Penny stocks seem to be getting fashionable again. More and more people are trading penny stocks with the hope of getting rich quick. Whilst penny stocks can make you a lot of money in a short amount of time, there is also a huge risk of them making you bankrupt.
Shorting Penny stocks
Most traders who short stocks love to target stock that trade below $1. This is because most penny stocks will go to zero. A company’s stock becomes a penny stock when it is on life support. When it is grasping for air. And the odds at this stage favour a bankruptcy and a complete wipeout of the share price.
If you look at the the short interest (the percentage of the outstanding shares sold short) for penny stocks, you will often see the short interest at 30% or even higher. This indicates that many traders are betting on the demise of the company.
For a short seller, there’s nothing more enjoyable than watching a penny stock go to zero.
On the other hand… there’s nothing more painful than watching a penny stock rally 4,500% in 10 days. That action alone will wipe out years’ worth of profitable trades. And that is exactly what happened to people that shorted the shared of KaloBios Pharmaceuticals (KBIO) two weeks ago.
When Shorting Penny stocks leads to huge losses
At the beginning of November, executives of KaloBios Pharmaceuticals, a drug developer, announced that the company would be winding down operations and liquidating its assets. The company was running out of cash. There was no way for it to stay in business.
The stock dropped over 55% on the news, going from just over $2 per share to $0.90.
To many short seller, this was a dream. Here was a company that publicly proclaimed, “We’re finished. Our stock is worthless.” Yet, it was still selling for $0.90 a share.
This to short sellers is essentially free money. They could short the stock at $0.90, then just ride the position through the company’s liquidation and cover their trades for pennies.
But as you know the market is unpredictable and never makes ‘easy money’ simple to obtain.
As short sellers were shorting KaloBios Pharmaceuticals – selling stock they didn’t own with the hopes of buying it back later at a lower price – a consortium of investors led by Martin Shkreli was buying.
Shkreli is the infamous CEO of Turing Pharmaceuticals, who bought and then raised the price of Daraprim by a whopping 5,000%.
As the short interest of KBIO reached nearly 50%, the company announced it was in talks with Shkreli’s investment group for the terms of a possible cash infusion. That would keep the company alive a while longer. On this news, the stock jumped to reach a price above $16 per share.
Anyone who shorted the stock at less than $1 was now sitting on a loss of more than 1,500%. And the story gets worse for the short sellers!
Last Friday – the day after Thanksgiving which is traditionally one of the most illiquid days of the year – Shkreli’s investment group announced that it would not allow the shares it owned, which was now almost 70% of the outstanding float, to be sold short.
In effect, Shkreli’s consortium took possession of the shares it owned thereby limiting the ability of short sellers to “borrow” stock – which is necessary in order to sell short. As you can imagine, this action created a buying panic in KBIO shares.
What Shkreli did was entirely legal and it had the effect of reducing the outstanding float of KBIO shares to less than the number of shares sold short. Brokerage firms, by law, were now required to force short sellers to cover their trades and buy the stock in order to deliver the shares to Shkreli’s investment group.
This move sent the shares rocketing to a high of $45 per share.
The short seller, who shorted shares at $0.90 was now sitting on a loss of 4900%. On the other hand Shkreli’s investment group, which bought its majority position for about $1 million, was sitting on a $44 million gain.
The lessons learnt from the short selling nightmare
What happened to the shares of KaloBios Pharmaceuticals proved to be an absolute nightmare for the people selling this share short. A few lessons cane taken from this ordeal:
1) When it comes to the stock market, there’s no such thing as ‘easy money’ or a sure thing. Stocks that are a sure to go to $0 which are essentially on life support can recover.
2) When trading in illiquid stocks, they may not be a chance to get out of the market. You can see that you are losing money by the day but your are powerless to do anything.
When the KBIO shares umped from $0.90 to about $16, there was little opportunity for anyone to buy back the stock and close out the short position, returning it to the people from whom he borrowed the shares.
To understand why thesis the case, you need to know that the stock market is like an auction – you can go from [a} price to [c] price without ever seeing [b] in between. So if you are thinking about penny trading and say something like “I can always sell on the way down if things go badly”, you need to think again. By thinking this way, you make a significant assumption that the opportunity will be there; an assumption that displays a considerable ignorance about the mechanism through which prices are determined in the equity markets that can come back to harm them when they can least afford it.
3) No one is safe from manipulation
KaloBios Pharmaceuticals is a worthless company. It has no value, no viable products in its pipeline, and has virtually no reason for existence. It should go bankrupt. And, it will… eventually.
But in the short term, supply-and-demand pressures can influence the price. When Shkreli’s investment group refused to allow their shares to be loaned to short sellers, they significantly reduced the supply. And when short sellers were forced to cover, they jumped over each other trying to close their trades.
Those are the conditions that can send a $0.90 stock up to $44 in just a few days.
Shkreli’s actions were a blatant manipulation of the stock market. He targeted a stock with a high short interest, acquired a majority stake, and then issued press releases that would send the stock higher.
There’s little doubt that weeks from now we’ll learn that Shkreli’s group liquidated most of their “investment” in KaloBios Pharmaceuticals during this recent run up. And he’ll record a $44 million profit on a $1 million investment.
Meanwhile, the people that sold KBIO short – betting on a “sure thing” – got wiped out.
That’s just how the game is played.
That is why I stick to investing in good solid companies for the long term using my own money. I do not use leverage or buy on margin as a broker has the right to ask for their money back when they like. This could be detrimental to your returns even if your call on the stock turn out to be right in the end. Going long or buying stocks outright in good solid dividend paying companies is a better way to get wealthy over time on a risk adjusted basis.