Why Technical Analysis Often Doesn’t Work with Penny Stocks - dummies

Why Technical Analysis Often Doesn’t Work with Penny Stocks

By Peter Leeds

The more trades and penny stock investor activity involved in establishing a technical analysis (TA) pattern, the more reliable that pattern will be. Whether you find a resistance level, a price dip, or another indicator, the TA will be more trustworthy in direct proportion to the amount of trading volume that established it.

Think of political polls. If the results were based on the opinions of 20 people, most folks would put less stake in the findings than if the results were generated from the answers of 2 million people. The more answers behind a survey, the more likely the findings will be representative. TA is very similar, and the reliability increases with the amount of trading volume that generated the pattern.

Similarly, the lower the trading volume, the less a TA pattern should be trusted. As penny stocks are generally subject to less investor activity, meaning fewer trades, the majority of TA techniques shouldn’t be used, and wouldn’t be consistently reliable even in the cases where the patterns implied a future price direction.

Having said that, a few TA indicators can provide hints at future price direction in penny stocks, but even those only apply when the underlying shares have been enjoying enough trading volume. What constitutes “enough” trading volume, or critical mass, to generate a TA pattern that you can trust? It depends greatly on the stock and the situation, but in general consider these factors:

  • Percent of shares trading hands: If about 1 percent of total outstanding shares trades on any given day, there will not likely be any reliability to patterns that may seem to form. On the other hand, if the penny stock shows an optimistic indicator on 5 percent of shares each day, then the reliability of that indicator is very high.

  • Turnover of total shares: Calculate how many days it would take at current trading volumes to turn over an amount equivalent to all the shares one time. If a penny stock with 100 million shares trades 1 million a day, that is a total share turnover rate of 100 days. The shorter that turnover becomes, the more reliable the underlying pattern will be.

  • Daily trading volume: Watch the number of shares trading hands each day. You want to see hundreds of thousands of shares being bought or sold each day to be able put any trust into the underlying TA pattern.

Also consider changes in trading volume. If buying and selling activity suddenly starts increasing day by day, some great TA patterns may be forming from all the new investment activity. Although indicators become more reliable with high trading volume, they are even more trustworthy when that trading volume is not only high, but getting higher.

TA with penny stocks is a very involved concept. What works with some shares won’t work with others, and what constitutes enough trading volume to make the patterns reliable for each situation is difficult to state in general.

Each stock and each situation is very different, and the effectiveness of various indicators can vary significantly from one penny stock to the next. Like most aspects of investing, you’ll get much better at it as you proceed.