Shorting Penny Stocks: Pros and Cons

Many beginner investors and traders believe that penny stocks are a quick way to get rich—even with all their volatility. However, there are drawbacks to them and, as a result, shorting these types of equities is also an option.

Before you decide on shorting penny stocks, let's unpack the potential risks and possible rewards of this approach.

What Is Shorting Penny Stocks?

This strategy could also be applied to penny stocks, i.e. stocks that generally trade under $5 per share.

Is shorting the penny stocks legal? Yes, this strategy is perfectly legal, although it is considered very high-risk. Some brokerages may choose not to lend penny stocks because of the perceived risk.

» Take a look at our blog on how to start trading penny stocks online

Why Traders Short Penny Stocks

Potential Scenarios for Short Selling

Traders may consider short selling if they anticipate events such as:

• A company facing potential bankruptcy
• Broader financial markets entering a bear market phase
• A stock having a high short float (a large number of shares being shorted relative to the total number of shares available for trading)

» Find out how long you can hold a short position in stock trading

Diversification

Shorting can also be a diversification tool in your investment portfolio. This is especially true during bear markets.

There are two ways to diversify through shorting:

1. Directly shorting stocks
2. Finding exchange-traded funds (ETFs) that short specific sectors, products, or the entire financial market.

Risk Management

Can stocks be long and short at the same time? Yes, you could hold a long-term position in Coca-Cola or Tesla Motors and still short these stocks during turbulence on the New York Stock Exchange. Shorts could potentially help hedge your long positions when there is intense volatility.

The Risks of Shorting Penny Stocks

Potential for Significant Losses

Short selling—whether it involves penny stocks or blue-chip stocks—is considered highly risky. In the event that a shorted stock's price rises rapidly, short sellers can face substantial losses.

This risk was seen during the 2021 "meme stock" phenomenon, where some Wall Street hedge funds experienced considerable losses from their short positions in companies like GameStop and AMC.

For retail traders, the risk of unlimited losses is particularly relevant when shorting penny stocks, as these securities can experience rapid and significant price increases.

» Discover when does a short squeeze happen

Volatility

Anyone who has participated in the financial markets knows that penny stocks come with extreme price swings. They are well known for their price volatility due to tepid trading volumes. This type of volatility is the norm with penny stocks, and it amplifies the risks.

» Learn how short covering affects the stock price in Forex trading

Limited Borrow Availability

Another challenge in short-selling penny stocks is the potential difficulty in finding available shares to borrow. To short a stock, a trader must first borrow shares from a broker or another investor. However, some brokerage firms may not allow the short selling of penny stocks, or there may be a limited number of shares available in the market to borrow.

» Do you know what is the importance of liquidity in stock trading?

Shorting Penny Stocks: A Risky Business or Rewarding Strategy?

Shorting penny stocks might seem like a guaranteed strategy, but the experience in the financial markets will likely teach you that nothing is guaranteed.

Yes, this approach can be potentially profitable, but there are sizable risks—for example, unlimited losses. That is why careful research on penny stocks is vital to determine risk management tactics in short selling.

Shorting penny stocks is but one strategy out of many in a well-diversified investment portfolio. Still, the best way is to dive into available resources, read about various strategies, and learn about the stock market.