Penny stocks are attractive to many investors, but few understand the risks. They can go up in a short period of time with substantial percentage gains, but after any fast rise, most fall back low or lower than they were. Shorting any rally in a penny stock may seem like an easy way to make substantial returns, but don't be fooled: It's exceptionally hard to short a stock that is actually trading for pennies. Normally, investors choose to short stocks that cost over or at least near a dollar.
Most Brokerages Do Not Allow Shorting of Penny Stocks
The most popular online brokerages, such as Etrade or TD Ameritrade, don't allow shorting of penny stocks or OTC stocks in general; nor do full-service brokerages like Fidelity. This presents one of the first obstacles to shorting penny stocks. The costs for shorting penny stocks can get steep, but this varies among brokers. Also, specialty brokers that allow trading of this sort may have expensive requirements for opening an account.
SureTrader is one of the few traders that allow shorting of penny stocks. The company has no pattern day-trading rule because the brokerage is a foreign one. It typically has more shares to borrow than other brokerages. This introduces the second obstacle to shorting penny stocks. Even if your brokerage allows shorting, shares might not be available to actually initiate a short position. Shorting is about borrowing shares and selling them again, and if there are no shares to borrow, shorting is impossible even if it is allowed. SureTrader has only a $2k minimum as of 2013, but since shorting requires a margin account, the requirements might be different.
Interactive Brokers has a wider range than SureTrader by allowing shorting and lower price levels than SureTrader, although shares to borrow are difficult to come by for very low-priced securities. Interactive Brokers requires a $10,000 minimum deposit, and also tends to have higher fees. SpeedTrader is another brokerage firm, but it requires a certain level of trading to avoid steep fees. There are many specialty firms such as proprietary trading firms, but these vary like traditional brokerages. Broad St. Trading is a proprietary trading firm that requires a $5,000 minimum deposit, but any short position for penny stocks must be closed the same day it is made.
Understanding Margin Requirements
Shorting stocks is done on margin, and for penny stocks, the margin requirements are steep. Many of the firms have a 100 percent requirement, which means you can't short without a large cushion of capital without risking a margin call. If a margin calls occurs and there is not enough money in your account to cover your position, the brokerage will require you to deposit more money. If you cannot deposit more money, positions in your account will be closed till the margin call is met. You have no choice in what positions are closed. With the volatility of penny stocks, a margin call is a serious possibility if you're trading a large percentage of your account. Interactive Brokers has a percentage requirement or $2.50 per share, whichever is more. If you're shorting stocks that are around $1, you're paying more in fees than you would be for the position. Before you open an account at any brokerage, evaluate its fee structures.
Nihar Patel covers finance and investing for several online publications, including Seeking Alpha. He also runs his own investment analysis website. Patel holds a J.D. from UC Hastings College of Law, as well as a bachelor's degree in political science and history from UC Davis.