Penny stocks are a peculiar and increasingly popular asset class among beginning traders. While these stocks carry a handful of benefits – for instance, their lack of competitiveness – they’re also highly volatile and prone to market manipulation. Couple that with the fact that many of the underlying firms are either startups or on their last legs, and one might find it a wonder that investors choose to own these tickers.
And in fact, many investors don’t own them; rather, they use penny stocks as a short-sell investment to increase their market returns. The same drawbacks that make them risky buy-and-hold positions ups the ante for massive profit potential for short-selling traders. While substantial percentage gains abound, so do significant drawdowns if you don’t time the market just right.
But if you’re so inclined to dabble in shorting penny stocks, the first thing you need to know is how.
What is a Penny Stock?
According to the SEC, penny stocks are securities that trade for less than $5 per share (though some brokers may set a different bar for in-house trades). While a handful of these stocks trade on large exchanges such as the NYSE, most are limited to OTC (over the counter) transactions.
Typically speaking, penny stocks are issued by startups, smaller companies, or poorly run businesses in need of capital. And while not all penny stocks are inherently bad companies, it’s also not uncommon to see firms with a history of fraud, meagre balance sheets, or unfortunate management decisions on the list.
As an asset class, penny stocks are often considered speculative instruments that carry a high degree of risk. Several reasons play into this, such as their:
- Lack of liquidity
- Historically high volatility
- Limited SEC filing or other public information requirements
Additionally, OTC exchanges maintain no minimum standards, meaning that even shoddy companies can continue to trade. And with many penny stocks having no or poor track records and small prices, they’re easy to manipulate – often at the expense of new investors who fall prey to pump-and-dump schemes.
Risks aside, it’s not unheard of for penny stocks to grow into upstanding members of the business world. But those tend to be the exception, rather than the rule.
As such, while penny stocks make risky buy-and-hold investments, they tend to be popular among one particular class of traders: short sellers.
Short Selling: A Primer
Short selling is an advanced trading technique wherein you flip conventional market wisdom of “buy low, sell high” on its head. The shorting process is fairly simple:
- You borrow a set number of shares from your broker at what you believe to be a high price using your margin account
- Then, you turn around and sell your borrowed shares to another investor
- When the security falls (assuming that it does), you repurchase (cover) the same number of shares and return them to your broker
- The price difference between your borrowed shares and your bought shares is your profit
In other words, you’re betting that the stock price will go down and profiting off that belief if all goes well. And if you make the right call on the right stock, that belief can put thousands of dollars in your brokerage account on a single transaction.
Short Selling Risks
That said, short selling is a strategy that comes with literally limitless risk. If you make the correct call and sell out in time, you can pocket profits to the tune of thousands of dollars. But if you make the wrong call and don’t have a stop-loss order in place, you can empty out your account in minutes.
And while that seems like an extreme statement, a quick example shows just how risky short selling can be.
Let’s say that you borrow one share of stock at $1 and sell it at the same price to another investor. Unfortunately, the stock rises instead of falls, and you’re forced to buy back the same share for $6, leaving you $5 in the hole on your investment.
By the time you add fees and interest for borrowing stocks and trading on margin, you’re out your investment several times over – and that’s just for a single share.
Additionally, shorting stocks comes with a risk of getting caught in a short squeeze, such as what happened with the hedge funds that lost billions on GameStop and AMC. Essentially, a short squeeze occurs when many short sellers cover their positions early, causing prices to soar and gouging the capital in your margin accounts.
Moreover, traders are required to open margin accounts to short stocks. While the practice lets you leverage more than you deposit for a chance at greater gains, you’re also subject to forced buy-ins if you can’t meet your margin call.
Can You Short Sell Penny Stocks?
Now we come back to the topic at hand: shorting penny stocks.
You may have heard from your broker that you can’t short a stock below a certain price, usually around $5. But that’s not entirelyaccurate – there’s no SEC regulation to that effect. However, the SEC did implement Regulation SHO in 2005, which established “locate” and “close-out” standards to limit unscrupulous short selling activity.
Regulation SHO outlines four general requirements, two of which are relevant here:
- Locate: In order to facilitate a short sale, a broker must reasonably believe that they can locate, borrow, and deliver the shares on a specific date before the sale occurs
- Close–out: Sets in place increased requirements for securities that have a history of extended delivery failures at clearing agencies.
All that to say: yes, you can, technically, short penny stocks.
However, your ability to do so is contingent upon the stock following locate and close-out rules – in other words, the broker needs to be able to source the shares you’ll borrow. And with most penny stocks circulating in low volume, that can prove a difficult challenge. (Of course, you can contact your broker and ask them to locate shares, but you’ll probably pay a premium and a hard-to-locate fee for the privilege.)
Additionally, many brokers don’t allow traders to short penny stocks due to excessive risk, if they allow shorting at all. And some, such as Fidelity and TD Ameritrade, prohibit shorting OTC stocks, thereby ruling out most penny stocks from the get-go.
How Do You Short Penny Stocks?
If you’ve come this far and you’ve decided that shorting penny stocks is next on your to-do list, then all that’s left is knowing how to initiate the trade.
- Find a broker that will facilitate short sales on penny stocks.
- Find a penny stock to short – ideally, one that you believe will dip fairly soon.
- Borrow the shares from your broker and place a sell order.
- Watch the stock charts. When the stock drops to a degree you find acceptable, buy back your shares. Alternatively, if the stock rises, you may consider a stop-loss order to limit your risk.
- Return the borrowed shares to your broker and pay any required fees and interest.
- Pocket the difference as profit.
Know the Ideal Times to Short
Of course, it’s important to know when to short a stock. And unfortunately, the process is far from an exact science. That said, traders often look for these indicators when selecting their next short sale:
- Bear markets with swift, steep declines
- Negative news that may drop a stock’s price in coming hours or days
- The deterioration of a stock’s fundamentals, such as slowing revenue growth, rising costs, or even geopolitical challenges
- After a stock has bounced and peaked again
- When investors or influencers on social media overhype a stock to unreasonable prices and then lose interest
The Cost of Shorting Penny Stocks
Unfortunately, penny stocks, like other securities, are not immune to brokerage and trading fees. And if you’re not careful, the amount you’ll owe your broker – even if you make the right call – may outpace your earnings on stocks worth just pennies on the dollar. As such, it’s important to watch out for charges such as:
- The “$2.50 rule,” which states you must front at least $2.50 per share regardless of the stock’s price
- Borrow fees, or interest on your borrowed shares, which vary by stock
- No-locates or “hard-to-borrow” fees, which your broker may charge for sourcing obscure or illiquid securities
- Minimum margin fees, which some brokers charge regardless of the price of the underlying security
Considerations When Shorting Penny Stocks
Keep in mind that shorting penny stocks isn’t for everyone. In fact, if you’re new to the game, inexperienced in penny stocks, risk-averse, or otherwise inexperienced in short sales or quick trades, then this practice probably isn’t for you.
But if you’ve done your dues with paper trading and believe you have what it takes to succeed in shorting penny stocks, there’s definitely the potential for big profits. And because the shares are so cheap, you can get started with much less capital than you’d need on larger stocks.
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