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Why Can’t I Short Some Penny Stocks?

Why Can’t I Short Some PennWhy Can’t I Short Some Penny Stocksy Stocks

 

Many traders check the daily gainers & losers list in their screener and find an overhyped penny stock that could be a favorable short-selling opportunity.

But when they go to short the stock, their broker frustratingly stops them in their tracks, leaving the trader asking “why can’t I short some penny stocks?” 

The short answer is because your broker can’t find shares for you to borrow.

There’s several reasons for why this can happen, which we’ll detail in this article.

To fully understand why you can’t short some penny stocks, we need to understand the mechanism of short selling in the stock market.

When you sell a stock short, you’re selling shares that you don’t actually own. That might seem strange, that you’re able to sell something you don’t own. You might ask: “isn’t that like creating new shares?”

But it’s completely normal, you’re simply temporarily borrowing the shares from someone who owns them.

You sell them upfront and then buy them back later to return the shares to the rightful owner. If you make a profit in between, you made a good trade. 

Here’s roughly how the process works, although this is automated nowadays. You’re not going to be calling your broker to arrange locates. 

  • You decide you want to sell stock XYZ short
  • You call your broker to locate shares of XYZ so that you can short them.
  • Your broker calls Mutual Fund A, who owns a large block of XYZ, to see if they can loan you some. The Mutual Fund agrees to lend you the shares at a 0.5% interest rate.
  • You now have your locate and can sell the stock short

Your Stock is on the Hard-to-Borrow List

You can break stocks into two tiers when it comes to short selling at US-based brokers: easy-to-borrow, and hard-to-borrow.

Easy-to-borrow are stocks like Apple (AAPL) or Johnson & Johnson (JNJ). There’s almost always plenty of shares to borrow and you don’t need to manually locate them. When you try to short sell them, it’ll be like you’ve already borrowed them. 

You need to locate hard-to-borrow stocks manually. Usually it’s as simple as typing in the ticker symbol and the number of shares you want to short into their locate screen which is usually tucked away in a menu within their trading platform.

The problem is that they’re called hard-to-borrow for a reason, because it’s hard to borrow them, and hence, sell them short. 

You can think of borrowing stocks as a market in itself.

Because you need to pay an interest rate when you borrow shares to short sell, there’s a supply and demand mechanism in the borrow market. When everyone wants to short the same low-float stock at the same time, there’s simply too much demand and too little supply. 

When you’re having trouble borrowing a hard-to-borrow stock, there’s two possible scenarios: (1) your broker has bad locates, or (2) everyone has bad locates and nobody can get locates on the stock. 

You can partially overcome these issues by using brokers that are more specialized in locating hard-to-borrow stocks. We’ll get into that in a later section. 

Why Are Some Stocks Hard-to-Borrow?

The short answer is supply and demand.

Just as everyone buying Bitcoin pushes the price up, everyone wanting to short the same stock at the same time makes it hard to borrow because there are few shares available to borrow.

This usually occurs in stocks with a low public float.

A stock’s float is the amount of shares circulating on exchanges that have no restrictions attached to them. Think of the situation where a stock with a low float that never moves suddenly has breaking news. The trading population of the stock just multiplied several times with the same amount of shares circulating.

So there are few shares to go around. It’s not uncommon to see a stock trade multiple times its float in daily volume when it has huge breaking news. 

Of course, when there are few shares to go around, there are few shares to borrow. And if you don’t have a fancy high-net worth account open at a prestigious bank like Goldman Sachs, chances are you won’t see the locates 

Your Broker Won’t Allow You to Short the Stock

Brokers manually restricting their clients from buying or selling certain stocks has become much more common in 2021 with the advent of the insane short squeezes in stocks like GameStop.

In the age of meme stocks, there’s a much higher risk of you blowing out your account and owing money to your broker when shorting a hyped up stock, so sometimes brokers feel it necessary to not even allow you to short it. 

When you’re shorting a stock, you’re borrowing the stock from your broker, making your broker your creditor. They’re under no obligation to extend you credit to take big risks shorting penny stocks, just as you’re under no obligation to continue giving them your business.

There’s a key distinction between brokers cutting off customers from buying cash-secured positions in a meme stock, and from extending customers credit to short that same stock. 

In this situation, your only choice is to use a different broker. If you regularly short penny stocks, you probably already have multiple brokerage accounts open. 

How To Get Locates on Hard-to-Borrow Stocks

The simplest way to get locates on hard-to-borrow stocks is to use a broker that specializes in the practice. Stock lending is still a relationships business, and retail brokers that don’t develop their lending desks won’t have the best borrows.

Here’s a few brokers that penny stock traders typically praise:

However, you get what you pay for.

Not only do these brokers have higher than average minimum deposits (usually starting around $25,000), but they charge more for their services. Expect to pay around $0.004/share in commissions unless you do a lot of volume, and pay a monthly fee for a trading platform. 

Another method is to have accounts open at several mainstream retail brokers like Schwab, TD Ameritrade, ETrade, etc. This is a power in numbers game.

While none of these brokers has good locates on hard-to-borrow penny stocks individually, combining their locates will sometimes get you locates you thought you couldn’t have. Make no mistake though, penny stock traders are not the target customer of these brokers and their poor locates reflect that, so don’t expect too much. 

One more method is to join a proprietary trading firm, which usually has a prime brokerage relationship with a top bank, ensuring much higher quality borrows than retail brokers.

Bottom Line

It’s frustrating to be ready to make a trade only to be stopped in your tracks, greeted by that “HTB” indicator in your trading platform. But, you know what they say, “the enemy of art is the absence of limitations.”

It might sound weird, but sometimes having roadblocks in the way can help you stay patient.

If you’re used to finding trade ideas and not taking them, it’ll stop you from impulsively slamming your hotkey as soon as the chart looks interesting.