Chapter Seven: Penny Stock Chart Patterns

So here’s the first type of chart. It’s just the basic chart of the Dow Jones Industrial. You see all the other pretty colors. You’ve got all the technicals in there. This is a BAR CHART—which should be pretty self-explanatory when you look at the image below:

chart type: bar

Here’s another type: A LINE CHART. This is the same exact chart of the Dow Jones Industrial Average over the course of a few months, but instead of bars, it’s just a line.

chart type: line

This next one is what’s known as an AREA CHART. Obviously, you can see that this is the same exact type of chart, but instead of a line or bars, you have this kind of figure:

chart type: area

I don’t usually use these kinds of charts—honestly, I think they’re pretty ugly. My favorite type of chart is the CANDLESTICK CHART, because it shows you the movement of the stock. If the stock or the index moves up, it’s a white bar or black bar; if it moves down, it’s red.

chart type: candlestick

Looking at this chart, you can see that over the course of a few months, there are definitive time periods where there are a lot of red days and certain time periods where there are a lot of up days.

Now that you know what types of charts you’re looking at, you want to start to look for patterns in their movement. In this section, I’ll cover one of my favorites—the clean chart pattern.

Some of the charts I’m going to show you in this guide are pretty old, but that’s not what’s important. You don’t need to look at recent charts to see the patterns I’m going to show you. What’s more important is that you learn how to identify each of the setups I’m going to describe here so that you can spot them when you’re planning out your own plays.

Clean charts are some of my favorite charts to trade because they’re very orderly. There’s a very orderly rise or fall in the stock price, which is great to see as a trader.

The Symptoms. Prolonged bouts of one-sided price action, with only brief interruptions.

The Treatment. So how do you treat this? You focus your trades on stocks with clean charts. I can’t repeat that enough. If you focus your trades on stocks with clean charts, you’ll encounter a lot fewer headaches and much greater odds of success. Just contrast these charts with the messy charts I’ll cover later on and you’ll see what I mean.

chart type: clean

Here’s an example of a CLEAN CHART—eFuture Information Technology, EFUT. This is a very volatile stock, as you can see. What I don’t show you in this clean chart is that it ran out from basically $5 dollars a share to $40 dollars. I’ll show that to you later. But, for now, the point is that, in this chart, you see a very clear trend.

This is a very bearish trend. We see the stock going pretty much continually down with only a few spikes. You see a spike up towards the end of March from 20 to basically 24, followed right down by more down days. Then you get continuous down days all the way up until early May, when the stock tries to rebound again, although it keeps going down. So then you get a spike up in June, followed by lots more down days.

This is very clean, and it’s very one-sided trend. This is the type of chart that you should look to play—obviously, you’d play this chart from the short-selling side, because pretty much any time it goes up, it’s a good opportunity to bet that the stock price is going to go down again.

Here’s another example of a clean chart, just to help you get a feel for what you should be looking for:

chart type: too clean

This is Manchester (MCN), and it’s almost too clean. This is actually a pretty amazing chart—it didn’t have one major down day for nearly an entire year. It might have had a down day of a few cents in there, but as you can see, the chart is just pretty amazing. At the end of October, it gets to be too clean, though. You can see where it pretty much goes from $7.50 to $8.50 in a few days—it becomes way too steep.

chart type: results of too clean

And, as you see, this is what happens when a chart is too clean. You see the rise in October all the way up to $8.50. and then look what happens in mid-October. Look at that big drop—you don’t even get any warning. It goes from $8.50 to $5.50 for one day, and $3.50, and then it gradually sinks all the way down to $2 dollars.

Remember back to EFUT, where they had a few days that were opposite a trend and that was very important. When there are no prices opposite the trend, it’s just dangerous. In this case, I know that what happened was that the company registered a 50-page complicated SEC filing and investors got spooked off. But in most cases, you won’t know what’s going on. You just have to understand that when charts look too clean, they aren’t great opportunities—they’re dangerous.

Here’s the next chart pattern—A CLEAN BULLISH-LOOKING CHART. As you can see, Aspen Bio (obviously a biotech company) keeps going up gradually. It’s a nice little pattern. You can see at the end of February 2007 when it really starts to get into the same pattern, due to the fact that they had positive FDA news on February 22nd.

So you see the huge run-up from basically a little over $3 dollars a share to $4 dollars a share. And it continues up gradually. Again, it’s not too clean because there are some trend changes along the way, and then you see a big drop in August 2007 from $5 dollars to $4 dollars a share.

That’s basically just a little sell-off due to very low trading volume. You can see in the bottom of the chart the trading volumes statistics for each day—it was basically 200,000 shares. This wasn’t a huge amount of sellers, it was just no buyers. Then, earnings came the next day and brought it right back up from $5 dollars to $6 dollars and the stock broke out. This is the kind of chart you should like.

Unfortunately, in this case, Aspen’s volume only ever reached 750,000 shares—even during their biggest run-ups. That’s really not enough volume for me. I like to trade stocks that are trading millions of shares, so that whether I have a few hundred shares or a few thousand shares, I’m such a tiny percentage of the stock that I don’t influence it. When the stock is trading 200,000 shares a day, you really could influence it with a few thousand shares.

So this stock really isn’t liquid enough for me to play, but it’s still a great example of a clean bullish pattern.

Here’s an example of a CLEAN BEARISH PATTERN—Local.com. You see the big run-up at the beginning of July. It’s pretty amazing, as the stock goes from $4 dollars all the way up to $13 dollars a share—basically tripling within 4-5 days.

The reason behind this run-up was patent news. The news that the company got its patent was released right around when it was trading at $7 dollars a share. The run-up at the end of June that went from $4 dollars to $7 dollars was due to rumors that this was going to happen, but the patent news itself is what was behind the run-up to $13 dollars a share. As you can see, though, less than two months later, the stock is all the way back down to $5 dollars a share.

This is an example of a clean bearish chart because, even with the patent, it doesn’t matter—the stock keeps going down. It’s very gradual, but you see that pretty much every single day is a red bar.

Obviously, the patent wasn’t that important. People just got excited over nothing. This is a great example of hype and what hype does to a company. Don’t trust hype—it only influences prices for only so long, and then eventually, the original pattern takes over.

Here’s an example of a CLEAN BREAKOUT. Look at that chart—it’s so pretty. It’s very not clean for the entire chart, but it is a clean breakout. If you look at the little blue line that I drew, you can see that it’s pretty much right at $8.75 a share, which it tested at the end of March on the left hand side of the chart. And you see that it tested and it went down again, taking all the way to August to break it.

Really, what happened was that an article in some newsletter said that this was a great growth company, and the stock broke out because of it. It hits resistance at $8.75 at the end of March, but after about five months—when the article came out—the stock rose very nicely, broke out of $8.75 and continued higher.

This is a clean breakout, but again, look at the volume. This stock—even when it breaks out—only trades around 300,000 shares a day. So you can’t really buy more 1,000 or 2,000 shares without influencing the stock and risking not being able to get in or out when you need to.

Mutual funds and hedge funds ignore this type of stock because they can’t buy 100,000 shares. But for individual traders like you and me, this kind of pattern is perfect. What I’d do in this situation is buy this stock at $9 dollars a share and wait for the breakout. You see right after it broke out that there was one red day where it wasn’t clear if the breakout was going to continue.

So (if the volume was right, which it isn’t in this case) I’d buy a few thousand shares right around there $9 dollars, maybe $9.25 and sell it at around $10 dollars. All I’m trying to do is make a few thousand dollars in a few days by banking $1 dollar a share in profit. It’s a small gain, but these kinds of plays can really add up.

Here’s an example of a CLEAN BREAKDOWN. Obviously, the chart is very messy. From March to July, you see the stock is just trading between $10 dollars and basically $12.50. You can’t really determine which way it’s going to go. You see lots of red bars and lots of white bars. You have spikes. Nothing happens until you see that it breaks support at $10 dollars a share in August on the right hand side of the chart.

Look at that. It tested $10 dollars a share, which is a good example of a big fat round number. People like big fat round numbers like $10 dollars a share and they put their stop loss orders in at these milestones. They say, “Okay, I’ll get out at $10 dollars a share,” and they all get taken out immediately.

Stop loss orders are meant to protect you, but unfortunately, they’re computer generated. So when 50 stop loss orders light up at once, it’s nothing but sell orders and the stock price is just going to get annihilated. This is what happens. There’s no news whatsoever, and yet, the stock goes pretty much straight from $10 dollars to $9 dollars a share. It’s the same thing as the clean breakout above, just reversed.

In this case, it’s very easy to make $1 dollar a share. You can see in August that, when it had its breakdown, the volume looks to be around 500,000 shares. So you could probably build up your position a little more—maybe 5,000 shares. Short your 5,000 shares around $9.50, wait for the breakdown to occur, and two days later, buy to cover your short position at $9 dollars a share. You’d make $2,500 dollars in a few days, with very little effort and very little risk (again, as long as you try not to risk more than 5% to 10% of your account in any one position).

Here’s another example of a nice, clean breakdown:

This is another beautiful chart. You can see that it had a nice run-up in May on the left hand side of the chart from $4 dollars all the way up to $8 dollars a share. It was pretty much just doing nicely until that big down red day, where it goes from $8 dollars to $7 dollars in one day. Then, you can see that the trend has completely changed. It goes all the way down to $4.50 pretty much all throughout June and July, before it balances off at around $4.50.

The key is to wait for that balance. Don’t try and guess that it’s going to hold at $4.50—wait for a little bounce and then see. Look at August, where it broke right through $4.50 cents. There, you had a nice piece of news that the company delayed their quarterly report to the SEC. The SEC actually also launched an inquiry into the company and news got out that the company had credit problems.

Talk about problems! This company announced all of that in one day. But the stock itself didn’t drop all in one day—it actually took three days to drop from $4.50 to $3 dollars. When you see it break to $4.50, that’s your opportunity to short. And you can see the volume is a lot higher on this stock, so you can short as many shares as you can find.

Obviously, again, you shouldn’t risk anymore than 5-10% of your portfolio, depending on how much risk you want to take on. But you see that on big down day, it traded over 3 million shares. At that point, you could have taken freaking 30,000 shares and you’d still only represent 1% of the stock’s entire volume.

So if you had taken 30,000 shares, you’d be risking a little over $100,000 dollars—so you would have needed to have a $1 million dollar account to pull this off. But if you did, you could have made nearly a $1 dollar a share in two days. That’s a profit of nearly $30,000 for just two days of work. I know people who make that working full-time at a single job all year!

This breakdown didn’t occur immediately when the news hit. The reaction to the news took days to filter down and finally affect the stock’s price. That’s one of the beautiful things about penny stocks—everything is gradual. A lot of the people who are playing this game don’t even track their stocks everyday and you can take advantage of that. If you are diligent about tracking every single day, you’ll be ahead of the crowd and you’ll be the first to make money on moves like this.

Here’s a CLEAN CUP AND HANDLE CHART. This is another common technical analysis term that you need to know. As you can see, there’s a run-up between November and December from basically $1 dollar a share all the way up to $3.50.

And again, when a chart gets too steep like this, either the company is a miracle worker or there’s something screwy going on. Obviously, there was no news to account for this drop, but there’s still a drop all the way from $3.50 to $1.50. It’s tough to play this type of action, but you can do it as long as you wait and find your points.

In this case, the point to play is all the way on the right hand side of the chart in August, when the stock basically reaches $3.50 a share. This is the exact peak that it reached almost seven months ago and you can see that it breaks $3.50, goes basically up to $4 dollars, and then comes back down to $3 dollars a share.

Your point to buy would be right when it breaks $4 dollars for the second time and goes straight to $5.50. And as you can see, the volume is over a 1 million shares. Since I don’t like to be in for big positions, I’d buy 10,000 shares at $4 dollars—maybe $4.20—and sell it at $5 dollars within a few days, leaving me with a very nice 20% gain. Forget about waiting years for your Home Depot stock to do something like that!

Here’s a pattern that’s known as the CLEAN DOUBLE TOP. This is basically the same thing as a cup and handle, except it doesn’t break out.

This is an older chart, but it’s one I played a lot when it ran up from $2.50 all the way to $6 dollars. The 75 million shares traded a day is great volume, so you can take a big as a position as you want and still get in and out of it.

You can see that the stock goes all the way up to $6.50. It’s very scary to short when a stock triples like this because you don’t know if it’s going to stop at $6.50. So you wait for this pattern—you see it come all the way down to $2.50. There’s really no good time to play this until July, where you see a perfect double top that was put in place right at $6.50.

What happened was, this company was on the cover of Time Magazine. There’s a common saying that when you’re on the cover of a magazine, it’s time to go the opposite way. This time, you see at $6.50 that the stock reached the exact same point that it did a few months ago—only this time, it just couldn’t hold it.

If you could find the shares, the best time for you to short this stock would be to wait for the double top to come in. So if you short it at $6 dollars with a small position and sell to cover at $5.50—or $5 dollars, if you have the patience—you can see a nice return, even while risking a small amount of your money. If you can handle being a long-term short (which I’ve never been able to do), you could wait until it goes all the way back down to $3 dollars. Personally, though, I like to protect my losses by getting in and out within a few days.