Penny stocks are the most peculiar asset class that beginners get drawn to.
At the same time as having immense benefits: least competitive, highly volatile, and daily runners, they also have huge drawbacks: they’re the riskiest, most of the companies are shoddy, and are often manipulated.
The drawbacks of penny stocks are reasons many traders tend to prefer trading them on the short side, but this introduces even more risk.
The structural advantage of shorting penny stocks can’t be overstated.
When there’s a factor of predictability in a typical asset class, there’s usually a risk-factor on the other side weighing down that predictability. Penny stocks are an anomaly in that there are several structural advantages to trading them on the short side.
While shorting penny stocks offer what seems like massive advantages, I think it’s obligatory to include the Keynes quote that “markets can stay irrational longer than you can stay solvent.”
This couldn’t ring truer in the world of penny stocks, so it’s not a child’s play to short these stocks. But, it’s hard to find a more substantial structural advantage in financial markets than shorting penny stocks that are rising exponentially, when the advance is based on air.
The Importance of Fundamentals and Filings
Even though you’re trading on a very short-term time frame, I think fundamentals and SEC filings are hugely important when shorting penny stocks. That’s because real moves do occur in the penny stock market.
Some of the companies are real and are making moves that increase their market value. We definitely want to avoid shorting these companies.
- 8-K filings
We want to pay attention to a few key things: recently filed 8-K filings. An 8-K is an SEC filing for any material change within the company. Whenever there’s news, it will be filed in 8-K.
The great thing about reading an 8-K in favor of press releases is that the SEC doesn’t allow much fluff in their filings. Anything disclosed in a filing must be reasonably substantiated.
Penny Stock Technicals
Everything I mentioned above is useless without the ability to make profitable exits and entries on parabolic stocks.
Without coupling technical analysis and risk management into your analysis, you’re essentially a short-term value investor, assuming the market is going to come to the same conclusion as you within a short time frame.
Volume Profile and VWAP
Don’t worry, I’m not going to hit you over the head with jargon about TPOs, buying tails, and such. There is immense value to the deeper aspects of auction market theory and market profile, but it’s unnecessary for these types of trades.
All you need is a charting service that can plot volume-at-price. I know that Thinkorswim, StreetSmart Edge (Schwab’s active trader platform), and TradingView all offer the feature.
Volume-at-price allows us to perform more in-depth volume analysis than a traditional volume histogram. As the name says, it displays how much volume is executed at each price.
Here’s an example:
As you can see, the majority of the volume at the daily highs on GLUU was selling volume, as indicated by the large red bar.
In addition to volume profile, we’ll make use of the Volume-Weighted Average Price (VWAP) indicator, which is widely known and available in just about every trading platform.
So now that we have a basic understanding of our tools let’s move onto understanding the patterns that these stocks tend to follow.
Opening Fade Pattern
Here’s an example of a penny stock that gapped up today (February 13th, 2020): CPAH. We can observe that prior to today, CPAH was thinly traded and saw choppy price movement.
After the gap up on huge volume today, we quickly saw the sellers step in big-time around the open.
The above is what your typical parabolic penny stock pattern looks like. The chain of events of a successful short trade on one of these stocks looks a bit like this:
- Gap up on high volume
- Rejection of the opening range high
- A retest of the opening range high
- Rejection of the retest
- A Wyckoff “distribution area” (more on this in our Trading Reversals section)
Here’s another example:
Entries and Exits
Making good trading exits and entries are more art than science.
Unfortunately, markets are chaotic and unpredictable. If there were a formula to find the perfect exit or entry, the method would stop working as soon as HFTs found it.
With that said, there are some general guidelines to follow when making exits and entries.
Everyone loves to discuss trading entries, usually failing to plan for their exits. But, exits can be the most critical aspect of a trading plan, especially when shorting penny stocks.
Having a smartly placed stop loss in place when things hit the fan can make the difference between a small loss and a loss that blows out your account (like some of the trading disasters we’ll cover later in this article).
Many opt to use a volatility-based stop loss to plan their exits on losing trades. The most common method is using a multiple of the Average True Range (ATR) of the time frame you’re trading. That multiple will depend on the pattern you’re trading as well as your trading style.
It’s typical to use wider stop losses (more ATR multiples) as your profit targets grow. If you’re trying to join a trend and capture a significant market move, you have to give the market room to breath in the form of a wider stop loss.
Scalpers, on the other hand, will use very tight stops, as they’re only trying to capture a few ticks.
Another popular method for placing your stop losses is based on levels present in the market. In a short setup like those that we’re evaluating today, you may opt to put your stop above a resistance level or VWAP.
Because there are several ways to short penny stocks and be profitable, there’s no single answer to the question of “where should I place my stop loss when shorting this parabolic runner?”
The only straightforward thing I can tell you is: wherever you place it, make sure you actually place a stop, period.
When it comes to entries, I actually think there’s more room for imperfection then exits. I take the philosophy that if you get the main idea right, your entry is less important than trade management.
Now, that’s not to say that they don’t matter, I just think that, initially, your time is better spent focusing on making sure your trade ideas are sound.
With that said, here are a few entry criteria you can look out for within a stock you want to trade:
Shorting at VWAP
The average trader who is long a parabolic penny stock doesn’t typically have a strong hand. As the market crosses below VWAP, this means that the average holder of the stock is now in the red on the trade.
As soon as traders begin to see red in their P&L when trading these stocks, panic selling begins to pick up.
Below the Opening Print
The opening print of these stocks is a psychologically important level. The smart money accumulated their positions in the subsequent trading days, they’re not typically buying at the open.
This means that the opening print has immense significance to traders who bought early in the day.
Once the stock’s run loses steam and higher prices are rejected, traders begin to sense that the action is waning.
Usually, the only thing stopping the market from breaking down is that there are still stubborn longs holding onto their shares. As the price crosses below the opening print, the stock is essentially in gap-fill territory.
It’s not uncommon to see the largest bearish candles occur right around the opening print.
Risk Factors – Runners Can Longer Than You Think
The run in Enteromedics (ETRM) lasted around ten trading days, starting with a huge gap up right before the new year. This was one of the hottest stocks on Twitter and in trading chat rooms, and many bears were slapping bids all of the ways up.
ETRM is another case of a parabolic stock running much further than anyone anticipated and should serve as a cautionary tale to short-sellers.
Helios and Matheson Analytics (HMNY)
HMNY is the company behind MoviePass, the subscription service that promised customers one movie ticket per day for $10 per month. This was an obviously ridiculous offer that seemed impossible to profit from, let alone survive as a company at this price.
The stock looked like a classic hype-driven penny stock run that was soon to lose steam.
What penny stock short-sellers failed to notice is that the MoviePass product had mainstream recognition, bringing in a slew of retail investors eager to cash in on the next hot startup.
This new money propelled HMNY’s stock to run longer than many expected, resulting in many short sellers getting crushed.
As you can see in the (split-adjusted) chart above, the stock ran for about a month before losing steam. Compare this to the usual 2-3 run of a parabolic penny stock, and you can imagine how many short-sellers lost their shirt on this one, especially those who were using the famous “first red day” penny stock short selling strategy.
Overnight Black Swan Risk
In addition to parabolic runs lasting longer than anticipated, which can be controlled to an extent, another massive risk factor as a penny stock short-seller is the dreaded overnight gap up.
The worst part is that there’s no real way to hedge out this risk when holding these stocks short overnight. A short-seller either has to only day-trade or significantly reduce their overnight position sizing and expect the occasional black swan.
Everybody knows gap ups can happen, but until you actually suffer a massive loss from a gap, it doesn’t really feel real. Nothing can replace the experience of a gigantic loss to keep your risk management in check.
Still, perhaps the following cautionary tales can provide some perspective to BE CAREFUL WHEN SHORTING PENNY STOCKS!
KaloBios Pharmaceuticals (KBIO)
I’ve written about the case of the KBIO short seller who resorted to a crowdfunding effort to recover his retirement savings from his catastrophic experience holding KBIO short overnight, only to check his account and realize that his $2 short went to $16, leaving him with a loss of around $140K.
The stock is delisted, and even charting services like Barchart, who usually have data on delisted companies, don’t seem to have the chart available. The best I could find was this one from the MarketWatch article which profiled the perils of the KBIO short seller.
If you think it was terrible for the guy short KBIO, imagine how bad it was for whoever got caught short a tiny penny stock called Gateway Industries in 2011. The stock was more of a shell company than a serious operator.
The stock was trading for around two pennies before media mogul Robert F.X. Sillerman acquired the company, sending the stock soaring approximately 20,000% overnight!
Gateway was traded on the foreign OTC market at the time, meaning it probably didn’t show up on most traders’ radars, even at the time of the big run.
Again, because the charts for these types of companies are challenging to find, here’s a chart I was able to recover from Business Insider:
As an aside, I think the long-term prospects of most of these companies are obviously pretty low, given the fact that both stocks are now delisted.
Downside to Shorting Penny Stocks
One of the biggest drawbacks to shorting penny stocks is there has to be shares available to short, meaning it can’t be hard-to-borrow (HTB).
Since most people do not hold penny stocks long term in a margin account, there may not always be shares to borrow and if there is it could be expensive to borrow them.
So before you get excited about the possibility of shorting a big move in a penny stock, make sure your broker has shares available for you to short! Usually they will have a hard-to-borrow list, but if not you can always give them a quick ring.
Shorting parabolic penny stocks offer immense structural advantages. In a few other corners of the market, can you find a class of stocks with such predictable patterns.
But, of course, with great reward comes considerable risk. These are the scariest stocks to hold short, and they can quickly punish you.
I’m a firm believer that those with the right personality and trading preferences can kill it with this strategy. Still, for others, it makes much more sense to trade a more conservative strategy, like trading trend pullbacks.