Brokers require investors to put up collateral to guarantee against potential losses in the form of margin requirements. Often times, brokers will require OTC investors to have $2.50 of margin per share to short a stock under $2.50, which can make shorting penny stocks very costly. For example, if an investor shorted 2,000 shares of a stock at $0.50, you have to have $5,000 in your account. All along, the maximum profit for this position would only be $1,000, if the stock went to zero.
Penny stock short sellers must also worry about execution risk with their trades. Short selling involves borrowing shares from someone else and selling their shares, so even if an investor finds a great short selling candidate, they may be out of luck if the broker has no shares to lend. Similarly, the pricing for these short trades may not be favorable due to the often-large disparity between the bid and ask price. As a result, investors must watch these prices carefully before initiating a short position.
Market manipulation has always been a problem in the world of penny stocks, but this risk is especially large when shorting penny stocks, since the losses when short selling are unlimited. The best targets for short-selling are often those subject to manipulation or promotion by unscrupulous web sites of funds. However, these manipulators have a distinct advantage over the short seller - they have capital, price and liquidity on their side - which means investors must be very careful.
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