Make Money 101: Short Squeezing Penny Stocks

The phrase is used so often that investors take the meaning for face value rather than understand its entirety and how it affects their decision making.  So, let’s examine what the meaning is of  “Short Squeeze”- a moment when a lack of supply meets an excess in demand propelling the stock price upwards.

So let’s examine the Penny Stock Short Squeeze.

Penny stock short squeeze occurs more often than not. The short squeeze is much more likely to occur in a penny stock with a small market cap coupled with a small float.  It is virtually impossible, though it does occur, for a blue-chip with a multi-billion dollar market cap to have large percentage moves than it is for a penny stock with less than a $100 million market cap. Since penny stocks can have much less than $100 million market caps, it is not so far-fetched since the majority of penny stocks have less than $100 million market cap.

It is the basic principle of make money 101: Supply and Demand.

Whenever an investor has a “short” position in a stock, its simple description is that they are placing a bet that the stock in said company is going to decrease in value prior to when they are required to cover their position.  If a short squeeze is happening in a penny stock, it can become “asses and elbows” in the market to get shares in the penny stock.

The effect: Share Price.

When there is a large short position, the price of the penny stock goes up and the shorts are forced to cover.  Either those penny stock investors in short positions want to get out before they lose too much or are required to fulfill margin requirements.  By covering the position, essentially they are buying the stock back.  Depending on the size of the Float, this can make the penny stock increase in price even further, sometimes triggering off more margin calls and creating a buying spree, driving the price of the stock up.

How Short Squeezing Really Works:

When considering what sways an investor’s decisions trading penny stock, fundamental and technical analysis, as well as the psychological aspect, comes into play.

Fundamental analysis: 

The main focus on what may make a penny stock move. Take into account revenues, price-to-earnings ratios, positive or negative cash flow, debt, dividends, etc. Penny stock traders sometimes find the fundamental analysis most interesting. On its own, trading penny stocks solely on fundamental analysis rarely ever is coupled with profits. Actually, analyzing fundamentals is more often a hindrance rather than assistance when trading because penny stock traders tend to form an opinion of what the penny stock “will do” and most times, that opinion blocks objectively analyzing what the penny stock actually does.

Think of all the times you have bought a “good penny stock” but it turned out to be a bad penny stock. The company had good revenues, little or no debt, earnings (which is rare for a penny stock) but it didn’t perform the way you thought it would.

Technical Analysis: 

On the other hand, technical analysis is a more adequate tool to use to determine when and for how long a penny stock may move. No one ever consistently profits in penny stocks that does not research some form of technical analysis. A penny stock trader can look, objectively, at the price action of a company to determine a good or bad trade by using technical analysis. Technical analysis can help to make trading decisions in a penny stock without having any idea of what the company may do or what the fundamentals may be.

Psychological Aspect: 

Everyone drops their major in college to study it but it is still the hardest factor to measure. The psychology of penny stock movements is most often gauged with technical indicators and struggles to answer the question: Who? Under the circumstances, who would be a seller and who would be a buyer?

Huge profits can be made in a penny stocks movement when there’s a positive combination of the three.

How the Three Factors Meet in Short Selling: 

Short selling (“Shorting”) simply is trying to profit on the decline in share value by selling a penny stock at a high price in hopes to later repurchasing the penny stock at a lower price. Short sellers (“Shorts”) profit by selling high and buying low. Sounds like simple Business 101. Note that once a penny stock is sold short, the Shorts are future buyers representing future demand because they are required to buy the penny stock back at some future date.

The sex appeal of shorting is easy to understand but, like with any unleveraged bet, there are risks involved. The biggest of the risks to shorts is a penny stock price going up instead of down. A rise in share price in a penny stock that is heavily shorted can, as mentioned before, often lead to dramatic upward movement as losses mount for shorts and they do everything they can to minimize their losses by buying the penny stock back. Motivation to buy back the penny stock by the shorts is simply fear. Fear that they will have to pay even more than they already have to resulting in unlimited losses.

When you buy a penny stock at $0.40 per share, the maximum you can lose is your entire investment, $0.40 multiplied by how many shares you bought. When you sell a penny stock short at $0.40, the potential for losses, in theory, is unlimited. The penny stock may rise to $0.80, which means you lost 100%, but what is there to stop that penny stock from rising to $1, $2, $5, even $20? Such a rise in a penny stock price is the fear that can make for explosive upside in a heavily shorted penny stock. The marvel of a rapidly rising penny stocks with a large short interests is known as the “short squeeze.”

The Squeeze is in the Juice: 

In case you’re lost in translation, for the purpose of this discussion, short Interest is the total number of shares of a penny stock that have been sold short and have not yet been covered. When a penny stock trader sells a penny stock short, exchange rules mandate that the order must be identified as a short sale. Exchange rules also mandate that statistics on the total number of shares sold short are kept by the exchange and released to the public once per month. Statistics for Nasdaq stocks is totaled up and reported by the exchange on the 15th of each month. Those statistics are released to the public eight (8) business days later. Any changes to this number are released one-month later.

Short Interest Ratio (S.I.R.) is the number of shares sold short (short interest) divided by the average daily volume from the prior month for the particular penny stock. This number is important so that one can calculate the number of days it would take to cover (buy back) the shares sold short based on the average daily volume. The higher the S.I.R., the longer it would take to buy back shorted shares. Often, this leads to upward trending in the penny stock if sellers become ambitious to buy back their short positions.

Example: A penny stock has a short position of 15,000,000 shares and an average daily volume of 2,000,000, the S.I.R. would be 7.5, meaning it would take 7.5 full trading days of average daily volume for the shorts to cover their bet. If the stock had average daily volume of just 1,000,000 shares, the S.I.R. would then be 15.0, meaning it would take 15 days of buying to cover their positions.

From a contrarian investor point f view, a higher S.I.R is sexy because it is more difficult for shorts to cover their positions and often results that straight penny stock buys have the potential to create significant trading profits in a very short period.

Finding Fruit “Bear”ing Trees:

Finding those penny stocks that could be vulnerable to a short squeeze is as simple sometimes as a news event that changes investors’ perception as to the stock’s worth, long holders of the stock trying to push the price higher; in an attempt to tap into the “fear driven” buying that trapped shorts can offer.

Penny Stock Shorting for Dummies: if you are short a penny stock that is going up, there comes a point when financial pain cause you to become fearful to keep holding the position. What you may end up with is an emotional trauma of holding a big loser and cost you more than you bargained for. A once pessimistic seller now becomes a panicky buyer like a father looking for a toy out-of-stock on Christmas Eve for his kid. It is this buying frenzy that makes the penny stock advance at a furious pace.

Where To Find The Bears: 

Hundreds of websites source information about the number of shares that are short for any individual penny stock together with the S.I.R. and average daily volume. I like to reference to the 10-day average volume and even also checking the 5,10 and 20 day moving average of an individual penny stock. Professional penny stock traders and money managers who inaugurate large short positions are most often very disciplined about losses. That discipline can often work in your favor. When a penny stock starts rising that is shorted, the shorts will often act quick to cover their positions. They now become aggressive buyers attempting to minimize their losses. This buying most often benefits straight buys and long positions by sending the penny stock rapidly higher.

Take a look at any penny stocks that you own and see if they are on this list and how many shares are short compared to the float.

Getting Shorts In A “Bear” Hug: 

Legal, yet questionable, “Squeezing the shorts” is when a penny stock trader takes advantage of a penny stock that has been shorted substantially by buying up large blocks of the penny stock. The penny stock cannot sustain its current price level and is forced to increase which, in turn, forces shorts to try to buy the stock. Since the penny stock trader has bought up large blocks of the penny stock in question, the shorts may find impossible to buy back the penny stock at a price they want or are willing to pay. The penny stock trader has complete control over them now and can then sell the penny stock to the desperate shorts at a higher premium.

Squeezing the shorts is extremely difficult to accomplish. In the 1970s, Nelson Bunker Hunt attempted to squeeze the shorts in the silver market. Hunt and his associates, at one point, had acquired more than 200 million ounces of silver causing silver prices to move from roughly $2 per ounce in the early 1970s to nearly $50 per ounce by 1980. Unfortunately for Hunt, regulators decided to put a stop to Hunt’s manipulation by implementing higher margin requirements and limiting the amount of contracts that any one trader can hold. Eventually, Hunt’s scheme failed and he was forced to declared bankruptcy.

Bottom line:

Short Selling is a high-risk, high-reward sector of trading penny stocks. With such limited information on penny stocks and their major shareholders, penny stock short selling should be left for those who can afford to take the ultimate risk: losing all your money on an investment.

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