Technical Tips for Trading Penny Stocks
by: Jennifer Gorton from Forex Indicators
What are Penny Stocks?
Penny stocks are shares of companies which trade at below $1. Since these stocks trade for cents on the original dollars, they represent a highly pessimistic market consensus on their value as assets. Typically, a penny stock that achieves long term survivability and value will yield as much as 20:1 in the case that it can reach the level of an average stock, and trade at about $10 per share. As such, they are especially attractive to speculators who swoon with excitement on the prospect of making such a big gain at so little cost.
The news media does not distinguish between investors and speculators. The person buying and selling a currency pair in the span of five minutes, and the analyst who spends hours and days discussing and evaluating a possible trade before taking action are both called investors universally by all kinds of media personalities. Yet one can still make an argument about the validity of both the short and long term approaches in the duality of trading versus investing, and speak of short term speculators and long term investors in the context of different strategies. But even the most determined advocate of trading will shirk at calling penny stock traders investors. Penny stock trading is not very different from outright gambling, since the information and liquidity available to a typical penny stock trader presents discontinuities in risk analysis, and makes decision-making a very troublesome task.
If you do choose to take your chances at this game, make sure that you trade with cash that you can easily give away to charity, or throw to the dancers for fun, or burn in the fireplace for the novelty value (maybe to impress a girlfriend). Never ever risk your savings or cash you will need in short time in penny stock trading.
Who trades penny stocks?
Penny stocks are traded by two types of people. The first is the company shareholder who is a worker, owner, or manager of the company for historical reasons. The person may have taken part in the venture for any number of reasons, and even as the stock price plunges, he refuses to sell out because of emotional reasons, or because of confidence that the company’s fortunes will turn around. The other kind of trader is the speculator who is in the game just to make a quick buck, so to speak. There is also a rarer kind of trader, often with insider knowledge, who seeks to take advantage of sudden crashes that result from panic in order to capitalize on long term fundamental value. This kind of trader is almost completely non-existent among the usual penny stock traders, so we exclude him from our discussion.
The trader profile is important for two reasons. First, the vast majority of penny stock liquidity is the result of speculative buy-sell activity that will quickly evaporate in response to negative news of any kind, and sometimes for no perceivable reason at all. Since these traders frequently base their decisions on sixth sense, gut feeling, or any other kind of intuition, if we are allowed to misuse the term, their motives and decisions are inscrutable. The previously mentioned discontinuities also make common techniques useless in dealing with them.
Risk and Reward in Penny Stock Trading
So if everything is so unpredictable in penny stock trading, how do we make trade decisions, and decide on risk/reward? We will take a look at the technical aspect soon, but let's examine to important matters briefly.
Liquidity is the most serious issue facing penny stock traders. You may witness a large scale transaction at some point in the day, and decide to get rid of the stock as soon as possible, but it is often the case that there is simply no one to buy your paper, regardless of how low you offer it (though if you give it away for very low prices, for great loss, some may appear in small quantities.) This situation is very unlike the case with common stocks like MSFT, or any of the large financials where there is ample liquidity even in the worst days. A trader who chooses to deal in penny stocks must always keep in mind the possibility that he may be unable to sell it before a declaration of bankruptcy, or any similar event.
Penny stocks tend to gap often. Since liquidity as so low, one day’s average, open/close prices, and other values may present severe discontinuities that make trading a great difficulty. The good side of this is that they gap higher almost as often as they gap lower, with the only difference being that some of the downside gaps result in the elimination of the company as a tradable entity. To deal with this aspect, leverage should be kept as low as 1:1 in penny stock trading.
The final issue that complicates trading penny stocks is invisibility. Penny stocks trade over the counter, and are unlisted at exchanges, so finding analytical information, and other kind of commentary is extremely difficult in many cases. It might even be impossible to reach sufficient information to form a reliable opinion on the fundamental strength of the company. In short, penny stock traders frequently trade blindly.
Which technical methods yield the best results with penny stocks?
The consequence of our discussion up to this point is that trading penny stocks is trading, and speculating, and not investing. We also recognize that fundamental methods are useless to a large extent, due to the limited availability of frequently outdated or lower quality information. If we trade penny stocks, we will do so according to technical methods. Here we’ll examine two kind of common formations that are used most often by penny stock traders.
The easiest and most reliable way of penny stock trading is taking advantage of cycles and channels where there are observable patterns of oscillations in the price action. Channels present well-established formations with buyers and sellers on both sides able to prevent any disorderly unwinding of positions, and enable somewhat safer trading of penny stocks. The common tools for trading channels are moving averages, trend lines on both sides of the price, and sometimes oscillators such as the RSI, although these will not be very useful due to the discontinuities of penny stock movements. By simply taking positions on both sides of the channel, cashing out as soon as possible, and refusing to remain in the market for more than a short time, penny stock traders try to minimize risk and maximize profits.
Range trading is another viable option, as ranges are somewhat more frequent in penny stocks than they are in the overall market. Since these stocks have low liquidity, the accumulation of sufficient momentum to drive strong trends is difficult. Also, those who still hold a penny stock are frequently unwilling to sell them at such low prices. Ranges established in such a context can be long lasting and somewhat more reliable than what is common with common stock trading.
The standard tools for range trading are viable for trading penny stock ranges if they are well-defined. Oscillators, and even more so, Fibonacci Retracement levels can be highly useful for trading this type of market.
By far the riskiest method of trading penny stocks is trying to exploit breakthroughs. Any kind of reason may lead to sudden movements, and when they occur, the movement is often complete before the average trader is aware of it. Since these stocks are held often by a smaller group of individuals, and are not covered by the more powerful news providers, by the time you acquire information, it may well be outdated. It is by no means uncommon that the management of a penny stock will reassure stockholders that rumors are groundless in the noon, before declaring bankruptcy in the evening.
Penny stock trading is the most extreme form of speculation. Basically, penny stock traders trade blindly, with close to zero visibility, no long term insight, at a low liquidity, high volatility environment. If you do decide to play the game, keep leverage very low, and stay away from the cheapest stocks. The problem is that whatever you do, you go against the basic principles of trading by buying and selling penny stocks. . Penny stock traders are aware of the dangers, so they tend to cut profits short to get out of the market as soon as possible, and to stay put with large losses in the hope that they will turn around as the company survives. It is fine if you just trade it for excitement, relieving stress, or cheaper, quieter kind of gambling, but do not attach great expectations to the activity, and never risk your necessary cash in trading them.