Shorting Penny Stocks: What You Must Know About This Risky Strategy

To some traders, shorting penny stocks seems risky and dangerous. For others, it’s their go-to strategy. 

This setup is not for the faint of heart. It’s often viewed as the dark side of trading. 

Short selling can potentially be profitable … if executed well. But it’s insanely risky if it goes wrong — you could end up owing your broker money! So let’s take a closer look at the nitty-gritty details of the dark side.

Read on to find out what every smart trader needs to know about shorting penny stocks.

What Is Short Selling Penny Stocks?

When you long a stock, you buy low with the intention of selling higher. Shorting is the opposite — you anticipate the stock price to fall. You sell first, with the intention of buying lower. Buying lower to exit a short position is called covering. 

But … how can you sell a stock you don’t own? Good question! You gotta borrow it from your broker first. 

It’s pretty easy, but you pay interest fees to do so. To do this, you locate shares to short from your broker. That’s why finding short shares to borrow is also called finding locates.

You also need a margin account to short. Not all brokers offer margin accounts for short selling. Many entry-level brokerages don’t, like Robinhood for example. Some focus more on novice traders and investors and don’t provide tools for more active trading. 

That’s why you need to make sure you have the right broker for the task…

And brokers make short selling available for large-cap stocks, but not for penny stocks. Other brokers may block short selling for certain stocks. 

As far as available shares, brokers may have shares early in the trading day, but run out later in the day when you need them. That’s where things like pre-borrowing come into play. That’s where you borrow shares early and short them later.

Is It Illegal to Short Sell Penny Stocks?

There’s a ton of misinformation on short selling. One long-standing myth is that short selling is illegal. While it’s often seen as a harmless lie to discourage risky trading, it often creates confusion for curious traders.

Let’s get one thing straight: Short selling is very risky but perfectly legal. 

I’m not personally a fan of short selling, but SteadyTrade Team mentor Michael “Huddie” Hudson grew most of his account shorting penny stocks. So to recap … short selling is not illegal. All you need is the right brokerage account and a solid approach.

Why Short Sell?

When you trade penny stocks, you learn many different patterns. My buddy Tim Sykes discusses some of these in his penny stocking framework. There are indicators that can signal weakness in stock price.

Maybe an overextended stock is having its first red day after a multi-day run. Or maybe a key support has cracked after a long period of consolidation. It could also that a negative news release stands to hurt the company.

These are all reasons why you might want to short a penny stock. Again, if you’re just starting, learn how to go long first. It’s safer — though not risk-free — in a volatile market like we’re seeing this year.

How to Short Sell Penny Stocks

Say you’re ready to short sell. You’ve set up your margin account with a broker. And yep, you checked — they allow you to short sell penny stocks. 

Now you gotta wait for the ideal setup.

To place a short, you usually sell the stock first. Some brokers have a dedicated ‘short sell’ button. This opens a negative position in your account. 

Sometimes your broker might not have the shares. In that case, there’s nothing you can do. They might later in the day, so keep checking. But only short if your setup hasn’t played out yet.

Depending on the broker, you may be able to pre-borrow shares earlier in the day and short them later in the day (sometimes within a few days too).

You often gotta be quicker in taking profits when shorting than going long. There’s the risk of a squeeze after a dip, and you pay more interest the longer you hold.

So, do you short anything that seems overextended? Or short anything that’s starting to make new lows?

Nope. These are overly simplistic views of short selling that trip up many newbies.

Know the Risks of Shorting Penny Stocks

Short selling penny stocks brings unique obstacles to the already complicated day trading niche…

Think of short selling as a far riskier version of going long. You gotta be more careful and diligent. When you’re long and the stock goes against you, the most you can lose is your entire position. 

But when you short, you can lose more than your entire position. Much more…

Unlimited Losses

Shorting overextended stocks opens up short sellers to unbelievable short squeezes. We saw this on Eastman Kodak Company (NYSE: KODK) recently, after President Trump mentioned the stock. 

Shorts thought the stock was overextended at $12 … then the following day at $20 … then at $30…

The stock ran all the way to $60 before pulling back.

Let’s do some simple math here. If you shorted Kodak at $30 you’d be down your whole position. All the money you put into it, gone. 

If you shorted at $20, you’d lose double your position. That’s right, you’d owe your broker. And if you shorted at $12 … you’d lose four times your initial position. Let that sink in…

If your short position was $1,000 when Kodak was at $12, it would become –$3,000 when Kodak was at $60.

There’s no reward that can balance out that risk. The most you can theoretically make on a short is to double your initial position (when the stock goes to zero). But this rarely happens because of the costs of short selling and massive short squeezes.

Short Squeezes

Short squeezes for shorts are the same as panics for longs. These happen when many shorts cover their positions at the same time. I sometimes use these squeezes to my advantage when I go long using my dip and rip pattern.

What happened with Kodak was a massive short squeeze. I warned students in the SteadyTrade Team to not short KODK at any price. But a lot of stubborn shorts on Twitter did … and blew up their accounts. 

I’m talkin’ big six-figure losses.

I’m not saying this to rub it in but to prove a point — short selling is risky. When a stock squeezes and you’re stuck without a plan, you won’t know what to do. 

Like a deer in headlights, you freeze as your account gets crushed FAST. That’s months or years worth of work gone in an instant.

Don’t short the front side of the move!

Short Selling Safely

When shorting, you gotta be smart. I see many newbie traders trying to ‘call the top’. They try to short when a stock is making new highs. It can look like it’s the top… until the stock makes a new high. 

While it’s impressive to snag a stock as it’s approaching new highs, you’ll take many paper cuts along the way as it squeezes up.

I have a few tips to help you avoid shorting strength and the front side of the move…

Avoid First Green Days

Never short the first green day. First green days are the most likely to continue running. Ideally, wait for the first red day to short after multiple green days. 

Avoid Parabolic Moves 

Big parabolic moves are very risky to short. Especially when the stock is making new highs or halting while doing so. You might not have any resistance level to help you set your risk level, so you may set an arbitrary level. Not worth it.

Avoid Low Float Stocks

A low float has a float of under 10 million shares. These stocks can have a steady downtrend and a massive squeeze after a press release. The moves are sudden and quick. Don’t risk it. 

Avoid Choppy Stocks

These stocks are all over the place. They show classic signs of weakness … but squeeze higher when you least expect it. CytoDyn Inc. (OTCQB: CYDY) is one example. (Pro tip: pull it up on your scanner to check it out. Get a 14-day trial of StocksToTrade and see how awesome our charts are.)

Shorts mistake weakness when the stock goes red. They think it’ll finally collapse. But it can quickly reverse and squeeze out shorts.

Some shorts play the same stock day after day. They’ll suffer losses on a choppy stock to try to prove they’re right. Don’t be that trader!

Hidden Costs of Short Selling

No Locates (Hard-to-Borrow)

Sometimes short borrows are in high demand and unavailable. So traders can’t trade the stock. If they waited for a prime opportunity, they’ll miss it. 

Other times, those short borrows are available, but the broker adds a hard-to-borrow fee to the shares. That’s an extra cost for shorts. 

Forced Buy-In 

A forced buy-in happens when the broker needs to cover your shares. It can occur without warning or after a margin call. That’s when you borrow more on margin than your account allows. The broker needs to buy in some of your positions to keep your account within your allowed margin size.

Short-Sale Rule (SSR)

The short-sale rule (SSR) kicks in after a stock has fallen 10% from its previous closing price. SSR only allows short sellers to short the uptick. This SEC rule exists to prevent stock panics.

$2.50 Rule

Some brokers have this rule that applies to shorting stocks under $2.50. You’ll need $2.50 of capital for each share, even if the stock is priced much lower. 

Borrow Fees and Dividends 

Borrow fees are the interest rate that short sellers must pay. They vary by stock and depend on how in-demand the stock is and whether it’s hard to borrow. 

Short-sellers must also be mindful of any dividends as they must pay them on dividend dates. 

Shorting Penny Stocks: Strategy Basics

Overextended Gap Down

This popular short-selling strategy involves watching multi-day runners. Watch for three or more green days in a row and the price doubling or more since the start of its run.

When the stock opens red either premarket or into the open with weaker volume compared to previous days … that’s the ideal time to short. You’re anticipating a morning dip. Weak longs will sell their positions, and hopefully, some stops will be taken out too. 

Sometimes these stocks fade the rest of the day, but the morning dip can be the most predictable.

Key Support Crack

After a multi-day runup, some stocks have a period of consolidation over a strong support level. Wait for the stock to have weaker volume compared to previous days. Then short after the support cracks. Be careful — shorting before the support crack can shake you out on a bounce.

Bounce Short 

Do you have FOMO because you missed shorting the big initial drop? Don’t fear! Big drops usually have big bounces. Huddie loves this setup on OTCs. The bigger the bounce, the better. When the bounce loses strength it can be time to short. Usually, it fades for the rest of the day.

Stock Pumps

Stock pumps are a way to promote stocks. These days you now find a lot of promoters on Twitter. One sign of a pump is multiple green days in a row with an active promotion campaign. The stock rallies for a while before crashing hard when all the promoters sell. Shorting when the rally weakens and the volume decreases is a fast strategy.

Wanna see what’s up on Twitter? Use StocksToTrade’s social media search tool to catch the latest buzz. Learn more here.

Negative News

Negative news can beat down stocks. And with penny stocks especially, news can take a while to move the stock. If you recognize a bad catalyst and the price action isn’t yet fully priced in, you can potentially short the weakness.

How StocksToTrade Can Help You Short Penny Stocks

To short sell, you need the best tools. You need to track the top multi-day runners. StocksToTrade allows traders to screen for these hot stocks with customizable screeners. That’s in addition to 40+ built-in scans and multiple tools you can add on for your short-selling needs.

Our latest feature is the Breaking News chat room. Two stock market pros hand-pick news that can move low-priced stocks. This feature is incredible. Top traders can’t get enough, like Tim Sykes! 

There’s also the Oracle Daily Direction Alerts that can help you hone in on hot movers. 

Inside the platform, you have access to high-end charting, scanning, news feeds, algorithmic trading analysis, chat rooms, watchlists, and so much more.

So many top penny stock traders start each trading day by loading up StocksToTrade. Come and see why — get your 14-day trial for just $7!

The Skinny on Short Selling

Short selling is a challenging trading strategy. High risks and hidden costs mean you need to be disciplined. So it’s often better to try once you’ve gained more market experience and confidence.

Focus on solid strategies and risk management. And only short when multiple indicators show the stock’s weakening.

Don’t short the front side of the move. Keep a tight risk and never attempt to short the top. Countless Kodak shorts wish they hadn’t.

A great way to gain experience is under the guidance of already successful traders. With the SteadyTrade Team, you work under the mentorship of advanced traders like Huddie and me. 

We give helpful insights to longs and short sellers. You’ll find these in the twice-daily webinars every trading day. I also tell you my take on what I see before every market open and close.

Education is critical to becoming a consistent, smart trader. You gotta constantly work to learn, refine, and improve. That’s why we focus on how we can be better traders every day. We want you to become a knowledgeable and informed trader, too… 

Wanna see how I trade every day? Join me and an amazing group of traders at SteadyTrade Team now! And connect with me daily on Instagram for my premarket and noon live sessions.

Also, keep tabs on the StocksToTrade blog and SteadyTrade podcast. We cover what’s going on in the market, day trading essentials, key scanning tips, and much more.

Short selling is one of many tools in a professional trader’s arsenal. The higher risks and costs require greater discipline than other strategies. Know what you’re doing and what’s at stake.

How do you feel about shorting penny stocks and shorting as a strategy? Do you short sell penny stocks? Leave a comment below and tell me what you think!