Designed as a place for new companies to get a start, the sad truth is that the vast majority of the nearly 3,500 juniors listed on the Over-the-Counter Bulletin Board (OTCBB) will never make it onto the big boards. Most run out of money or simply disappear before their products or services become profitable.

However, that hasn't stopped the phenomenal growth in trading volume. In 1993, just 3 billion shares traded annually, but by the peak of the internet bubble in 2000, this number had swelled 40-fold to 117 billion. In 2006, nearly 650 billion shares were traded. (To learn more, see Catching A Lift On The Penny Express.)

Most penny stocks have neither profits nor revenues, but traders can learn how to pick out those that have the highest likelihood of survival. Read on as we cover some penny stocks that appear to have good prospects and show you how we found them.

Putting Probability to Work
Knowing what to look for is half the battle. The other half is finding the right tools (like stock screeners) to help you scan thousands of stocks.

Here is a list of conditions that can be used as a starting point when searching the universe of more than 3,000 OTCBB stocks.

  1. Because most traders want stocks that have a lot of room to run, it may be a good idea to limit the search to those priced between $0.05 (the average price of an OTCBB stock is $0.10) to a maximum of $2. The higher the price, the fewer the candidates.
  2. Liquidity allows traders to quickly enter and exit a trade, so look for stocks trading a minimum average daily volume of 100,000 shares.
  3. Go after stocks that are currently moving higher, so be on the lookout for those with a positive three- and 10-week price delta in which the nine-day simple moving average (SMA) is greater than the 18-day SMA, which suggests an uptrend.
  4. Fundamentally, we want stocks that are not bleeding cash, so exclude companies with negative earnings per share (EPS) or negative earnings growth rates.

To ensure that you don't get caught with a one-hit wonder or stocks that have a single good day or swing, it is wise to perform the search over an extended period, such as over a five-day period. Stocks that come up frequently over the period should be the ones in which you take the most interest.

Finally, each candidate should pass the visual, short interest and news tests. To begin, it has to have a healthy chart pattern. This means that it should be above support levels and in an uptrend. (For more insight, read Analyzing Chart Patterns.)

Next, stocks in which short interest as a percentage of the float is 5% or higher could mean trouble ahead. However, very high short interest often portends a short squeeze (price is moving higher as those who sold the stock short betting it would all rush to cover) and this generally pushes price even higher. (To learn more, check out Short Interest: What It Tells Us.)

Finally, check the news on the stock. Has it been positive? If so, it attracts attention and that can mean higher prices ahead.

Three Penny Winners
Here are three examples of stock that came up in our scan and how the trades developed over time. The green arrow in each example represents the point when the scan signaled a buy signal. The red arrow is a sell signal, which is formed after the stock has started to show weakness in its prevailing trend.

The first example is Silverado (SLGLF) in Figure 1, which demonstrates a bullish basing pattern. It had been the target of a potential short squeeze and had been included in the SEC's Regulation Short (Reg SHO) threshold list of stocks for which shares in the company were classified as "failed to deliver". This made SLGLF a potential naked short candidate, but it was rallying, which generally causes shorts to cover, adding extra impetus to the rally.

This is an example of a stock in the consolidation phase, when a stock is building a foundation from which to move higher. As you can see from the chart below, the cup and handle formation was used by traders to illustrate that the momentum was shifting to the bulls' side and that it may be a good candidate for a move higher.

Figure 1 - Daily chart of Silverado Gold showing bullish cup and handle chart pattern in the final stages (blue curved line).

Figure 1 shows a good example of a stock in the base-building stage. If the stock breaks more than 5% below the straight cup, if long, a sell would be prudent; if not, hold until it breaks back above the trendline. The purple line is the 50-day moving average, which can be used as a backup or additional sell point. In cases such as Silverado, when the cup is significantly broken, it is best to exit.

Federal Mogul
A second candidate was Federal-Mogul Corp. (FDMLQ), which markets after-market vehicle and industrial components. As well as coming up in our scan a number of times during the week, it has a relative value based on analysts' estimates above its stock price, which is good news.

Figure 2 - Stock chart showing the bullish rounding bottom chart pattern, which shows stock consolidation.

FDMLQ met our scan conditions (green arrow) and remained a long candidate until it broke down from a consolidation flag pattern (horizontal green line) after which it broke below the 50-day moving average and rounding pattern, both of which are bearish.

Patch International
Our third candidate was Patch International Inc. (PTCH), an oil and natural gas exploration, development and production company. As shown in Figure 3, after consolidating after a drop, it began to rise, demonstrating an uptrend, which it held for three months. However, it broke down through the uptrend line and 50-day moving average about the same time, which triggered an exit.

Figure 3 - Patch International chart showing buy (green arrow) and sell (red arrows) signals. Note the bullish volume build as the trend gained momentum; a drop in volume was the first sign that the run was getting tired.

A Word on Stock Screeners
There are a number of free and subscription-based stock screeners out there. The old adage that you get what you pay for certainly applies here. The challenge comes in finding a screen that does an adequate job of merging technical and fundamental criteria. You may have to use more than one screener ,and if this is the case, it would be best to first use a technical screener and then check out the fundamentals of the passing candidates. It is not uncommon to have a difficult time finding information or credible research on many penny stocks due to their lack of liquidity and sparse following from the bigger market players. (For a complete list of stock screeners, please read Getting to Know Stock Screeners.)

Penny Proof
Investing in penny stocks is undoubtedly more risky than large and mid caps, but by employing a system to find the best candidates, investors can greatly increase their odds of winning the game. An important caveat is that no matter how good a system for finding stocks, it's essential to always use a stop loss. A 5% break of a major trendline or rounding bottom pattern is a good exit point.

While there are never any guarantees for success, the more technical and fundamental factors in your favor, the greater the chance of making money.

For further reading, check out How To Evaluate A Micro-Cap Company, Spotting Sharks Among Penny Stocks and The Lowdown On Penny Stocks.

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