Brokerage firms and other institutions like to keep a certain amount of inventory on hand.
    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.

    The firm will lend shares to a
    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
    shares bought back automatically. Ultimately, the customer's credit worthiness will be 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.
    Familiarize Yourself with Short Events to Gain a
    Better Long Perspective
March 16, 2011  PSW Staff
    Latest Micro Cap Basics Articles
    Fundamental Penny Stock Trading Information
Free, unbiased analysis & opinion on small & micro cap stocks
You need Java to see this applet.
    Enter Symbol, Company Name or Keywords:
    Free Premium Subscription Offer
    Full article access includes Buy, Sell & Stop-Loss conditions along with a no
    nonsense trading strategy and risk analysis.  Also, access our actionable,
    unbiased portfolio, exclusive articles and more.
    Enter your Email Below to get Started for Free