Shorting Penny Stocks – The Ultimate Guide
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Shorting penny stocks is one of the most alluring trading strategies for many traders. That’s because most penny stocks turn out to be essentially worthless securities that end up being delisted and never heard from again. Therefore, the prospect of making a quick, sizeable profit by selling penny stocks short is an attractive intention indeed.
But it can’t be repeated too often that the basics of risk and reward mean that wherever there’s the potential for large profits, there’s usually also the potential for significant losses.
In this article, I’ll explain what penny stocks are, what short selling is and how to short sell stocks that fall under the category of penny stocks. We also look at the relative benefits and risks of shorting penny stocks.
See Also: Best Broker for Shorting Penny Stocks
What Are Penny Stocks?
According to the US Securities and Exchange Commission (SEC), the definition of a penny stock is any stock selling for less than $5 per share. Most penny stocks are also identified by the fact that they’re only traded over the counter (OTC) rather than on a major stock market exchange.
Some low-priced stocks are traded on an exchange, but most penny stock companies can’t meet exchange listing requirements such as minimum stock price or market capitalization.
Most OTC stocks are very thinly traded, resulting in much wider bid and ask spreads compared to stocks traded on a major exchange. Low liquidity also makes penny stock prices extremely volatile.
The effect of the low liquidity that produces wide bid/ask spreads is magnified by the low share prices of penny stocks. A five-cent difference between the bid and ask prices for a stock that’s selling for $300 a share is relatively insignificant.
But if the stock’s price is only five cents a share, then a five-cent bid and ask spread means the stock has to double in price just for an investor to break even.
Penny stocks are a highly speculative investment for several reasons:
Small, Young Companies
Penny stock companies are typically small companies that haven’t been in business very long and don’t have extensive financial resources.
Little Available Information
Penny stock companies aren’t required to publicly disclose the same financial information that exchange-traded companies are required to report. Plus, they’re typically not covered by market analysts.
These two factors make it difficult for investors to do basic investment research to obtain reliable information about most penny stock companies.
Subject to Being Hyped by Fake News
Penny stock prices are often manipulated through things such as email, newsletter, or social media hype. Novice traders are frequently suckered into buying shares of a penny stock.
For example, when they read “news”, that often turns out to be wholly fabricated or, at best, greatly exaggerated, about a penny stock company.
Then they see the stock price surging higher, for example, from 50 cents to $1.00, to $2.00, to $4.00 and so on. The innocent investor buys in, thinking the predictions of $50 a share are coming true.
But instead, they see the shares they bought at $4.25 promptly fall back down to just 40 or 50 cents a share, handing them roughly a 90% loss.
What is Short Selling?
When you sell short a stock, you are looking to profit from a subsequent decline in the stock price. Short selling is a trading strategy employed when you think a stock is likely to go down in price rather than up.
Most investors initially find the idea of selling short a confusing, but it’s not really all that mystifying. When you sell short, you’re simply doing a buy and sell stock transaction in reverse order. You start by selling first, opening a trade, and closing the trade with a buy order later.
But the bottom line remains the same: Just as with the common practice of buying stock to open a trade and selling it to close the trade, you still profit as long as your sell price is higher than your buy price.
We will later talk about the risk of short selling in detail, but I want to mention the biggest risk of short selling penny stocks here.
If you short sell a penny stock, your risk is unlimited since the price can go to any price level. This is different from simply buying penny stocks since your risk is always the capital invested. Keep that in mind.
How to Short Sell Penny Stocks
When introduced to the concept of short selling, the first question traders usually ask is, “How can I sell something I don’t own?”. The way you do that is by borrowing stock shares from your broker. A short sell trade progresses as follows:
1. You start by borrowing shares from your broker
You begin with a margin deposit – a percentage of the total value of the borrowed stock shares. Your broker charges interest on the loan until the shares are paid back.
2. You open a trade by selling the shares you borrowed from your broker.
The “sell” part of your stock trade is done – doing the “buy” part will close out your trade.
3. When you close your short position, buying a number of shares equal to the number you sold, you then use those purchased shares to pay back the share loan from your broker.
If your buy price is lower than your short sell price, then you make a profit. So, for example, if you sell a stock short at $50 a share. The stock’s price subsequently declines to $40 a share. Then when you close out your trade with a buy order at $40, you’ve made a $10 per share profit – that’s like if you had first bought the stock at $40 and later sold it at $50.
One of the things that make shorting penny stocks a high-risk investment is that your risk is theoretically unlimited. Theoretically at least, the price of a stock can rise infinitely higher. In contrast, when you make the usual trade of buying a stock first, your loss is limited because the stock price can’t go any lower than zero.
Shorting penny stocks is popular with many traders because the prices of penny stocks are often temporarily inflated to a level high above the stock’s true market value. Traders sell short, betting that the stock will decline to a price that reflects its fair value more accurately.
A Note on Brokers and Short Selling a Penny Stock
Some brokers are friendly toward shorting penny stocks, and some aren’t. Some brokers won’t allow you to short sell penny stocks at all. Some brokers may not have the penny stock shares in their inventory for you to borrow. You can ask them to find and buy the shares via a so-called “short located of hard to borrow shares” practice, but they’ll charge you an extra fee for that service.
A couple of brokerage firms popular with penny stock traders are Interactive Brokers (IB) and Cobra Trading. Do your own research when selecting a brokerage account. There are big differences in the minimum deposit required for a margin account (varies from $2,000 to $5,000) and the amount of margin required to borrow shares (can vary from 50% all the way up to 100%). Interest rates brokers charge on share loans also vary significantly.
Benefits of Shorting Penny Stocks
Although the risks associated with shorting stocks in general, and short selling penny stocks in particular, are considerable, the potential rewards are still sufficient to attract many traders.
One benefit of shorting penny stocks is simply that there are plenty of opportunities for generating profits. While some penny stock companies eventually become very successful, most do not.
Besides just being small or new, there’s usually a reason why a company can’t get its stock listed on a major trading exchange. You may lose money selling penny stocks short, but you probably won’t lose money as often as investors who regularly buy penny stocks.
Another benefit is that it’s relatively easy to gain a significant trading edge that increases your likelihood of being a profitable short seller. As previously noted, it’s often difficult to obtain reliable information on penny stock companies.
But suppose you limit your short selling to companies you are able to obtain solid information on. In that case, you find you in a better position to reasonably determine if a stock’s intrinsic value has genuinely increased or if it’s just enjoying a brief run of popularity.
For example, assume that a mining stock is being touted by some newsletter or social media, with claims about all the rich mining deposits the company has control of. But suppose you’re able to get a look at the company’s actual financials and see that not only has it never had a profitable quarter.
In that case, it’s had nothing but increasingly higher losses for the past two years. Armed with that knowledge, you can conclude that the odds are good that any rally in the stock’s price will be short-lived.
Risks of Being Short Penny Stocks
Short selling, as previously noted, exposes you to theoretically unlimited losses. You can lose more than your original investment. You can even lose more than you have in your trading account and be left owing your broker money.
The high risks involved in shorting penny stocks make it critical that you practice solid money management. Use stop-loss orders to limit your risk, and if a trade goes strongly against you, don’t stubbornly hold onto it, increasing your losses. Instead, be willing to admit when you’re wrong and cut your losses short.
Short sellers sometimes get caught in what’s known as a short squeeze – when a sudden, sharp rise in a stock’s price begins forcing short sellers to close out their positions in order to avoid more severe losses. As they have to buy to close out their short trades, that buying further fuels the upward pressure on the stock price, forcing more shorts out of the market, which creates even more buying pressure.
This year has seen some notable short squeezes. For example, social media groups organized massive buying campaigns specifically designed to profit by generating a short squeeze that would push a stock’s price substantially higher.
Short Sell Penny Stocks Summary
Short selling penny stocks is a potentially very profitable investing strategy. But being successful at it requires doing diligent research before initiating a trade and practicing careful risk management once you’re in a trade.
One aspect of technical trading you need to master is identifying market reversal patterns in price action and candlestick formations. This way, it is more likely that your undergoing of short selling penny stocks will be of success.
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