By Justin Kuepper Thursday, April 2nd, 2009

Many OTC companies are either brand new unprofitable companies or larger bankrupt companies that have fallen from centralized exchanges. As a result, there is a great opportunity for traders to short-sell these stocks – or bet on them declining in price – and make a hefty profit. In fact, some notable traders like Timothy Sykes have made a fortune making such bets. However, there are many large risks to making these short trades must consider.

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Getting started shorting penny stock is very simple – just ask your broker if they support this type of activity. Often times, discount brokers will allow clients to short-sell certain popular penny stocks, while only specialized trading firms will allow shorting of almost all penny stocks. However, these specialized firms often have higher commissions and/or a minimum number of trades per month in order to quality. Finally, investors should also make sure they have access to real-time level II screens.

Trading Strategies

Short sellers are simply looking for stocks that are overvalued and betting on their decline. Since the losses are unlimited and profits are limited, it is very important for short sellers to carefully research their prospects and be sure that things are bad. Moreover, it is important to be wary of penny stock promoters that may be trading against short positions and bidding up the prices of the stocks. However, there are many ways to profitably short penny stocks.

Here are a few tips to get started:

• Only short penny stocks that are $0.25 or higher (due to margin requirements and the likelihood of manipulation).
• Carefully watch past price ranges to determine your expected margin requirements.

• Watch for stocks that go up on fluff news or press and wait for the day when it tops out.
• Watch level II quote screens to identify where market makers are placing the floors.

Risks of Shorting Penny Stocks

Margin Requirements

Brokers require investors to put up collateral to guarantee against potential losses in the form of margin requirements. Often times, brokers will require OTC investors to have $2.50 of margin per share to short a stock under $2.50, which can make shorting penny stocks very costly. For example, if an investor shorted 2,000 shares of a stock at $0.50, you have to have $5,000 in your account. All along, the maximum profit for this position would only be $1,000, if the stock went to zero.

Execution Risk

Penny stock short sellers must also worry about execution risk with their trades. Short selling involves borrowing shares from someone else and selling their shares, so even if an investor finds a great short selling candidate, they may be out of luck if the broker has no shares to lend. Similarly, the pricing for these short trades may not be favorable due to the often-large disparity between the bid and ask price. As a result, investors must watch these prices carefully before initiating a short position.

Market Manipulation

Market manipulation has always been a problem in the world of penny stocks, but this risk is especially large when shorting penny stocks, since the losses when short selling are unlimited. The best targets for short-selling are often those subject to manipulation or promotion by unscrupulous web sites of funds. However, these manipulators have a distinct advantage over the short seller – they have capital, price and liquidity on their side – which means investors must be very careful.