Options for Short Selling Penny Stocks
Original post by Michael Wolfe of Demand Media
Most investors look to invest in companies that they believe will rise in value, whether it's due to changes in market sentiment or improved financial results. However, contrarian investors choose to look not for companies that are undervalued, but for companies that are overvalued. Sometimes, the so-called short sellers will turn to penny stocks, for which they will purchase put options.
Penny stocks, which generally refers to stocks whose share price is under $1, are often sold off a regulated exchange, giving them a reputation for being the wild west of the investment world. This is because many of the companies issuing these stocks do not have the same type of regulation that companies issuing stocks on regulated exchange do. However, while penny stocks can offer the investor the chance to make a value, it may make more sense to bet against them.
The best way that an investor can bet against a penny stock is by short selling it. Short-selling is a process whereby a speculator borrows shares of stock, usually from a broker, then sells those shares in the market. When the short-seller wants to exit his position, he purchases the same number of shares he borrowed at the current market price (if it's lower, he makes a profit, if it's higher he makes a loss). He then returns (covers) the shares to the original broker who lent him the shares. Although penny stocks often experience large declines in price that would theoretically provide an opportunity to profit from selling them short, it is often difficult to find a broker who will lend shares of penny stocks. Also, the bid/ask spread of penny stocks are much higher than blue-chip stocks. Even if the quoted market price declines after you short-sell a penny stock, it does not guarantee you will make a profit since you are forced to borrow the shares, sell at the "bid" price, then purchase the shares back at the "ask" price.
Another option is buying a put option on the stock, one that gives him the option to sell the stock at a given price on a certain date. When the option matures, if the price of the stock has fallen, then the investor nets a profit.
It is often more difficult to short sell a penny stock than it is to short sell a blue chip stock sold on a regulated exchange. This is true for two reasons. First, many investors have little faith in penny stocks and therefore will not be willing to purchase an option from a short seller. Second, because penny stocks are often unregulated, investors may believe that the short selling is part of a scam by the company to short itself and make money by going bankrupt.
In some cases, a person may wish to short sell a penny stock, but he will be unable to find a buyer for the option. In addition, a person may not be able to short sell a stock that is priced too low. This is because the stock may be so low and there may be so few shares available that the transaction cost of buying the option would cut too deeply into any potential profit.
- "Investing For Dummies"; Eric Tyson; 2008
About the Author
Michael Wolfe has been writing and editing since 2005, with a background including both business and creative writing. He has worked as a reporter for a community newspaper in New York City and a federal policy newsletter in Washington, D.C. Wolfe holds a B.A. in art history and is a resident of Brooklyn, N.Y.