When Technical Analysis Is Good for Penny Stocks - dummies

When Technical Analysis Is Good for Penny Stocks

By Peter Leeds

If you plan to invest in penny stock, you will need to know when to apply technical analysis (TA). Most investors do their research on the basis of fundamental analysis. They want to invest in healthy companies with proven management teams, positive news releases, and increasing market share. A good fundamental review will tell you all of that.

Other investors want to predict where the share price is going simply by reviewing the trading chart and applying TA. These investors are less likely to worry about the fundamentals of the company.


TA, when done well, has tremendous advantages over the more conventional fundamentals-based research approach. However, this trading technique also has numerous downsides, and you should consider the pros and cons before you proceed.

Although you can use TA on its own, without any fundamental or abstract reviews, many investors prefer to use it in combination with the other research approaches. You may want to apply TA to your research in some combination with a full fundamental and abstract analysis review, to give you the most clarity from your research approach.

TA can be highly effective, and most appropriate for you, in specific situations, such as:

  • You want to eliminate all the work required for fundamental analysis. With TA, you don’t need to worry about a company’s market share, revenue growth, debt load, profit margins, or anything else. You’re not investing in a company, you’re trying to squeeze gains out of the action of the share price based on what it has done immediately leading up to this point.

  • You’re a short-term trader, not a long-term investor. Most investing is about fundamental analysis, and that involves buying into a great company and hoping to profit as the operations improve over time and the share price eventually increases as a result. If the patience game isn’t for you, and you want to see changes in share prices much more quickly, TA is much more appropriate for you.

  • You need more clarity about good buy and sell opportunities. By watching trading volume, chart patterns, and price direction, TA often reveals pretty accurate buying and selling points. Read on to see how a huge drop-off in volume, or shares approaching a resistance level, or an upward trend, can clearly indicate when it’s time to trade a penny stock.

  • You want to minimize your investment exposure. Every minute you have dollars in stocks, they’re exposed to events that may play out on the market. By trading short term based on TA, you theoretically should have fewer dollars sitting “out in the open” at most times. Keep in mind, though, that although this shorter time frame limits your exposure, it doesn’t limit your risk.

If the points mentioned appeal to you, then so will TA. You don’t necessarily need to go 100 percent into TA for all your investment decisions, but you can use it as a tool to augment your trading in fundamentally solid penny stocks.

Many investors who trade stocks based on TA don’t want to own their shares overnight and certainly not over a weekend. Because events can occur when the markets are closed, and those events may impact share prices when the markets open, it leaves the day traders and TA investors exposed to losses. They’re often more cautious about issues that may impact the share prices when they’re unable to react immediately.

The most effective research approach usually involves a combination of both a fundamental and technical review. By using fundamental analysis, you can locate high-quality, well-run penny stocks whose operations are moving in the right direction. By applying TA to the trading charts of those stocks, you can uncover great buying and profit-taking opportunities.

TA has a lot of benefits, but the approach also has a pretty serious downside. Understanding the shortcomings helps you recognize how to perform TA wisely, if it even turns out to be appropriate for you at all. Consider that TA

  • Has nothing to do with the actual underlying company: You aren’t buying shares in a company as much as buying shares in a potential price direction. As a trader, not an investor, you may not be watching when the company is growing, or increasing its profits, or if its biggest competitor goes out of business. This may result in you selling at some of the wrong times.

  • Involves a tremendous amount of work: Those relying mainly on TA typically look at hundreds of trading charts per week. Out of all those charts, they may not identify any good trading opportunities because most TA will not show any predictable patterns most of the time. The traders who put in all that time researching trading charts tend to do much better than those who do not.

  • Takes a significant amount of time: Besides work, TA also involves a big investment of time. Sometimes that means 5, 20, or even 40 hours per week! Most of the time spent needs to be when the stock market is open.

  • Is unpredictable: All investor use different TA tools and use those tools differently. They also have their own ideas of which chart indicators work best and what level of gains to take. If you adopt this approach, you will need to decide on your own indicators and adjust your TA methods as you go, and even then there is no certainty that it will be effective.

  • May result in missing the really big gains: Because most TA involves taking smaller gains more frequently, you could miss out on the big 50 percent, 100 percent, and even 2,000 percent moves. A single penny stock that triples in price may generate more profits than years of taking 20 percent gains and losses.