5 Common Penny Stock Traders and Their Trader Psychology
The biggest misconception I’ve seen in many beginner day traders is that they are always on the quest to find the best penny stock trading strategies, penny stock patterns, and indicators. What most fail to realize is that those things only work if people use them.
In order to profit, we must think for the other buyers and sellers and understand who the players are and who is in pain.
The most common players in the penny stock market are breakout traders, momentum traders, dip buyers, short sellers and swing traders. I will be breaking down the basics of these traders’ psychology in the market, so you will be able to analyze and profit from day trading beyond just memorizing patterns and strategies.
Trader Psychology
1. Breakout Traders
These are the traders who buy into a penny stock when it’s at the point of breaking a previous high. Let’s use the $ABIO intraday chart as an example. On a particular day, the stock got pumped up by PR and traded as high as $9 from $5 in the morning session. It sold off a little bit mid day and retested the previous high at around 1:20 PM in the afternoon.
At this retest price, breakout traders see that the stock is about to make a new high and think to themselves, “I can see the price break $9 and possibly go up to $10 or even more. I must get on this.” Breakout traders are the most predictable traders because it is the most common “strategy” taught in penny stock day trading courses, dvd’s and chat rooms. They term this strategy “breakout pattern”, “U shape pattern” etc. This is very important. We’ll come back to talk about this in detail a little bit later, so hold on tight.
The volume increases in the stock around the previous price level of $9 as more breakout traders hop on to this stock. In this case, there are more breakout traders than sellers, so this breakout becomes successful. The stock breaks the previous high in the morning at $8.95 and runs higher to $11.50 and almost $13 dollars at 2:00 PM.
2. Momentum Traders
Once all the traders watching $ABIO see that the stock has just made a new high breaking above the previous resistance of $8.95, this is where the momentum traders get interested. They are thinking, “Oh that break out on $ABIO was successful, and when stocks break previous day highs successfully, it’s really likely that more volume is going to pile in. I should hop into strength as well!”
These momentum traders hop in along with the breakout traders, and that's why when penny stocks break a previous resistance with strong volume, the price will squeeze even higher. Remember this; momentum traders join strength.
When strength weakens, this is where momentum traders sell their position and get out. The breakout traders who got in to break the previous high of $12.69 failed. The stock only went twenty cents higher at $12.88 and quickly slammed back down to $11.
This is a sign of weakness and extension, and when the stock no longer has strength, that is when the momentum traders who got in earlier start selling. There were not enough fresh breakout buyers coming in, so the increase of selling and decrease of buying caused the sell off for the stock from $12.80 back down to $10 and below.
3. Short Sellers
This is where the third kind of players come in, the short sellers. Short sellers love to lurk at the top of each stock. These are the traders who can spot an increase of selling and decrease of buying in the volume and level 2. Short sellers love overly extended stocks on the day like our example using $ABIO.
They saw $ABIO and these “shorts” thought, “Ummm okay, this stock ran from $5 to almost $13 today. This is over extended. I think the buying has slowed down and selling is going to increase now. I want to short this stock down.”
In our case, if the short seller entered at the top around $12.80, he or she was correct in their thesis, and they made profit from the stock selling off all the way down below $10.
However, there are always those impatient short sellers. Those are the “shorts” who got in too early from before. Some traders love to short everything that’s up, so they short here at $7 and $8 because the previous high was $9, remember. I bet you there were many shorts taking entries around that price at 1:20 PM.
Well, those short sellers got in too early. There were more breakout traders and momentum traders buying than the overall selling, and the stock was breaking highs. When that happens, these early short sellers are thinking to themselves, “Holy $#!%. I didn't think this stock could possibly break $9 and now it's breaking above $10. I am down a lot now because I thought this breakout would fail, but I'm wrong. What if it goes to $20 or $30? Oh my god! I better get out before I blow up my account.”
The short sellers who are in pain decide to get out, and they need to buy to cover to get out. That causes a short squeeze. The “shorts” buying along with the breakout traders and momentum traders buying causes the $ABIO stock to squeeze even higher.
Let’s get back to the successful short sellers here. If I was a short seller who shorted at $12.80 and now the stock is back down at $9, I would start to cover a piece around this level at $9. Why? Because I know that dip buyers are going to start coming in.
4. Dip Buyers
These are traders who buy into a stock when they see that a stock has made a high and retraced back to previous support level. Dip buyers love to get into the stock on pull backs after it shows impressive strength to the upside.
For example, dip buyers would be looking at the $9 level and think, “Hmm, the stock was just trading around $12, and now it's pulled back. I can buy into this at a cheaper price. Previous resistance level was $9, and previous resistance once broken becomes support. Ok, $9 is a support price. I think it’s reasonable to buy in.”
At the same time, short sellers also look at the previous support levels at $9 and think, “Ok, I need to beware of dip buyers. They may look into getting into this stock at this level, so I better start covering up.”
It's this exact balance between all players in the market that creates these support and resistance levels. Dip buyers buy at $9 and short sellers buy to cover. That makes the stock price bounce from $9 again to $11.70, and this bounce pattern only happened because dip buyers and “shorts” came in to buy.
This is why I've stressed not focusing on memorizing patterns. Focus on understanding the players involved in the stock and what they are doing to form the pattern and price action. Think for the other traders.
At the end of the day, in this example, one run up $ABIO closed around $9. The next day we saw the stock gapped up to $19 pre market. This is where the fifth major player comes in.
5. Swing Traders
Swing traders are the people who love to buy a strong stock holding that gains overnight. Swing traders would be thinking, “Ok, this is only day one of this move on $ABIO. This penny stock is holding up its gains really well and has not sold off. I think the news release could potentially drive more buyers to come in overnight. I can then sell my position at tomorrow’s gap up or into a morning spike.”
Guess what, the next morning, these swing traders are laughing to the bank. The stock is trading at $19, and the swing traders are thinking, “Wow this is amazing. I just made $9 a share in less than 12 hours. I better lock in some gains in case this stock sells off back down to $10.”
At the same time, let’s think about the breakout traders who are trading by following chat room alerts. Remember how I mentioned earlier that we’ll come back to those people? The most common day trading chat room strategies are buying breakouts of previous day highs, premarket highs, etc.
Now, let’s put short sellers into consideration as well. As I mentioned, there were shorts piling in around $12.80 the day prior and probably held overnight because they think the stock could sell off even more back down to $5.
Put it all together
What do you think the swing traders, after profiting $9 a share overnight, are more likely to do at the market open? They would probably sell and take their 90% ROI and run. Short sellers, who were holding short overnight from $12.70, woke up to see that they are down $7 a share. They’d probably panic and want to buy to cover immediately at market open. Breakout traders in all the penny stock chat rooms would probably get an alert by their moderators to buy at the break of premarket high $19.50 and sell at the next whole number $20.
At the market open, breakout traders pile on to buy at the premarket high of $19, and short sellers buy to cover. Those two players together drove the stock shares up from $18.30 to a little bit above $20.45. Swing traders who got in the previous day want to cash out on overnight gap up or spike at the open. They start selling their overnight positions at the same time and take home their profit.
The amount of selling outweighs the fresh buyers and short sellers covering, so the price did not go higher. This is when chat room followers and breakout traders panic. At that point they’re saying, “Oh $#!%, I thought the stock was going higher to $25 or $30 after I bought at $19, but now it’s breaking down below premarket highs at $17. I better cut my losses before the stock tanks back down to $5.” All those breakout traders who were stuck at $19 or $20 at the open start selling as well.
Now, the smart short sellers who didn't get squeezed from their overnight positions would be lurking around this premarket high. They would be thinking, “Ok, the stock just gapped up $9 overnight. If I was long and up so much, I would totally sell and take the profit. I think this stock might spike a little bit at the open with people chasing and immature shorts covering, but I think ultimately there would be more sellers than fresh buyers. I want to take this short.” Basically, this is the foundation of the gap up strategy.
This is the cause and effect relationship that is so crucial to understand. Chart patterns are byproducts of psychological decisions by buyers and sellers in the stock. This is why no patterns or strategies are 100% guaranteed.
If dip buyers didn’t come into $ABIO at $9 on day 1, do you think the stock would have bounced? If there weren’t enough breakout traders buying vs selling, do you think this breakout would have been successful?
Most people think to make money in day trading penny stocks you need to understand the market and analyze the patterns. Sure that could help, but really it's not you against the market; it’s you against the other people in the market.
This is why I believe day trading psychology is so important. You have to think for the other players involved. This is the kind of psychological analysis that will separate you from the sheep that follow alerts and study just patterns. Don’t trade chart patterns. Understand the traders in the stock and trade those traders.
