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Technical Analysis Falls Short With Penny Stocks

Technical Analysis (NYSEMKT:TA) is a great tool to predict upcoming share price activity based on past trading action. While a way to gain an advantage over other traders, TA does have it's limitations.

With any TA pattern, to be reliable it should have a significant amount of trading volume behind it. The more investors and trades that create any technical pattern, the more that pattern can be trusted. For example, a support level where 20% of all the outstanding shares trade hands is much more likely to remain intact than if only 3% of shares were bought and sold.

When it comes to penny stocks, this trading volume requirement can become problematic. Many low-priced shares of smaller companies do not have enough trading activity to generate any degree of reliability. Even when a perfect TA pattern emerges on a penny stock's trading chart, it should not be trusted.

I should clarify my position, of course, since I have often cited TA for about 10% of the penny stock research my team and I conduct, and even dedicated an entire section to TA in my books, most recently "Penny Stocks for Dummies," published by John Wiley & Sons. I'll discuss some patterns which can sometimes be helpful with penny stocks, but first let's examine why they usually aren't.

While a perfect cup-and-handle pattern on a large cap stock's chart implies a near term upside move in price, that exact pattern on the chart of a penny stock with very low trading volume may mislead you and cause investment surprises... and losses.

To better understand how the thin trading volume makes the TA patterns less reliable, consider public opinion polls. Ask five people if they agree with a specific position on some hot button topic. Does the response from five people represent overall sentiment of the entire nation? Not really. However, as you ask 50 people you will get a better view of the general opinion on the topic. If you were to ask 5,000 people, you will find that the result is much more representative of public opinion, and may even be much different than that of the first five people. In other words, the larger the sample size, the more trustworthy the information. This fact is just as true in stocks as opinion polls.

TA can be a useful tool for stocks with high trading volume, such as those investments which have millions of shares traded per day, or millions of dollars worth of the company exchanging hands every week. Unfortunately, you may be hard pressed to find any penny stocks which meet this trading activity criteria.

Even when thinly traded penny stocks seem to be displaying certain TA patterns, you should proceed with caution. Unless significant buying and selling took place to form the indicator, it should not be trusted to play out as expected, even when the pattern appears like a textbook example of any particular TA pattern. For example, what looks like a topping out pattern in a penny stock may not be one at all. Investors who mistakenly act on the TA indicator are putting themselves at risk, since the shares may not act as the set-up implies.

While relying on TA to predict future prices in penny stocks is generally not helpful, and in fact can be quite misleading and costly, there will still be many investors who continue to place their trust in this analysis style. And yes, I am one of them.

If you choose to ignore my heart-felt warnings above, and intend to apply TA to penny stocks anyway, try to stick to the few indicators which I have found to be more reliable than others. These include:

On Balance Volume (OBV) is a running total of shares traded each day, expressed as a line. Those from a positive closing day are added to the total OBV, while those from a negative closing day are subtracted. The line generated typically mirrors that of the stock's trading activity, but when the shares do not it can imply that the stock price will shortly move back in lock-step with the OBV.

Support and Resistance Levels show up often with penny stocks since it takes less buying or selling in small companies to generate them than is needed in large caps.

Volume Spikes typically insinuate that the current price move will be lasting... that is, until the trading volume slows, at which point the move might soon reverse.

Moving Averages (NYSE:MA) of shorter duration are more effective indicators with penny stocks. My favorite (and generally the most reliable) are the 9 and 18 day MAs. When the 9 day line crosses above the 18 day line, it implies a buying opportunity.

The Money Flow can be very telling in penny stocks. Any small company that has yet to increase in price, despite a strong flow of money into the stock, will typically see a short term uptrend begin within weeks, and probably days.

I will suggest again that you proceed with caution when applying TA to penny stocks. The rules of the indicators do not apply, even when those patterns appear exactly as you would hope. If you are going to lean on technicals anyway, then at least stick to some of the more appropriate ones for thinly traded penny stocks, as I have discussed above.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.