Why Shorting a Penny Stock Is a Bad Idea
By Taylor Carmichael – Nov 16, 2021 at 6:06AM
KEY POINTS
Buying a penny stock is almost always a bad investment.
Shorting a penny stock is worse than buying a penny stock.
It's debt that makes shorting (or buying on margin) a bad move. You want to be on the right side of the miracle of compounding returns.
Motley Fool Issues Rare “All In” Buy Alert
You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More
It might be tempting to short a ridiculous micro cap that has no future, but it's actually very dangerous.
If you play Motley Fool CAPS, you might be forgiven for thinking that CAPS stands for "crush all penny stocks." What is CAPS? It's this amazing free tool at the Motley Fool. It works like this: You pick stocks that you think will beat the market. And the CAPS software measures how your stock pick does versus the S&P 500.
Almost 60,000 Fools have been playing CAPS for almost 15 years now. One of the things that CAPS has taught me is that if you buy and hold fast-growing innovative companies (i.e. Rule Breakers), you'll be wrong a lot. But your winners will absolutely kill the market, and overall you will, too. So definitely you should play CAPS, and test your stock calls against those of all the others in the Fool universe.
Penny standing on its edge on a piece of paper with a stock chart going up.
IMAGE SOURCE: GETTY IMAGES.
But there is one danger in CAPS that I want to highlight. In CAPS, some of the very best players have gotten to the top by shorting awful micro caps. Is that the best strategy in the actual stock market? No! In fact, it's a horrible strategy. Here's why.
1. Money, money, money, and money
In CAPS, we're just giving our opinions about what stocks are going up and what stocks are going down. So in that universe, where it's just ideas, the very best investment plan is to short awful penny stocks while simultaneously going long on the S&P 500. That's absolutely the best winning strategy. CAPS has proven it.
But CAPS is a game that measures our opinions, whether we are right or wrong on a stock. In real life, we're investing dollars. And the introduction of money changes the dynamics of whether your opinion is right or wrong.
MOTLEY FOOL RETURNS
Motley Fool Stock Advisor
Market-beating stocks from our award-winning analyst team.
STOCK ADVISOR RETURNS
321%
S&P 500 RETURNS
104%
Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 10/11/2022.
Discounted offers are only available to new members. Stock Advisor list price is $199 per year.
Join Stock Advisor
That's because of the way a "short" is structured. You're not just giving your opinion that a company is bad and its stock is going down. You're simultaneously going into debt in order to short a company. You're borrowing the shares from your brokerage. And now you owe your broker money.
It's the debt that makes shorting a dangerous strategy. You owe your brokerage money now, which makes you vulnerable. You have an obligation to pay back this debt. If the stock goes up, your broker will ask you for more money. If you can't come up with the money, your broker will close out your position at a loss. This common maneuver, known as a short squeeze, happens every day.
INVEST SMARTER WITH THE MOTLEY FOOL
Join Over 1 Million Premium Members Receiving…
New Stock Picks Each Month
Detailed Analysis of Companies
Model Portfolios
Live Streaming During Market Hours
And Much More
Get Started Now
2. Penny stocks are thinly traded
Penny stocks are horrible investments. Once in a blue moon, a micro cap will emerge from obscurity and give you a truly amazing return. I had this experience with Novavax (NVAX 9.08%) in 2020, which was a lot of fun. But it was a highly risky stock, and so my position was tiny at first.
At least Novavax was trading on a major exchange. (It had to do a 20-for-1 reverse split to stay up there!) The company wanted to avoid delisting because that is usually the kiss of death. Most investors stick with the New York Stock Exchange and the NASDAQ, and avoid the pink sheets except when buying an ADR of a major foreign company. Sometimes you will have micro-cap investment opportunities on major exchanges, like Novavax. So you might want to limit yourself to that cohort if you want to risk it. (And micro caps are extremely risky).
It doesn't follow from this that shorting a penny stock is a brilliant idea. Even if 99% of penny stocks are horrible investments, that's a long-term phenomenon. In the short term, a penny stock can make dramatic moves up or down. A market maker can look at the short interest and decide to double the stock price of a penny stock today. Which is fairly easy to do if the float is small. All of a sudden your position is precarious and you are forced to pay money to your brokerage, or else.
Traders can easily manipulate a penny stock. You can be completely right on your analysis of the stock, and the company's future. It can be a horrible company, and its valuation can be ridiculous. But your debt to your brokerage often makes your long-term thesis irrelevant. You're looking at the forest and the tree smacks you in the head.
3. Long and strong is the best strategy where money is concerned
The stock market rewards positivity and optimism. You want to evaluate the risks and avoid stupid ones. However, if you own shares in top dogs and first movers in important emerging industries, the math really is on your side. Over time your winners will absolutely crush the market and make you forget about all your bad stocks that lost money.
As a bull, all you can lose is 100% on any particular stock. Meanwhile, your upside can zoom past 100%, or even 1,000%, and you might even pass 10,000%.
It's the miracle of compounding returns that makes this happen. You want to be on the right side of compounding. Debt puts you on the wrong side. That's why margin is bad. And shorting a stock is a dangerous move for the same reason. And if you're shorting penny stocks that are thinly traded, short-term trading strategies will often negate your long-term thesis.
In short, if you're relying on debt to get ahead, the odds are against you, and as you rack up debt you're really going to get killed.
These Stocks Could Be the Biggest Winners of the Stock Market Crash
Historically speaking, moments like this can be incredibly profitable times to start investing.
Our analysts in Stock Advisor Canada have been working hard to capitalize on the buying opportunities we’re seeing while providing our members recommendations that we believe have a chance to beat the market over the long run.
Join Stock Advisor Canada today and receive two brand-new stock recommendations a month, five timely “Best Buy Now” stock picks, a fully stocked treasure trove of industry reports and much more.
Learn More About Stock Advisor Canada
Taylor Carmichael owns shares of Novavax. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
5 Stocks Under $50 [Free Report]
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by the Motley Fool. I’d be sitting on a gold mine!” And it’s true.
And while Amazon and Netflix have had a good run, we think these 5 other stocks are screaming buys. And you can buy them now for less than $50 a share!
You can grab a copy of “5 Growth Stocks Under $50” for FREE for a limited time only.
Get Your Free Report
STOCKS MENTIONED
Novavax, Inc. Stock Quote
Novavax, Inc.
NVAX
$17.78 (9.08%) $1.48
decorative
Motley Fool Stock Advisor's Latest Pick
Get Access 321% Avg Return
*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.
RELATED ARTICLES
GettyImages-1366255168 (1)
2 Ways to Fish at the Bottom of the Market
GettyImages-155351397
Why Did the Market Drop So Much in January?
stressed investor at laptop
Anxious About a Market Crash? Start Doing These 3 Things Right Now
Pictures of Money healthcare
Why Valeant Pharmaceuticals, Resource Capital, and Novavax Jumped Today
5 of Last Week's Biggest Losers
Our Most Popular Articles
Buffett TMF Photo
If You Invested $5,000 in Berkshire Hathaway in 2000, This Is How Much You Would Have Today
Hourglass Calendar Procrastinate Date Congress Getty
Here's Precisely When Social Security's "Raise" for 2023 Will Be Announced
2022-Rivian-R1T-22
3 Electric Vehicle Stocks Down 78% to 80% That Billionaires Can't Stop Buying
Getty - stock market crash uncertainty recession risk
Jamie Dimon Thinks the S&P 500 Could Fall Another 20%: What Should Investors Know?
Premium Investing Services
Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.
View Premium Services
The Motley Fool
Making the world smarter, happier, and richer.
Facebook
Twitter
Linked In
Pinterest
YouTube
Instagram
Tiktok
© 1995 - 2022 The Motley Fool. All rights reserved.
Market data powered by Xignite.
ABOUT THE MOTLEY FOOL
About Us
Careers
Research
Press Inquiries
Contact
Advertise
OUR SERVICES
Stock Advisor
Rule Breakers
Rule Your Retirement
The Ascent
All Services
AROUND THE GLOBE
Fool UK
Fool Australia
Fool Canada
Fool Deutschland
FREE TOOLS
CAPS Stock Ratings
Discussion Boards
Calculators
OUR AFFILIATES
Motley Fool Asset Management
Motley Fool Wealth Management
Motley Fool Ventures
Lakehouse Capital
1623 Capital
Terms of Use
Privacy Policy
Disclosure Policy
Accessibility Policy
Copyright, Trademark and Patent Information
Terms and Conditions
Do Not Sell My Personal Information
decorative
