Should You Short Sell $5 Stocks?

Should You Short Sell $5 Stocks?

Should You Short Sell $5 Stocks? 1024 576 Steven Dux

Should you short sell $5 stocks?

This is a question I’m often asked over email, social media, and especially inside my mentorship courses like The Freedom Challenge.

Stocks $5 or under are referred to as penny stocks, and they are definitely riskier and more volatile than higher-priced stocks.

It’s possible to make money on all kinds of stocks if you know what you’re doing.

But there is, of course, a method to the madness.

Stock selection plays an important role in how successful and long-term your trading career will be. And part of that is choosing whether to short stocks under $5 or above.

As a beginner, the concept of short selling may seem quite intimidating and confusing…

That is usually the first reaction whenever a new trader comes across its concept. It’s pretty understandable why they react this way. Short selling (or Shorting) goes against all the principles of a long or a traditional sell. When seen practically, its core concept can seem disconnected from how we do any kind of transactions in real life.

Let me explain…

While trading traditionally, we buy stocks, hope for their price to rise, sell the said stocks, and pocket the difference which is now your profit. Simple.

It’s something we have all heard of. You buy low and sell high.

That’s the order of how a transaction goes chronologically.

Buying comes first and then comes the selling!

With Short selling (or Shorting) though, you reverse this order: selling high and then buying low, all while earning a profit. Sounds implausible, right? Well, it isn’t.

Through today’s article, let’s try and get to the bottom of it…

An Introduction To Short Selling

If you saw the movie (or read the book) The Big Short, you’ve likely grown curious about shorting.

The story is about the lives of financial professionals who made a prediction regarding the build-up and collapse of the housing bubble in 2007-08.

The premise of the story is that it was predicted the housing bubble will pop and therefore shorting was done by people who could predict this accurately. The “big short” in the title here refers to the concept and practice of shorting.

Short selling–also referred to as shorting a stock–or a short sell occurs when a trader sells shares at a high price and buys them at a lower price. As odd as it may sound, it’s a common practice in a falling or bearish market, albeit with some risks.

If a trader can understand its workings and be sure of a stock’s price falling, they can make Short Selling work for them.

Why Short Selling?

Considering the situation we are in right now (on the back of a global pandemic impacting the world economy negatively) it can be downright scary to want to invest your hard-earned money in the share market. That coupled with the general volatility of the market are some legitimate concerns that many have.

Short selling is one of the most important ways you can make profits as a trader. It is something I use for my portfolio and also teach my students.

It is mainly significant because it allows you to earn even in falling markets.

As you can see through this article , I was able to make $4+ million in 2020 despite the pandemic affecting the market creating an economic crisis. That is the power of shorting.

It can help you make some good profits, in various situations.

As a new trader, short selling can seem foreign because its basic idea is the complete opposite of how any good trade or transaction works.

So while Short Selling can be a way for many to take advantage of a falling or bearish market, it still needs to be done with a proper understanding of the various ins and outs.

How Does Short Selling Work?

Simply put… in Short Selling, shares are first borrowed from a broker and then sold at the price they are valued at. The hope here is to buy these shares back when the price of the shares decreases. When it does decrease, these shares are bought back at the new lower rate and returned back to the broker.

The difference between the high price the shares are sold at and the low price they are bought back at is the trader’s profit.

It goes against the traditional way (also called longing a stock) where you buy low and sell high later for obvious reasons. Here, that order is reversed but still, a profit can be earned. Since this order isn’t traditional, there are usually a certain set of questions that many can have regarding Short Selling and its process.

To begin with, there’s always confusion around how someone can one “sell” something that doesn’t belong to them in the first place. Well, it’s possible because of the very simple reason that it is being borrowed.

Most governments around the world allow their citizens to sell short and therefore traders can “have” these shares and sell them without actually owning them. But practically, most traders don’t short sell on their own, they have brokers that do this for them.

In such cases, the borrowing of the shares that will be sold later is done via a broker and these shares are returned back to them at a later time. The profit earned in this whole transaction will include the broker’s fee too.

The next big question is: what if the price of the share you were supposedly sure would decrease, actually increases?

The simple answer is that you face a loss.

Your whole bet here is on the share price decreasing, so when it increases, after returning the shares you borrowed, the difference between the prices of the two would be the loss you incurred.

What makes this riskier than the losses of a traditional trade is that, unlike a traditional trade, there’s no limit to the amount of loss you can have. Theoretically, it’s infinite! This just further proves that short selling needs to be done only when you have the right understanding and proper training.

A Quick Example To Understand A Short Sell

Let’s take an example to understand the concept of Shorting.

Say you think a company that currently has a share price of $5 will have a decrease in it after their yearly income reports come out. So you borrow some of its shares from a brokerage firm and sell all of them at $5 per share.

As expected, once those reports come out, the share price decreases to $4.

So you buy the same amount of shares that you sold and return them to the broker.

What happened here is that you borrowed, sold, bought back, and returned a certain number of stocks. But in this process, you earned $1 ($5-$4) per share as a profit — all yours to keep except for the brokerage fees and such.

This is how a short sell works.

How To Go About Short Selling?

To begin with, it’s necessary to determine what kind of short selling you want to take part in.

Are you eyeing bigger stocks or penny stocks? Once you know what you want, you can start looking for a broker who allows that kind of trade.

With a good broker by your side, start “locating” the shares to short or borrow from your broker. There is a certain interest fee that needs to be paid to the broker before you can move ahead.

Another essential factor is having a margin account, and, in addition to this, having a mentor by your side so you can learn from them (and what to do versus what not to). Someone who has been shorting for years could guide you in the best way, to generate the most profits and do this long term.

This is something I go through in my course The Freedom Challenge

Should you Short Sell $5 Stocks?

In general, Short Selling can be a high-risk game for both the trader and the broker.

Because of this, a lot of brokerage firms don’t let their traders short sell $5 stocks or other similar low-value stocks. They try to safeguard their transactions by trying to keep losses, if any, at a minimum.

But it should be noted that this is the requirement of certain brokerage firms, not something that is set by the SEC (Securities and Exchange Commission) or the FINRA (Financial Industry Regulatory Authority). So by law, it’s completely fine to short sell stocks below $5.

Overall, penny stocks are traded long but can be traded short.

But, it is often advised to not short sell a penny stock because of its highly risky nature (not because it’s illegal, which is a misconception).

With time, experience, and learning how to read different patterns, it’s definitely possible to short trade penny stocks successfully and consistently.

Although, the risk factor shouldn’t be completely ignored.

It is this risk that makes a lot of brokers hesitant to want to allow short trading penny stocks. The reason behind their hesitancy is simple, that the higher the value of a stock, the less the loss could be when you go to short sell it.

So a trade where penny stocks are shorted can be extremely risky.

BUT… they can also be VERY profitable if approached the correct way.

I recommend shorting stocks that are $5 or above because they are more expensive, and the more expensive a stock is the less risk you are taking. 

A stock that is priced high is not going to push too much as compared to a stock that is priced under $5. The more expensive a stock is, the fewer shares buyers can buy.

That reduces the chances of a price surge.

Tips For Successfully Short Selling

1: Learn And Practice First

When the high risk of short-selling low-value stocks is taken into consideration, it becomes necessary to be well-informed.

As a beginner, your primary focus should be on knowledge building.

To help you with that, I created the Investing for Beginners series where you’ll find articles on various essential topics for a new trader.

Over the last few years, it’s become my mission  to help beginners understand more about the stock market so they can turn this into a full-time career and achieve financial freedom.

It’s difficult as a beginner to figure out what you need to know before you begin trading, what to do when you actually start to trade, where you can find the right information for learning, and the best resources to find these.

So I developed a course that breaks down the techniques and strategies into simpler to understand concepts. The Freedom Challenge and my mentorship are here to help you make day trading your primary source of income.

In the last few years of my mentoring career, I’ve seen all the time that only the students who take the time to learn properly and practice find sustainable success.

2: Study The Patterns

Base your shorting decisions on patterns and stats, not on emotions, not on your gut, and certainly not on a whim.

Go through this article  where I discuss how to recognize and read patterns in 2021 and beyond.

3: Do Paper Trades

Before short selling in the actual market, my recommendation is to practice with paper trades.

Paper trading allows you to buy and sell stocks, just like you would in day trading but without risking your money. I advise my students to prepare themselves for 12-months of studying the markets and experimenting with paper trades before they invest large amounts of money.

Conclusion

So, should you short a $5 stock?

It’s definitely possible to short these low-priced penny stocks successfully and consistently.

But if you want the best and most sustainable results, look for higher valued stocks.

From penny stocks to stocks with higher values, all kinds can be traded. Although, I recommend you go for a more expensive stock when planning to sell short (to better minimize your risk).

Yes, shorting comes with its own set of risks but if you’re well informed, have some experience, and find a broker that’s right for you… it can be a breeze!

It’s often seen as a savior for active traders wanting to make a profit in a falling or a bearish market. It is not advised to many new traders because of the risk factor of it.

But here’s the thing… once you get the hang of it, short selling can be very profitable.

It plays a large role in how I’ve built my own portfolio to $11 million over the last few years…

All in all, it is a method worth trying for a situation wherein you’re sure about a stock price falling.

To learn more about short-selling and much-much more, be sure to subscribe to my YouTube Channel and Free Day Trading 101 Newsletter.

You may like to check out The Freedom Challenge and learn how you can personally work with me.

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