Short selling is an investing strategy employed by day traders to profit from a company’s share price declining. Shorting stocks involves borrowing shares from your broker and buying them back at a future date. A trader intends to profit from the decrease in value by buying back the shares for a lower price. Betting against worthless penny stocks trading at inflated prices can be profitable because these companies will eventually crash. However, unlike normal investing, your losses theoretically are unlimited.
Contrary to what some people believe, you are allowed to short sell penny stocks but there are restrictions. This tends to surprise people because investopedia.com stated in the past it was illegal. Obviously, this has been proven false by infamous short seller Tim Sykes, who has made millions exploiting this method. Learning how shorting works makes you a more diverse trader because you can make money in any market environment. This gives a person the unique ability to make profits on the way up or on the way down. Statistically, the odds are in your favor since every pump and dump will inevitably drop 95%, following the promotion. The hardest part is waiting for the price to collapse and locating shares to borrow.
How to Short Penny Stocks
- The first step is finding a suitable broker with a low account minimum and offer margin accounts. The best brokerages for short-selling penny stocks are Interactive Brokers, Etrade and TD Ameritrade.
- Learn technical analysis and study chart patterns to identify company’s that are overbought. This involves using various technical indicators such as moving averages and RSI to inform your decision making. Another option is to follow the news and spot a catalyst that will impact share price negatively. This could be shorting a company based on them releasing a weak earnings report.
- The moment you short sell a penny stock, you borrow shares from your broker who has shares available.
- Once the trade has gone through, follow the stock price and be ready to exit for a loss if it doesn’t work out as planned.
- If the price drops, use technical analysis to determine the optimal time to exit your position and buy the stock back. Your profit is the difference between the price at the time it was borrowed and the price it was originally purchased.
There are a number of factors that should be taken into consideration while using this strategy:
1. Allocating Shares is Becoming Increasingly Difficult
Trying to locate shares can be really difficult and time-consuming. The margin rate is very high when you try to hold these stocks in the long term. You will need to open multiple accounts in order to find the best borrows. There is no single broker that will allow you to short every company. If you set up accounts with the top 4 brokers this will allow you to short roughly 80% of your plays. But remember each broker has different account minimums so this strategy is not ideal for people with a small account as the PDT rule will come into effect.
2. A Margin Account is Needed
As mentioned before you need to trade with margin, on the other hand, this is not required when buying shares. Many traders don’t feel comfortable borrowing capital due to the risks involved. Also, more capital is needed to open a margin account instead of a cash account. You are required to put up 50% of the total position size that you want to short, as collateral. (This is known as initial margin). If the stock increases, then your margin levels will fall. If they fall below 30% your broker will issue a margin call. This forces you to deposit more money until your margin level is brought back up to at least 50% or your position will be liquidated immediately. Penny shares can spike 50-100% rapidly due to unforeseen circumstances such as stock promoters sending out an email alert during market hours and you end up losing money purely because of bad luck.
3. Short Squeezes
When you short you are borrowing shares from someone who owns a stake in that company. The original owner may ask for their shares back at any time. This is can cause what is known as a ”buy-in” and can happen anytime from a few days up to 2 weeks. A broker may issue a ”buy-in” if you’re in a massive losing position without warning. Essentially you have little or no control over what happens, as the broker will buy back the shares at the current market price. This can cause short squeezes which increases the share price artificially. CYNK is an example of a crazy short squeeze in action. Back in 2014, CYNK Technology Corp, a worthless “social media” company surged from 0.06 to $22 (36,000% gain) before finally being halted by the SEC. At one point this one man run business had an insane market cap of $6 billion when it was really worth $20. In hindsight, the accident was caused by a hedge fund trader.
4. The Market Can Remain Irrational Longer Can You Can Stay Liquid
In contrast to what old school economists think, the markets can be very irrational. A lot of investors predicted the housing and dot-com bubble but went broke shorting because the market continued to rise higher beyond expectations. These investors had sleepless nights after the bubble burst, they made the right trade but at the wrong time and wouldn’t cut their losses. Another example happened with DryShips Inc (DRYS) after Trump got elected and the shipping sector was extremely volatile. Within the space of 6 days, DRYS exploded from $5 to $72. I heard a story about a trader on Stocktwits who lost over $200,000 shorting DRYS at $20. He held onto his position and watched on in disgust as the price continued to rise. It was a freak event and now DryShips Inc is trading at $5.25.
Short selling is a clever strategy but there are various problems to overcome. I don’t recommend shorting shares under $1 purely because the risk to reward isn’t favorable, it’s like picking up pennies upfront of a steamroller. Patience and risk management are crucial to becoming a successful short seller. It’s common for new day traders to make profits on seven out of ten trades but then blow up on one stupid trade. Another big obstacle most beginners aren’t aware of when starting out is the PDT rule. Unless you have $25,000, you’ll only be able to place four trades in a week or have to use an offshore brokerage. Also, more restrictions include, multiple stockbrokers are required, potential short squeezes and increasing competition from others trading micro caps. Top traders like Timothy Sykes, Tim Grittani and Steven Dux have all made millions through thousands of small gains following the same repeating patterns. If you’re serious about learning more, check out free videos on YouTube and Timothy Sykes’ website for detailed information.