Why Shorting a Penny Stock Is a Bad Idea

If you play Motley Fool CAPS, you might be forgiven for thinking that CAPS stands for “crush all penny stocks.” What is CAPS? It’s this amazing free tool at the Motley Fool. It works like this: You pick stocks that you think will beat the market. And the CAPS software measures how your stock pick does versus the S&P 500.

Almost 60,000 Fools have been playing CAPS for almost 15 years now. One of the things that CAPS has taught me is that if you buy and hold fast-growing innovative companies (i.e. Rule Breakers), you’ll be wrong a lot. But your winners will absolutely kill the market, and overall you will, too. So definitely you should play CAPS, and test your stock calls against those of all the others in the Fool universe.

image source: Getty Images.

But there is one danger in CAPS that I want to highlight. In CAPS, some of the very best players have gotten to the top by shorting awful micro caps. Is that the best strategy in the actual stock market? No! In fact, it’s a horrible strategy. Here’s why.

1. Money, money, money, and money

In CAPS, we’re just giving our opinions about what stocks are going up and what stocks are going down. So in that universe, where it’s just ideas, the very best investment plan is to short awful penny stocks while simultaneously going long on the S&P 500. That’s absolutely the best winning strategy. CAPS has proven it. 

But CAPS is a game that measures our opinions, whether we are right or wrong on a stock. In real life, we’re investing dollars. And the introduction of money changes the dynamics of whether your opinion is right or wrong. 

That’s because of the way a “short” is structured. You’re not just giving your opinion that a company is bad and its stock is going down. You’re simultaneously going into debt in order to short a company. You’re borrowing the shares from your brokerage. And now you owe your broker money.

It’s the debt that makes shorting a dangerous strategy. You owe your brokerage money now, which makes you vulnerable. You have an obligation to pay back this debt. If the stock goes up, your broker will ask you for more money. If you can’t come up with the money, your broker will close out your position at a loss. This common maneuver, known as a short squeeze, happens every day.

2. Penny stocks are thinly traded

Penny stocks are horrible investments. Once in a blue moon, a micro cap will emerge from obscurity and give you a truly amazing return. I had this experience with Novavax (NASDAQ:NVAX) in 2020, which was a lot of fun. But it was a highly risky stock, and so my position was tiny at first.

At least Novavax was trading on a major exchange. (It had to do a 20-for-1 reverse split to stay up there!) The company wanted to avoid delisting because that is usually the kiss of death. Most investors stick with the New York Stock Exchange and the NASDAQ, and avoid the pink sheets except when buying an ADR of a major foreign company. Sometimes you will…