Learning how to short a stock is a critical skill for penny stock investors, even if you have no plans of ever shorting a stock yourself. Because of the large amount of short interest in the average penny stock, understanding what it is, how to find short interest, and what happens when a stock is shorted by an investor can help you avoid losses, but more importantly can be used as a weapon to aggressively expand the size of your portfolio by squeezing short interest. In some cases you may want to avoid stocks that are actively shorted by investors, in other times a stock that’s being shorted may be just the opportunity you’ve been looking for.
First, let’s cover the mechanics. Selling short means that an investor intends to borrow shares from his broker to sell to someone else. That leaves the investor “short” the shares sold. Because they sold the shares, the short investor receives compensation from the trader who bought the securities based on the current price. A short investor’s goal is to buy the shares back in the future for a lower price then they initially paid, allowing them to keep some of the money they received in the initial transaction. For this to happen, the shares have to decrease in value. Essentially, short sellers win when a stock price drops.
Knowing how much short interest there is in a stock can help you understand investor sentiment about a particular issue. If the stock trades on an exchange the short interest will be listed with key statistics about the company on a reliable financial website. There are even websites on the internet that specialize in making short interest available to investors. Ask your broker where to find short interest on your particular trading platform.
How do you use short selling?
Trading short works exactly the opposite as buying long. Rather than looking for solid fundamentals and increasing volume, a short trader is looking for weak fundamentals, such as too much debt, lower revenues, lower earnings, or negative news. While investors who buy a stock can only lose the amount of their initial investment, short sellers experience unlimited risk; if a stock they’ve shorted shoots the moon the investor will have to buy the shares at a huge profit for the company, forcing them to not only give back the initial money they gained initially, but also to dig into their pocket and cover the difference between the current price and price originally sold. For this reason, investors selling short take on additional risk and have to have special clearance to sell short. Ask your broker to add margin to your account to sell short.
How do you make money on short sellers without taking the risk yourself?
Stocks heavily shorted sometimes create a condition called a short squeeze which can be a huge financial boon for investors who have stock in the company. When a stock begins to rise dramatically, short sellers sweat. Every penny the price increases is a loss for them. To cover these losses, they begin buying back their shares, which has the effect of creating more purchases. This escalates the share price further. If they can’t get out quickly, short sellers sometimes need to even jump on board the stock, buying even more shares in an attempt to gain enough to cover earlier losses.
A short squeeze quickly becomes a rocket to the moon.
How do you get on board?
1) Find a website that screens for short sales. You’re looking for stocks with a high short ratio. If a ratio is 3, that means it would take three average days of selling for short sellers to cover their interest. A short ratio of 6 would take six average days for short sellers to catch up. The higher the number, the more short sellers will sweat any gains that occur in a penny stock.
2) Find out why the stock is short. There are often good reasons short sellers are interested in a position. Find out what’s ugly about the position.
3) Once you’ve decided you’re comfortable with a penny stock’s high short ratio, look for increasing volume and an initial price hike. This is the fuse that starts the chain of events leading to a short squeeze.
4) Invest with a stop loss. By placing a stop loss below a single day’s average volume, you’ll make sure that if the short squeeze sizzles, you’re not riding the shares down.
5) Raise your stop loss often to insure you’ve made a profitable trade. Many times a stock will quickly return to earth after everyone squeezing the short interest begins bailing out. A stop loss will make sure that even if you leave the room for a moment you won’t be caught when the landslide starts.
Because there are many weak companies in the penny stock market, shorting stocks may be a profitable, although risky endeavor. Far less risky is the practice of finding those firms with huge short interest and working the short squeeze. At the least, understanding shorts and short interest can help you avoid pitfalls while investing in penny stocks. At most, using shorts and short squeezes could help you create handsome returns whether stocks gain or lose money.
