For one reason or another, short selling penny stocks is a matter shrouded in informational eclipse. In general, it is widely considered that short selling penny stocks is only accessible to institutional traders. Few people know that in some occasions individual traders are also able to short sell penny stocks. But first things first.
What are penny stocks?
These are stocks that trade at a very low price and market capitalization. They typically trade outside the major market exchanges. Penny stocks are considered to carry a high risk, be quite speculative in nature due to their large bid-ask spreads, low liquidity and limited disclosure.
In contrast to a long position, where one buys a security with the hope of selling it at a higher price, a short position takes place when one first borrows a security and then sells it with the hope of buying it back at a lower price (and then return it to the borrower). Short sellers are required to provide a collateral for to the borrowed number of securities, which is also called margin. On the whole short selling is a much riskier strategy than the long position, yet it gives savvy market speculators the opportunity to make profits even when the market is declining.
Why short sell penny stocks?
Since there are a lot of unprofitable companies or recently bankrupt companies out there now, many of them move to trading on the penny stock market. This creates an opportunity for an investor who can identify if a stock is going to decline in price. Even though it is in penny stocks, the key here is to research these companies and understand the crux of their financial difficulties. If it appears that they aren’t going to be able to gain momentum and are trading in pennies, short selling is an option to take advantage of their situation and to make some profit.
Shorting penny stocks is also a good addition to your trading strategy as it isn’t a common technique. Being different has the ability to help achieve investment goals that you may otherwise not be capable of doing. Similarly, exploring new techniques assists in helping you understand what works well for you and your investment strategy.
How to short sell penny stocks
Now that you’ve decided to give short selling in the penny stock market a go, taking some basic steps to do it will get you on your way.
Step one – discuss your idea with your broker
Not all brokers will support short selling of penny stocks. The majority that do are discount brokers but will often work with certain popular penny stocks versus all of them. If your broker doesn’t dabble in this market, specialized trading firms usually do so approach one of them. Make sure that you always have access to real-time level II quotes. You need to also understand that specialized brokers may take a higher commission and other conditions than others so factor that into your plan.
Step two – research
The key of short selling penny stocks is that you are looking to bet on companies that are over-valued and will be declining in value. You need to make sure that the stock (and company) you are shorting on is worse for wear and will be in a poorer position than they are now down the road.
Step three – start selling short
There are a number of ways to start the process but it all comes back to doing your homework. Some important things to do are:
- Watch Level II quote screens to understand where the market makers are placing the floors.
- Watch the press to see which stocks move based on what is being said in the news.
- Try to watch historic price ranges to understand margin requirements.
- Try to avoid shorting penny stocks under 10 cents – remember you are counting on the stock to decline and you want to ensure you give yourself a bit of wiggle room.
Step four – monitor
Especially in the beginning, like anything, there is a risk of taking the plunge and facing consequences. Make sure to keep a close eye on what you’ve invested on, how the penny stock is tracking and referencing the tools mentioned above frequently. Once you get this process down, you will be in a position to maximize your return in the future.
Step five – assess your strategy
After you’ve shorted a few penny stocks, understand how you can improve the process as you implement this strategy on a regular basis. If you commit to adding the short sale of penny stocks to your investment strategy, you will want to be sure that you are doing whatever you can to make it as profitable as possible.
What are the risks involved?
Since short selling, in general, can be risky in itself, the implications of short selling penny stocks need to be understood before you commit to going down this investment track.
The greatest variable in short selling penny stocks is that of execution. As an investor, even if you find awesome penny stocks to sell short on, you need to find a broker who will lend you those shares. Since you are short selling you are essentially borrowing shares from someone else and then selling their shares.
So you need to take this into consideration when you do your research in order to avoid disappointment. In a similar vein, the bid-ask price needs to be considered as the price for these short trades may not be as favorable as hoped so watching prices carefully is key for this reason as well.
Understand that when you short sell on most stocks, especially penny stocks, brokers typically ask for collateral up front. This is done to protect the broker against any losses you may incur when selling short. These margin requirements can sometimes actually make shorting penny stocks costly. You must truly weigh up the costs and benefits to ensure it is all worth it in the end.
Finally, shorting penny stocks is susceptible to penny stock scams and frauds. Penny stocks are noted for being a target of fraudsters and shorting on these stocks poses even higher risks due to the nature of selling short. The scammers have a lot on their side in this trading situation as they typically have access to more capital and better prices. They hold more cards so you need to have research on your side in order to minimize your exposure to these threats.
Short selling penny stocks offer a different approach to your investment strategy, allowing you to take a advantage of a declining stock and profiting from it.