5 Penny Stock Trading Principles to Follow

How to avoid the “AMWI effect” on your penny stock trading……..

Penny Stock trading involves isolating noise from the current trend and capitalizing on that trend through well-timed entries and profit taking. These factors play a critical part in mastering potential profit expectations and risk. Penny Stock trading does have many challenges but by sticking to clear rules, success is much more probable. Since the market always moves in waves, guidelines can be created for exploiting this trend.

Most successful penny stock traders follow five simple rules to find high profit potential, low risk, penny stock trades:

1. Only trade on current intra-day trend

Penny Stock trading with the trend permits for low risk entries and high profit potential if, and only if, the trend continues. Intra-day trends do not continue indefinitely as many learned in early December with Amwest Imaging (OTCBB: AMWI). Reversals do occur but usually one or two trades and sometimes more can be made before the trend reverses. Isolating the phenomenon can be the difficult part for the novice trader. Trend lines, also known as peaks and valleys, present a simple and useful entry and stop loss strategy.

Focus on trading penny stocks with the dominant trend of the day only. Begin your trading with the new trend as and when the trend shifts.

2. Trade strong penny stocks in an uptrend, weak penny stocks in a downtrend

Most penny stock traders find it useful to trade stocks that have at least a moderate to high correlation with the S&P 500, Dow or NASDAQ indexes. Although a good indicator, it is nearly impossible to find a penny stock which trades this way. By trading stocks or ETFs with a high correlation to the major indexes, stocks that are relatively weak or strong, compared to the index, can be isolated. This creates an opportunity for the penny stock trader, as they can isolate which stocks are likely to provide a better return, given the movement of individual stocks relative to the index.

When the indexes/market futures are moving higher, traders should look to buy penny stocks that are moving up more aggressively than the futures. When the futures pull back, a strong penny stock will not pull back as much, or may not even pull back at all. These are the penny stocks to trade in an uptrend, as they lead the market higher and thus provide more profit potential and lower risk; smaller pullbacks mean less risk.

When the indexes/futures are dropping, short sell penny stocks that drop more than the market. When the futures move higher within the downtrend, a weak penny stock will not move up as much, or will not move up at all. Weak penny stocks are less risky when in a “short” position and provide great profit potential when the market is falling.

Which penny stocks are stronger or weaker than the market changes by the minute although certain ones may be relatively stronger or weaker for weeks at a time. Those who bought, sold or watched AMWI in early December saw this firsthand how in less than 50 minutes, AMWI’s bottom fell out. The same likelihood is due for ABOT Mining (OTCBB: ABOT.PK) before 2012.

3. Be patient – wait for the pullback

Peaks and valleys help to show how the market moves in waves. Peaks and valleys are an approximate visual guide to where waves in price will begin and end. Penny stock traders use peaks and valleys for early entry into the next price wave in the direction of the trend. If entering a long position, buy after the price moves down toward the valley and then moves back higher. To draw the valley, a price low and then a higher price low will be needed. The line is drawn connecting these two points and then extended out to the right.

Short selling in a downtrend is similar. Wait until the price moves up the downward sloping valley, then when the stock begins to move back down, this is when the entry is made.

By being patient, these two long trades provide a very low risk entry, as the purchase is made close to the stop level, which could be several cents below the valley.

4. Take profits

Since the market moves in waves, peaks and valleys, you want to exit before a correction occurs. Penny Stock traders have limited time to capture profits and must spend as little time as possible in a trade that is losing money or reducing “paper profits” to a significant degree. When a trade is entered into, if it becomes profitable but is not yet realized, it is a called a “paper profit.” Penny Stock traders focus on turning paper profits into real profits before the peak reverses on them.

There are two simple rules used to take profits when trading penny stocks with trends:

  • In an uptrend or long position, take profits at or slightly above the former price high in the current trend.
  • In a downtrend or short position, take profits at or slightly below the former price low in the current trend.

Since the stock price may meet resistance at an old price high, profits can be taken at the same price as the former high. The same method can be applied to downtrends whereas profits are taken at or slightly below the prior price low in the trend.

5. When the stock reverses, step aside

Penny Stocks don’t always trend. Intra-day trends can also reverse, quickly, so often that a true direction is hard to establish. If major highs and lows are not being made, make sure the intra-day movements, which will be within a range, are large enough for the potential reward to exceed the risk.

When there are periods where prices move in a horizontal price range, step aside and don’t trade. Alternatively, switch to a range trading type strategy. If switching to a range trading strategy, all the rules still apply. The overall trend does not exist, but is actually a range. Wait for the price to reach near the high of the range and then turn back lower. This will provide a low risk entry and then exit the trade at, or near, the low of the range. The same method can be applied to long entries within a range.
When low risk entries are not present or clearly visible, step aside and do not trade.

The Bottom Line

Penny Stock traders should trade with the overall trend, peaks and valleys, and patiently wait for low risk entries to potentially profit from that trend. Peaks and valleys can be used as a guide to help penny stock traders determine these low-risk entry points, as well provide potential stop levels. Buying penny stocks that are stronger than the index in uptrends and shorting penny stocks that are weaker than the index in downtrends should provide more safety and relative outperformance profits.

Profits must be realized and should be taken at or above the prior price high in an uptrend. Conversely, they should be taken at or below the prior price low in a downtrend. Do no trade when the trend is unclear. If a well-defined range develops, this may be traded by using a low risk range trading strategy.

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