Many investors believe that you can only make money on penny stocks when the prices go up. They are constantly thinking in terms of getting in on the ground floor of a new business or a small business that has the potential to become the next Microsoft. Note that we are defining penny stocks here as stocks that trade at a price of below $5. Because many of these new companies are inherently shaky businesses with no chances of survival and many others are outright scams, the next Microsoft won’t be along in a hurry and you could lose quite a lot of money in your quest.
Because many of you believe that you cannot short penny/microcap stocks, you can see no way to profit from price declines. The shorting is the exact opposite of buying and involves selling stock that you do not own. You short a stock because you think prices will come down and you can cover at a profit. Your broker will lend you the shares from his own inventory as you do not own the stock. When you close out your position, this loan of shares from your broker will be canceled and you would be left with a square position.
If you want to short penny stocks, you will need to have a margin account with your broker rather than a cash account. You can only borrow shares on a margin account which may be riskier than a cash account but has the benefit that, in a five business day rolling timeframe, you can complete three day trades. Even small investors can accomplish this without worrying about the $25,000 minimum balance in your trading account.
You have to appreciate that a large number of penny stocks, that is stocks that trade below five dollars, many of these stocks are of dubious companies and some of them are outright scams. Many of these companies pay brokers or other middlemen to perpetrate what is called “pump and dump”. These stocks are then hyped with false but favorable information and the buzz sends the stock prices sky-high. The company promoters then sell or “dump” their shares leaving unsuspecting investors to carry the can. While you would normally try and profit from the pump, there is money to be made on the dump if you short these shares.
Buying these shares and trying to time the market high is a difficult proposition at the best of times and risky as well and you may end up being trapped. Short selling is a better strategy in this situation because it is easier to read the dump. What do you want to do is to get in at the high of the pump and profit from the crash in prices after the promoters have dumped their stock. If you can identify the situation accurately and arrange with your broker to short the shares you are sitting pretty. Think of the irony of the situation. These scamsters or promoters make illegal profits when the share price rises and you make perfectly legitimate profit when the share price falls. You should therefore stop thinking of penny stocks in terms of buying at low prices and selling at higher prices.