Can You Make Money Shorting Penny Stocks?

Penny stocks are known to be risky investments. The old adage that the stock market generally grows doesn’t apply in the penny stock universe. Shorting stocks is betting a stock will fall instead of rise in price.

What essentially happens is you sell a stock you don’t own for money, but you owe the stock back in the future. You simply wait for the stock price to fall and then you buy the stock and keep the difference. While you don’t want to short stocks that sit stagnant or slowly rise over time you can improve your odds with a few simple tactics.

Check the Better Business Bureau

One fact of life for any company is that ripping off your customers will eventually send you out of business. Oddly bankruptcy is the holy grail of short selling. If you can find a penny stock that is truly hated on the internet, the BBB tells people not to buy from them, or find a government agency that has a negative report on a company this is a strong indicator that the company will end up dwindling to nothing. That’s what you want for a long term short sale play.

Problems with Resistance

When you find a penny stock on the rise, but continue to waver at each major resistance point than you may have found a good short candidate. This is because every time there is a good opportunity to take profits the majority of stock holders jump ship. It’s hard to push through the major price points without true investors in the business.

Resistance points come from a variety of trading strategies which include moving average crossovers, Bollinger bands, and simply percent change from the last average price. These points tell traders it’s time to exit the trade. Without investors to keep holding the stock the price will dwindle again. Without investors the price will eventually continue to drop through previous support levels.

Bad Financials

While penny stock information isn’t readily available, a chunk of penny stocks still trade on major exchanges like the NYSE or NASDAQ plus the pink sheets offer a premium subset of penny stocks that have filed audited reports equivalent to SEC requirements. Many lousy companies show their bad financials simply because they know their stock will be traded more heavily on the audited list because they are considered “less risky.”

If you can get a hold of the information take a look at the debt to equity ratio. Once you see this factor exceed 3.0 you know the company has almost no hope of ever paying off its debt. The interest payments alone will destroy this company until the wolves show up at the front door.

Another great metric to look at is free cash flow. Often these companies are showing negative cash. This is a death spiral, cash is like oxygen for a company. If the company is already deep in debt than you know they won’t have access to more money easily. Either the company will dilute itself away through more and more stock offerings or they will become bankrupt. Either way, score 1 for the short seller.

How Do They Make Money?

Another great factor for choosing penny stocks to short sell is complicated business models. Often a penny stock in a fairly straight forward industry will spin a tale of a very complicated profit model. This is often a sign that the company just can’t compete in the market. If the company looks like a retail store, but says it makes its money on investing the borrowed money it is supposed to use to purchase working capital you can feel more confident they are hurting.

You can make money short selling a stock, but it takes a certain mindset to bet on the failure of a company.