Most investors look to invest in companies that they believe will rise in value, whether it's due to changes in market sentiment or improved financial results. However, contrarian investors choose to look not for companies that are undervalued, but for companies that are overvalued. Sometimes, the so-called short sellers will turn to penny stocks, for which they will purchase put options.
Penny stocks, which generally refers to stocks whose share price is under $1, are often sold off a regulated exchange, giving them a reputation for being the wild west of the investment world. This is because many of the companies issuing these stocks do not have the same type of regulation that companies issuing stocks on regulated exchange do. However, while penny stocks can offer the investor the chance to make a value, it may make more sense to bet against them.
The best way that an investor can bet against a penny stock is by short selling it. This means that the investor sells a put option on the stock, one that gives him the price to sell the stock at a given price on a certain date. When the option matures, if the price of the stock has fallen, then the investor nets a profit.
It is often more difficult to short sell a penny stock than it is to short sell a blue chip stock sold on a regulated exchange. This is true for two reasons. First, many investors have little faith in penny stocks and therefore will not be willing to purchase an option from a short seller. Second, because penny stocks are often unregulated, investors may believe that the short selling is part of a scam by the company to short itself and make money by going bankrupt.
In some cases, a person may wish to short sell a penny stock, but he will be unable to find a buyer for the option. In addition, a person may not be able to short sell a stock that is priced too low. This is because the stock may be so low and there may be so few shares available that the transaction cost of buying the option would cut too deeply into any potential profit.
- "Investing For Dummies"; Eric Tyson; 2008
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