Stocks that trade under $5 per share are considered cheap stocks.

However, unlike stocks under $20 or stocks under $10, stocks under $5 are placed in a different category by the U.S. Securities and Exchange Commission (SEC).

According to the SEC, any stock trading under $5 per share whether it is listed on an exchange or trading through pink sheet markets or the Over The Counter Bulletin Board (OTCBB) is a penny stock.

In the past, penny stocks were often considered as only those stocks that trade below a dollar.

Penny stocks are mostly tied to small companies, often startups, which are unproven with little in the way of earnings. These stocks trade infrequently because they don’t have a lot of liquidity or ready buyers in the market.

As a result, it may be difficult to short sell a stock that is trading under $5 since there may not be any buyers at that time.

Due to the lack of liquidity, traders might have difficulty stumbling on a price that accurately reflects the market.

However, you can still come across good, established companies trading under $5 that may have seen their share price stall or slump for some reasons, but they still have good earnings and solid financial potential.

What is short selling?

Short selling or shorting stock, is when a trader borrows shares from a brokerage firm and immediately sells them, expecting to buy them at a later time when their price drops, return them to the broker and pocket the difference as a profit.

Unlike traditional (long) buy only strategy, in which one buys a stock/security with the hope of selling it at a higher price at a future date, short sellers first sell a stock with the expectation of buying it (covering the short sale) at a future date.

If the share price goes down, the trader makes a profit by “buying low and selling high,” but in reverse order.

Short sellers actually don’t hold the stock before selling; rather they borrow it from the broker/person already owing it. Later on, when the stock falls as per the trader’s expectation, he again buys the stock and returns back to the broker to cover up the loan.

Basically, this trading strategy allows you to speculate on stocks/securities that you believe will drop in value, allowing you to potentially profit from falling markets instead of just relying on the normal game plan of first buying shares at a low price and selling them later at a higher price.

Example of a short sale

Let’s say a trader believes Stock ABC, which is trading at $5 per share, will drop when the company announces its annual earnings in one week.

Therefore, the trader borrows 100 shares from a broker while short selling those shares to the market. So now the trader “shorts” 100 shares of Stock A which he did not own with hopes that the share price will decline.

A week later, Stock ABC’s price falls to $4 per share after the company announces annual earnings. The trader decides to close the short position, so he buys back 100 shares of Stock ABC from the open market at a price of $4 per share and returns those shares to the broker; this is a buy-to-cover order.

Therefore, the trader makes a profit of $1 per share which is a total of $100 for the whole transaction not including commissions and interest.

However, if the stock price increases to $7 per share and the investor decides to close the short position, he will need to buy-to-cover the 100 shares from the open market at the current price of $7 per share.

The loss for this short sale transaction will be $1 per share which amounts to a total loss of $200 (excluding commissions and interest), since the stock shares were bought back at a higher price.

What is required to be able to short sell

The process of shorting a stock is pretty easy, but you pay interest fees to do so. First, you need to find shares to short sell from your brokerage firm. You will need to be able to short sell them when their price is high and buy them back for a lower price.

You also need to have a margin account to be able to short. Not every broker offers margin accounts for short selling. Many entry-level brokerage firms don’t. Some cater more to professional investors and traders and don’t offer tools for more active trading.

In addition, you need to make sure that you are using a broker that makes short selling available for penny stocks. Some brokerages may block short selling for certain securities, including stocks under $5.

After you borrow the shares from the broker you can then proceed to place a sell order. Next, watch the price and chart action and wait for the share price to fall.

The final step is covering your position when the price hits your goals for the trade or a support level. Buy to cover to exit your position and give back the shares you borrowed to your broker.

Why you can short sell stocks under $5

There is so much misinformation on short selling stocks under $5. Even though short selling these stocks is perfectly legal, some brokers often tell traders that they can only short stocks trading above $5 discourage risky trading.

However, one can easily short sell stocks that trade under $5 since the SEC and the Financial Industry Regulatory Authority (FINRA) have not set any rules that bar people from engaging in this type of activity.

What to avoid when shorting stocks under $5

However, it’s important to point out that stocks trading through the pink sheet markets and on over-the-counter (OTC) markets have lesser regulations placed on them as compared with companies whose stocks are listed on the New York Stock Exchange or NASDAQ.

Therefore, stocks listed on OTC markets tend to be highly susceptible to fraud and manipulation.

So, the only penny stocks you should trade are listed on the NASDAQ or NYSE.

These stocks face stricter requirements to maintain compliance and thus are less likely to be fraudulent businesses. Trading pink sheets and OTC markets can be very unforgiving: It is like living in the wild, wild west!

Bottom Line

Short selling stocks under $5 can be a profitable venture.

But given the high degree of risk, short sellers have to be well informed and very careful to avoid stumbling into a stock that is about to move higher. So, short selling is not recommended for inexperienced traders.

While this strategy provides hedging opportunity and adds liquidity, it is better to leave it to sophisticated traders who have a higher risk tolerance, tons of research and deep pockets.