Timothy Sykes writes the blog TimothySykes.com, is a former hedge fund manager, star of the TV show Wall Street Warriors and author of the book, An American Hedge Fund: How I Made $2 Million as a Stock Operator & Created a Hedge Fund.
know what you're thinking: how can combining two of the riskiest niches in all of finance - penny stocks and short selling - be a viable trading strategy?
It's true there are misconceptions associated with these two terms: for example, you can short-sell stocks under $5, you just need to find the right broker, and no, it's not as risky as you might assume if you cut losses quickly.
In fact, I've made millions of dollars over the past few years doing just this, becoming the top-ranked short-bias hedge fund manager 2003-2006 (Barclays).
In fact, it's just about the only strategy that's ever consistently worked for me no matter the market environment, year in, year out, for the past decade. I don't expect that to change anytime soon because tiny companies will always need to hype themselves in order to raise capital to try to grow - no matter that the odds of business success are against them.
Hype is great for getting investors excited and pushing stock prices higher - at least temporarily - so it's that hype pattern that I love short selling into!
Short Selling
Let's start with the lesser of two evils: short selling, or betting on a drop in stock price. (Yes, you can profit from falling stock prices.) The old adage "buy low, sell high" still applies, you simply "sell high" and then aim to "buy low."
When you buy low, you're covering your short position, so it's called "buying to cover." For all its mystery, short selling is nothing more than your typical buy-and-sell transaction in reverse.
The obstacles to practicing this strategy successfully are many: people can't wrap their minds around the backwardness of it, stocks do tend to go higher over time, in order to short sell, you must borrow shares from your broker - requiring the use of margin - and because you can lose more than you invest (if you short 1,000 shares of a $5 stock and it goes to $15, you're down $10,000, or double your initial investment), many people find short selling scary, writing it off as impractical.
Penny Stocks
Penny stocks are even more derided as most brokers require their customers to sign special documents not to hold the broker responsible for what happens when customers "invest" in these stocks.
Because penny stocks, or stocks trading below $5, are the most speculative, developmental and manipulated companies in the entire stock market. They are also the most dangerous.
These are their qualities: little-to-no business fundamentals, hype-filled corporate press releases and internet message board chatter, little-to-no SEC filings, and paid-for stock promotion in place of credible independent research.
What's more, many stocks are influenced by spam emails encouraging people to buy shares and stock promoters who are straight out of the movie "Boiler Room".
Their stocks are priced so low because the odds of success are against them, so even minor news can be a catalyst for 20%-200% price surges within hours or days.
Of course, since they have so few customers, products and services, any negative news can be equally disastrous, leading to 20%-50% drops over the same time period. Add in the fact that the vast majority of these stocks are incredibly illiquid, and you've got yourself a dangerous combination of price volatility and share illiquidity.
These factors prevent large Wall Street players from participating because there's simply not enough profit potential. In fact, the only two real groups of people playing these stocks are amateurs who naively bet on long shots and professionals who prey on those amateurs.
Given such an environment, how have I survived - let alone prospered - short selling in the midst of a multi-year bull market no less? Simple: I take these risks and use them to my advantage.
Since I know amateurs fall for the hype and that betting on already low-priced stocks to go lower is incredibly dangerous and unpredictable, I wait for the variables to align in order to make my entry prices ideal - meaning for the stocks to be pumped up: it could be the right press release, nefarious boiler rooms and hedge funds who've gotten shares at discounted prices, paid-for stock promotion or shareholders looking to create stock spikes to sell into. Then it's just a waiting game, watching and waiting for these temporary catalysts to lose their influence, as they inevitably do.
Take Converted Organics (NasdaqCM:COIN - News) - on the backs of a flurry of partnerships and comparisons with other hot agriculture stocks like Monsanto Co. (NYSE:MON - News), Potash Corporation (NYSE:POT - News) and Mosaic Co. (NYSE:MOS - News), this now $50 million company has quintupled from penny stock status last year to its current price around $10 per share.
But for all their deals and rosy projections, they still have mammoth losses and 0 revenue. That's right - no revenue. And despite its willingness to distribute press releases by the bushel, the only way you'll find its earnings statement is in its SEC filings.
Call me cynical, but somehow I don't think it's a coincidence that their stock run-up started only after they hired a specialty PR firm - PR Financial Marketing - in October of last year.
Currently, I have no position because I respect the stock's ability to find support at $8 per share.
I'll only short when that support cracks because given the utter lack of any fundamentals whatsoever, technical analysis is all that matters here.
More recently, two OTCBB-listed companies, Bioshaft Water Technology (OTC BB:BSHF.OB - News), a company that owns a "revolutionary water treatment solution," and China Organic Agriculture (OTC BB:CNOA.OB - News), one of the largest producers of rice in China, has surged thanks in no small part to "newsletters" in the form of spam emails touting these stocks' bright futures.
CNOA got an extra boost from a naive CNBC reporter who mistook paid-for stock promotion for credible independent research.
Understand I have nothing against stock promotion or the promoters themselves, as I understand it's the only way for these companies to get attention and possibly funding. But due to the high predictability of reversals off the price surges created by such promotion, experienced short sellers grab all the shares possible so it's rather difficult to find large blocks to short.
That's why I'm writing openly about such a successful trading strategy - because for all its predictability, it's not scalable past a few million dollars. The good news is that last time I checked, a few million dollars is still something worth striving for.
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