Many investors are drawn penny stocks as their prices fluctuate wildly within a very short period of time. This gives ample trading opportunities and higher profit potential.
One of the ways to make money from penny stocks is through short selling. However, be warned that there are clear dangers involved with the short selling of penny stocks.
#1 Short selling gives limited profit, unlimited losses: In case you take a long position in a penny stock, the profit potential is unlimited while the loss potential is limited. But on the other hand, the profit potential for short selling is limited while its loss potential is unlimited.
This is best explained with an example.
Assume that you bought 1000 shares of a penny stock for $0.90 each. This means that you have gone long for this trade. Then, the maximum potential for loss for this trade (if stock price reaches zero) would be 1000 X $0.90 = $900. On the other hand, the stock can yield unlimited profits if it surges ahead, as any increase above $0.90 is a profit.
On the other hand, assume that you had gone short for the same penny stock. This means that you sold 1000 shares of the stock for $0.90 each. In this case, your maximum profit would be when the stock reaches zero. This is equal to a maximum value of 1000 X $0.90 = $900. As you can see, the profit is limited, since the stock cannot fall below $0.00! But losses, on the other hand, can be quite staggering. If the stock surges to say, $5, the losses would be equal to ($0.90 – $5.00) X 1000 = $4,100! In short, the loss potential increases with the increase in the stock price. So, short selling can cause potentially unlimited losses.
#2 Brokers intervene: Typically, brokers who deal with penny stocks do not allow short selling of penny stocks. The rare ones who allow it has clear rules regarding the short selling of penny stocks. Many times, the short positions are taken by you in anticipation of a price drop may be covered by brokerages to limit their risk exposure. This, in turn, may cost you a lot of money.
Tips –Which Penny Stocks Are Ideal For Short Selling
Now that you are aware of the risks of short selling penny stocks, here are some tips for choosing an ideal candidate for short selling.
Choose companies for short selling when
- They appear to be having a dismal future as per fundamental analysis.
- The technical analysis points to an upcoming decline.
- Short interests and Short interest ratios seem to favor bears.
On the flip side, be very cautious when short selling during a bull market. It is always best to wait for the trend change before short selling the penny stock.
The knowledge of short selling can be quite useful, as you can use it for either hedging your portfolio, or for profiting from a falling market. However, remember to have clear money management rules in place before you decide to short sell any penny stock. All successful short sellers have a specific amount of money that they are willing to risk while entering the shorts and they diligently follow it.