Making money in the stock market is all about being able to predict future trends. If you believe a stock price will go up, you go long (buy). If you believe a stock price will go down, you short the stock. The process is as simple as that, however, predicting price movements is not as easy as it sounds. If it were, everyone would make millions in the stock market. So, how does one predict the future price action of a stock? Chances are, if you asked 10 different investors you would get 10 different answers. Some will tell you to look at the company’s fundamentals and growth strategy. Others will tell you to do a sector analysis and make predictions accordingly. Some may even tell you to look at technical indicators such as the RSI, exponential moving averages, MACD, etc. So, who is right?
To put it simply, anyone who is making money is right. There is not one single way to be profitable in the stock market. Some people trade solely off of charts and make millions, while others trade solely off of company fundamentals and also make millions. Any strategy that makes money is a good strategy. That being said, I use somewhat of a unique strategy when I trade penny stocks. My strategy encompasses elements of all different strategies and aggregates them into a simple, easy-to use metric. I refer to this metric as “market sentiment.” This strategy is intended for penny stock markets, however, it could probably be applied to larger markets as well. So, what is market sentiment and why is it so important?
Market sentiment is very basic and very complex at the same time. Basically, market sentiment depicts how the majority of people feel about a certain stock at a given time. If the majority of people think the stock will go up, there is a strong positive market sentiment. If the majority of people think the stock will drop, then there is a negative market sentiment. Keep in mind that your opinions on the stock do not matter if they conflict with the majority of people. When people think a stock will go up (positive sentiment), they will put in a lot of buy orders. If people think the stock will go down (negative sentiment), they will put in a lot of sell orders. Essentially, this is somewhat of a self-fulfilling prophecy. The initial buy and sell orders on a given day can trigger even more buy or sell orders when people panic/rejoice at the price movement. By now, the concept should be clear. Positive sentiment drives the price up and negative sentiment drives the price down. This probably seems very obvious, so you should begin wondering how to gauge market sentiment.
First of all, gauging market sentiment is no easy task. In no way do I want to simplify the complexity behind trying to understand how an entire market feels about a stock. That being said, it is definitely doable, especially in penny stocks. Penny stocks are unique in the aspect that a lot of them are thinly traded (at least when compared to larger companies). This means that there is usually a small group of people trading the stock, which makes it easier to gauge the market sentiment. If a stock valued at a few cents trades 20 million shares a day, this means that 200 traders buying/selling in units of 100,000 shares could account for the entire trading volume. Of course, this number can be much higher or much lower, but you get the point. Gauging the sentiment of 200 traders is a lot easier than gauging the sentiment of thousands of traders for more popular companies. Additionally, penny stock day traders tend to be more vocal about their opinions on a stock. Understanding the market sentiment does not happen overnight nor does it happen intraday. Understanding the sentiment surrounding a stock can take days, weeks, and even months. Here is how I do it:
First things first, I like to find a stock that appeals to me. I make sure the stock has enough daily volume and investor interest to run when given the chance. Through a combination of fundamental and technical analysis, I create a watchlist of a few stocks at a time. As days go by, I watch how the stock trades. I pinpoint key support and resistance levels and start thinking of a good buy-in point. I also like to see how the stock reacts to different catalysts. What happens when news is released? Is anticipation building over an upcoming event? How does the market react to large sell orders? Watching the price action relative to different catalysts can be extremely insightful. However, if you want to truly understand market sentiment, you need to be more thorough. Focus on the psychology behind each of these moves. Luckily, penny stock traders tend to be very vocal about their opinions and even their actual buy/sell orders. Read message boards like Investors Hub. Browse Twitter, or use a tool like StockTwits. Check Facebook, LinkedIn, and other sites. You can never be too thorough. Read what people are saying and analyze it. After you believe you have done a thorough analysis, determine whether the market sentiment is positive or negative. You should also determine the strength of the sentiment. If the sentiment is strongly positive, the stock may move upwards in a day. If the sentiment is just slightly positive, it may take a few days to move, as the market will wait from confirmation from other traders. You will also want to make sure the stock has enough volume to move. This means you will want a lot of people to be talking about the stock, and not just a small group of loyal followers. Do not let your personal biases get in the way. Here is an example:
Awhile back, I traded a stock called PVEC. The company released a press release about a future dividend that would essentially give investors “free money” (Read the PR if you are interested in the details). I had never heard of PVEC before reading this article, and I had very little time to do research on the company. Instead, I analyzed the market sentiment surrounding the stock. People were raving about this new press release that offered investors free money. There was a strong positive sentiment surrounding the stock. Although there was some skepticism regarding the legitimacy of the dividend, this offer was too good for investors to refuse. So, after thoroughly analyzing the investor sentiment, I placed an order to buy shares at .0005/share. This was a Friday and I knew that the news would spread on the weekend. Did I believe the news? Not in the least bit. Did that matter? Not in the least bit. When I placed my order I knew almost nothing about the company, but that didn’t matter. What I did know was that there would be buying pressure on Monday and I could make a quick profit. Needless to say, on Monday, the stock ran up as investors lined up to collect their “free money.” I sold into the morning spike at a price of .0009/share for an incredibly easy gain of 80%. The validity of the news didn’t matter for this play, nor did the company’s fundamentals, the charts, or any technical indicator. All that mattered was market sentiment.
Market sentiment is an aggregation of every trader’s strategy. It accounts for fundamental traders, technical traders, momentum traders, etc. This is why it is futile to argue about trading strategies with different traders. If all of the chart traders believe a stock price will go down, and all of the fundamental traders believe it will go up, one group is inevitably wrong. As someone who trades on market sentiment, you just need to be able to pinpoint which group represents the majority. You want to find stocks where there is a strong sentiment. If 80% of people believe a stock will go up and 20% believe it won’t, there is a good chance the stock can run. Whereas if 60% of people believe a stock price will go up and 40% believe it won’t, the stock may not move because the naysayers will have a larger voice.
Overall, this strategy has helped me make a lot of money. That being said, my analyses are not correct every time, and this is not a fool proof method. There is no such thing as a fool proof method in the stock market. Trading based on market sentiment should be viewed as a tool that gives you a competitive advantage. Of course, this tool requires that you step back from the overall market, and develop an unbiased point of view. People who get emotionally involved in their stock picks will have a difficult time gauging market sentiment. You need to remain calm and analyze the situation apathetically. As always, I recommend testing all new strategies with paper trading so you can get the hang of them.