Penny Stock Short Selling
Trading in Penny Stocks doesn’t always have to be about price appreciation or future profits. Savvy investors know that, sometimes, “bad news can be great news” and that the best way to profit from bad news is with the trading technique known as the “Short Sale.”
The “theory” behind a short sale is quite simple:
- 1. You think that the price of a stock is about to go down.
- 2 You “sell” that stock, even though you technically don’t own it.
- 3. When the price falls, you then buy the stock that you originally sold for a price that is less that what you received in the first sale. The difference between what you sold the stock for and what you paid for the stock after its price fell is your gross profit.
In actuality, a short sale is a bit more complicated.
In Step #2, what you actually do is “borrow” the stock you sell from some other entity such as a brokerage house. In order to protect the brokerage house form a loss (and from government regulators), you will have to post a “margin” equal to some percentage of the value of the stock that you borrowed. As an example, if you sold a stock short that had a cash value of $1.000 and the margin requirement was 50%, you would have to post $1,000 × 50%, or $500 in margin. Additionally, you can expect to pay the usual brokerage commissions and fees on the transaction.
On the other end of the transaction, Step #3, when the price of your shorted stock falls, you buy the stock on the open market and “return” the borrowed shares to their original owner. The difference in what you received in the original short sale and what you paid for it in the second, or “covering” transaction, represents your profit Of course, you will again pay the brokerage and other such fees on this end of the transaction. And that, in a nutshell, is the short sale!
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Selecting Stocks to Sell Short
Many penny stock traders closely follow the activities of small firms on their local or state levels and are thus more attuned to news that will affect a stock’s price than many of the national brokerages. If this news appears bad, and the stock price seems ready to decline, this represents the ideal short sale opportunity. A second technique, made popular by financial writer Andrew Tobias and which involves no real effort on the part of the investor, is known as the “Secondary Distribution Rule.”
A Secondary Distribution occurs when a large investment fund or underwriter offers for sale a large block of stock that has already “gone public” in the sense that it was registered with the appropriate authorities but was not generally available to the private investor. In most circumstances, a Secondary Distribution occurs when an investment house or brokerage wants to unload a large block of securities but does not want to “flood the market and thus drive down the price. Most of the time, a “Secondary” reaches the attention of a private investor in the form of a sales call from a broker.
According to Tobias this represents one of the best times to sell a stock short, particularly the stock the broker is trying to sell you! Since most of the time the owner of the original security is attempting to “cover their losses” on that security, it is more than likely that the price will soon fall on the open market. Your response to such a sales call should be to short sell as much of that stock as you can afford!
Protecting Your Short Sale Portfolio
The major concern in any short sale is that the price of the shorted security will rise rather than fall. Many investors who actively place short orders will therefore be interested in techniques that can, at least, limit the potential for damage to their short sale portfolios. One of the most effective such techniques is the “Stop Order.”
Among short sellers in the major markets, “Stop Orders,” also called “Stop-Loss Orders,” have been the traditional way of protecting one’s position in a short sale against an unexpected rise in the price of the shorted stock. In practice, this involves selling a stock shot but simultaneously leaving an order with the broker to “cover” the short position if the price of the shorted stock should increase by more than a certain percentage or dollar amount. Thus, if you were short XYZ at $1.00 and had placed a stop order for $1.10, your position would automatically be closed when XYZ hit $1.10 and you would take a $0.10 loss on each share.
Unfortunately, many brokers do not accept stop orders on OTC or penny stocks. There are, however,t tools to accomplish essentially the same thing that are available to the penny stock investor.
The simplest way to simulate a stop order is to use trading software that will automatically notify you if your shorted stock suddenly appreciates in price. Such notifications have the advantage of protecting you from automatic executions of stop orders if your target stock happens to “brush against” the stop price in the course of a day’s trading session. In other words, your software simply notifies you of the preset “alarm” price but leaves you the option of making a closing transaction.
Available in some software packages is the “automatic close order” feature. This feature exactly duplicates the more traditional stop order in that it will execute a covering buy order if your stock hits a preset upper limit. You do nothing but concentrate on your other trading activities because your software will handle the technical details of the covering trade for you.
Another, less sophisticated, defense against losses in a short sale is plain and simple “grunt work” in the form of adequate research into the historical and projected performance of the shorted security. Ask yourself questions such as “Why do I expect this stock’s price to fall?” or “What would happen if the entire market sector were to dramatically move in one direction or another?” If “Eternal vigilance is the price of liberty,” then “Eternal vigilance is the price you pay for consistent profits in short sales.”
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