the huge volatility in penny stocks, but if traded correctly, offers a great opportunity to take a profit on shares that “fall through the cracks.” A penny stock price drop pattern resembles a retracement, or a sharp movement in the opposite direction of the larger trend. Price dips usually bounce back in a matter of minutes, so the best way to capture the movement on these thinly traded stocks is to maintain an open order well below the current price. That way, even if you’re not actively monitoring your trading screen, you’ll still be positioned to snap up some cheap shares.
At some point, most penny stocks experience a massive turnover in shareholder base. This is because, as a rule, most penny stock traders have high expectations for returns within a relatively short period of time. When the stock fails to deliver, they dump it in search of another opportunity.
This is actually good and precedes a period of consolidation after which prices typically rise. When you see heavy trading on a sideways market, the stock is under accumulation, which can be interpreted as a buy signal.