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 is profitable. 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 could happen. 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. |
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Fundamental Penny Stock Trading Information |
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