How "Penny Stocks" can be more about profit and less about peril.

There are a lot of traders and investors that are scared off by the thought of "Penny Stocks". The thought conjures ideas of quick rich schemes or scams, and for those desperate for quick returns and the dream of being overnight millionaires. A trader can be lured into the idea that it's as simple as buying a cheap stock and watching it increase ten or twenty times it purchase price, and a sure way to financial freedom. This false hope probably catches one dreamer every trading day, but for a technical analyst with a keen eye who can spot a bargain, the flipside can be very rewarding. I describe penny stocks as any stock with a trading price of below 20c, and the key is to treat these stocks just like you would a BHP trading in the 30's. The exception to the rule is that these penny stocks must be liquid, traded every day, not the type that only trade a couple of times a week. The thing to remember is that a stock worth 5c or one worth $30 both need to be accumulated and the floating supply to dry up before any large move can commence. They both follow the same principles of supply and demand. I want to share with you two charts that have both had great moves in the past couple of months and how we could have traded them with low risk for amazing reward.

The daily chart below is DTE (Dart Energy) over the last 8 months. This chart is a perfect example of the accumulation and mark-up phases. If I showed this chart without a price, most traders would think this is a quality stock and not one trading at the 4-5 cent level.

In late March of this year, we notice a down trending stock that falls "off the cliff" over three consecutive days. A large spread down day is followed by a narrowing spread of the next two with equally large volume. This is heavy buying into the stock. If the volume is the same three days in a row wouldn't you expect the second and third days to be just as large in spread. This would be the case unless large institutions were supporting the market and buying as much as possible off the weak holders desperate to dump their underperforming stock. There is no result from effort in this case. A lot of effort (volume) with very little result (no downside).

Once the stock has gone through the initial accumulation, it will form a trading range in an attempt to take the remaining supply out of the market, and leave strong holders in control. In early June the stock is marked down below the lows in March, creating a false break of the support level. If the stock breaks a major support level, you would think stops would be hit, supply would increase and there would be an increase in volume. The volume at this level in insignificant compared to the ultra high volume in March. This is the first sign that strong holders are in control and the weak holders no longer exist. The stock immediately rallies.

As the price rallies higher we see an increase in volume and a strong demand as the price pushes through the resistance level of late April. The strong holders have absorbed any selling at this level and continued to mark the price up. In late June we see a perfect pullback to resistance, a false break in fact leading to our entry on the 26th June. That day we see a test of the supply in the market - a check to see if sellers still exist. The narrow spread and false break of support with very low volume is a sign that supply has dried up and price is now ready to be marked up. The close of the day and possible entry was 6.8c. The support being so close to our entry means that we can have our stop just below the previous day (where price rallied from below support), creating a low risk entry and a great potential reward.

The stock price moves higher and after it makes a new high, we can define a trend channel by drawing a line connecting the highs and a parallel line through the low. Our first sign of a possible exit is when the price breaks through the supply line (where previous reversals have occurred) and fails to trade higher. The next rally is weak and after seeing a false breakout of the previous high, a lack of demand to go higher, the position would be exited. We would also have had a trailing stop as the price moved higher to protect from downside and loss of profit. The exit price on the 7th August was 14c. A trade of 30 days for a return of 105% with very little risk. This is how a good analysis of any stock can make you money if managed correctly with an entry and exit strategy. In regards to risk/reward, this trade would have been 1:10 and when anything over 1:3 is good trading, this was an exceptional opportunity.

The following chart I will not analyse in depth but it is a similar set-up to DTE. The chart is FAS (Fairstar Resources) and although the low volume pullback is similar, this stock was accumulated over time. The entry was on August 13 at 1.7c after a low volume pullback and test. Once again a low risk entry with the stop just below support and what a rally this stock had. On the 5th day after possible entry, the stock reached a high of 7.8c. This equates to an increase of 358% in five days. This would have been a phenomenal trade and although very difficult to have profited on the whole move but any piece of this would have been very beneficial.

Analysing stock charts is something that takes a considerable amount of screen time to develop and no doubt many years to master. These opportunities however exist in the market regularly but it takes a keen eye and good analysis to take advantage of. If the reader takes away anything from this article it is not what the value of the stock price is, it is the process in which stocks are moved. We are not trying to buy the bottom, but only after the stock has found support, been accumulated and demand is present on the right hand side of the trading range. If we follow this process, trading will become more low risk and of course if it happens to be a cheap stock there is potential for great reward.

By Mathew McCullagh.