Although broad in scope, this inventory generally includes shares of a variety of blue-chip
stocks. They tend to stick with stocks listed in the most prestigious indexes, like the S&P 500,
or NASDAQ 100. Penny Stock, or any stock below five dollars, is rarely included in this
inventory, at least not to any meaningful extent. This dramatically cuts the risk of tying up
capital in this inventory. Why would they want to take the risk at all? Well, in a word, because it
A conflict of interest arises when a broker also acts as a market maker for the stock. If the
inventory gets too bulky, are they more likely to recommend that stock to their clients?
Conspiracy theories aside, the excess inventory does allow firms to provide better service to
their customers on two fronts. First, because of the excess liquidity, they can offer split-
second executions on the vast majority of stocks investors buy and sell, making them more
competitive. The second benefit is being able to offer their customers the opportunity to profit
when a stock goes down.
customer provided they open a
margin account and agree to pay
interest. The trader can then sell the
shares on the open market, and
sometime in the future, if the stock
does not become utterly worthless,
buy them back and return them to
the broker with no questions asked.
For the entire length of the trade, the
investor must maintain enough
cash in their account to cover the
current market price of the shares
plus a hefty percentage. If the price
of the stock goes up significantly,
the customer will experience what
is known as a margin call, and will
have to add money to the account if
they would like to avoid seeing the
determining factor as to when the margin calls come.
Shorting is a simpler way to bet that a stock will go down than using complicated option
tactics. Shorting is not just limited to Blue Chip stocks; there are several ways investors can
short penny stocks, most of which require being heavily capitalized. Even if it is possible, is it
recommendable? The problem with shorting a penny stock is that the risk of loss is infinite,
while the gain potential is finite. What happens when a penny stock one is shorting sees a
remarkable event and climbs 100-1000% over night? Bankruptcy and seized assets are what
Getting a handle on a stocks short-interest can add to your overall perspective of the market
for that particular stock. This can lead to better decisions when entering and exiting long
trades, where your risk is limited to the initial investment. Short-interest figures cannot in and
of themselves determine the future direction of stocks, but they may be able to help
determine future volatility. Just because a stock has a high amount of short-interest does not
mean it will go down, in fact, a short squeeze could lead to the exact opposite.
Short-interest is often measured as a percentage of float for comparative purposes, or it is
measured as a percentage of the number of shares outstanding, or simply as the total
number of shares held short. This is the number of shares that short investors have to buy
back in order to close their positions, presumably at some point in the future. Short-interest is
usually reported monthly, so the transparency is not exactly real-time, but close.
To make the short-interest figures meaningful, we look at the previous months short-interest
and compare the two. The difference can become a relatively powerful sentiment indicator.
One needs to look at the difference in relationship to the recent direction of the stock. If the
difference is large, one needs to find out why it is large. Are there enormous financial
problems? Is the business model seen as unsustainable? A large amount of short-interest,
no serious fundamental flaws and a stable or slightly rising stock price could be a screaming
buy signal. Conversely, short-interest that is continually rising coupled with a shrinking stock
price could be cause to take warning. It is vital to remember that majorities, or large groups of
investors sharing the same point of view are not always right, in fact, the exact opposite could
be argued. Just because a stock has heavy short-interest does not mean that it is doomed,
and this is where contrarian view points often get rewarded. Keep in mind that selling activity
related to the short-interest figures has already occurred, and all those shares still need to
be bought back.
Bringing volume into the mix can allow for even more insight into short-interest as a
comparative figure. If a stock is lightly traded, a smaller amount of short-interest could be
more meaningful and more likely to move the stock. The short-interest ratio, or days-to-cover
ratio is calculated by dividing the number of shares held short by average daily volume. The
higher the number, the more days in theory it will take for shorts to cover their positions,
although stocks often do many times their average daily volume in one day, especially when
big news comes out. Be sure to find out what time frame was used to calculate average
volume, and take the time to run the numbers for multiple time frames, or time frames that
match your own strategy. The days-to-cover equation can also be used for indexes and
exchanges as a whole, and the calculations can be used as a broad market indicator. The
NYSE short-interest ratio, for example, is calculated by taking the total short-interest on the
NYSE and dividing it by the 30 day average total volume.
Better Long Perspective
Fundamental Penny Stock Trading Information
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