The majority of new investors get introduced to trading via social media, mainly through Fitwit gurus. They tweet or alert a stock, and their prediction comes to pass most of the time. To someone starting out this can seem almost magical or unreal. But there is no magic involved here, only a deep fundamental analysis of why a stock is good. The most important part of fundamental analysis are catalysts which are for all intents and purposes what drives the stock to move. This guide goes over what catalysts are and how they can be utilized to maximize profits.
What is a stock catalyst?
Starting out, people are quick to ask ‘what is a catalyst in a stock market’ after exploring FinTwit and other investment forums. A stock catalyst is an event that notably affects the price per share of a company. Because the stock market is a reflection of current events, legislation, and even international relations, there are many things that can be a stock catalyst. But in general, some of the most common penny stock catalysts are uplisting, news, stock dilution, mergers and acquisitions, reverse splits, share reductions, dividends, financial disclosures, influencers, and short squeeze speculation. We will be going through these catalysts in detail later on in this article.
Like any event, they have a start and end date which is what gives traders a timeline to look for when planning their entry and exit points. However, what counts as a catalyst for one company may not mean the same thing for another depending on their industry. For example, catalysts for pharmaceutical stocks are more unique and include Investigational New Drug Applications (IND), clinical testing, and FDA approval. For this reason, pharmaceutical stocks move on binary events and may go a long time before a catalyst appears to push the stock. This means the catalysts in pharmaceutical stocks’ forecasts are sometimes even more important than in other forecasts.
How to find a stock catalyst?
Now that we know what catalysts are, we need to know where we can find these catalysts. Timing is everything in trading and finding something before anyone else does means you get in the stock at a preferential price. As difficult as it may be, an important part of trading is the almost constant need to monitor news and events to find stocks’ upcoming catalysts. Because stock catalysts can have positive or negative effects, some traders make a penny stock catalyst calendar to track upcoming events and time their trades based on this.
Surprisingly, some of the best places to find stock catalysts are social media platforms with a strong community of investors. Twitter is only one example and depending on the investor, they may have better luck using Reddit, StockTwits, Instagram, or Facebook. However, if you want to go to the source, almost all investors use the fundamental sources for stock catalysts which are companies’ financial filings, press releases, and national trends.
What is DD in stocks?
Before diving into the catalysts in detail, its important to cover another terminology you might come across, Due Diligence or “DD” as it is usually referred to. As with any investment, it’s essential to understand where your hard-earned cash is going. Doing comprehensive, detailed, research about a company using both qualitative and quantitative methods is how any trader minimizes the risk of investing. For this reason, “due diligence” is the responsibility of every investor since each individual’s financial decisions should be based on their own conviction. In short, the DD stock meaning is the obligation and act of doing research on each investment.
However, the investment community is apt to share their research with each other as they highlight the negative or positive aspects of investing in a stock. Other traders’ due diligence is useful information that should be considered and not ignored, but it should not be the only thing driving you to invest.
Getting Started…
Understanding what catalysts are, how they work, and when they end, will more often than not be the deciding factor between making a profit or booking a loss in your portfolio. With this in mind, here is a list of some of the most common catalysts affecting penny stocks and why. While this is by no means a conclusive list – it is a useful starting point for anyone diving into penny stock trading.
Uplisting
One of the biggest catalysts you might come across is uplisting. Very simply put, uplisting is another word for a company going through a tier change. This usually refers to a company moving from one exchange to a bigger one. So a company might move from the OTC Market’s exchange and list on national exchanges such as the NASDAQ or NYSE. The OTC Markets itself has three tiers which OTC companies regularly try to uplist to. As you may have surmised this is a bullish catalyst because these exchanges have strict financial requirements and companies are required to undergo audits in order to move up the tiers.
Penny Stock Tiers
It is important to understand the different penny stock tiers within the OTC Markets as each have their own requirements, the most basic of which is OTC Pink. This tier indicates that a company is fully reporting which means that investors are able to accurately measure the stock’s value and market share through up to date filings.
Next is the OTCQB which is the “Venture Market” known for its entrepreneurial and development stage companies. All OTCQB companies must have a minimum bid price of $.01 and are annually verified to retain this status. On the other hand, the OTCQX is usually reserved for international companies or those with a Market Cap above $300 million. The OTC’s “Best Market” consists of some blue-chip stocks from Europe, Canada, Brazil, and Russia. However, these foreign blue chip stocks are often overlooked despite their reputations domestically.
An example of this is AXP Energy Ltd. (ASX: AXP) (OTC: AUNXF). To better reflect its economic growth, AUNXF is currently preparing to uplist to the OTCQB. It appears AUNXF is looking to bring attention to both its OTC ticker and its counterpart on the Australian Securities Exchange. If it successfully uplists, the additional publicity could bring more liquidity to the company and help expose it to US investors.
Caveat Emptor
It’s worth noting that some companies are still in the process of becoming Pink Current, and a catalyst can be when a stock shifts from Pink Limited to Current or removes its Caveat Emptor. A CE is basically a designation put on certain companies by the OTC Markets Group if they believe it poses a potential risk to investors due to stock promotion, investigations of fraudulent activity, regulatory suspensions, disruptive corporate actions, and more.
When a CE is removed, it can have a tremendous effect on the stock as more traders are able to access it through their brokers. Also, this is the sign of a company beginning operations after falling into inactivity, driving a large part of the stock’s demand. Bell Buckle Holdings Inc. (OTC: BLLB) is an example of a run up following a CE removal. After releasing the news, BLLB witnessed a massive 492% increase overnight.
OTC vs Nasdaq
Overall, the OTC has less stringent reporting requirements than the NASDAQ and NYSE. As penny stocks, the companies listed on the OTC usually have Market Capitalizations of $300 million and below but there are also foreign companies – such as Samsung and Danone – which were able to access the US market by trading on the OTC. This is because the NYSE and the NASDAQ do not allow companies without headquarters in the USA and do not pay taxes here to list on their exchanges. Foreign companies that do not have the financial means to establish a presence in the USA or meet the $4 share price required can still access US investors through the OTC. Given that the uplisting process is lengthy and demanding, a company’s uplisting plans is typically a bullish sign for investors exploring a company’s growth potential. Not only is it a sign that the company will explore avenues to generate the capital needed for uplisting, but trading on the OTCQX or the NASDAQ can bring more visibility and liquidity to the stock as well.
News and Press Releases
Almost everything is affected by news and penny stocks are no different. While national events often affect demand for a stock, announcements from the company itself in the form of press releases have a notable effect as well. Communicative companies that keep shareholders abreast of operations and plans are useful because traders can find investment opportunities based on how the news can positively or negatively affect the stock.
Typically, investors watch for how earning reports, new personnel, initiatives, commercial campaigns, and product launches could affect buying pressure. In this way, penny stock news is a crucial catalyst which is why many investors watch for penny stock press releases that could signal a huge shakeup for the company.
An example of how global events can affect penny stocks is Ocugen (NASDAQ: OCGN). Ocugen stock news is especially important for this stock’s performance because it is waiting for approval for its Covid-19 drug – Covaxin. Depending on the Covid situation in the USA and Canada, OCGN stock could move quickly.
But investors should never discount the importance of good management. Bringing the former CEO of L’Oreal on board as CEO of Cannagistics, Inc. (OTC: CNGT) was a huge catalyst for the stock – triggering a 1,316% run on the news. So far, the stock has maintained 200% of its original gains because investors believe Jim Morrison adds significant value to the stock thanks to his connections and experience.
While share structures and low floats are not catalysts, its important to understand them thoroughly before explaining how certain catalysts affect the share structure and the stock by affect.
One of the first places to check while doing your DD is the share structure (SS) which is found under the OTC Markets profile with the tab for “Security Details”. First is the Market Capitalization which is the overall worth of the company, this is calculated by multiplying the total number of outstanding shares by its current share price – therefore it’s always in dollars. The Authorized Shares (AS) are the total number of shares the company is allowed to issue, but the Outstanding Shares (OS) are the number of shares out in the market. Deducted from the OS are the Restricted shares which are shares issued to the company’s management and usually held for a period of 1 or 2 years depending on the agreement. This prevents the company’s CEO or CFO etc. from selling their shares too early and diluting the stock. Meanwhile, the float is the total number of unrestricted shares not held directly or indirectly by an officer, director, any person who is the beneficial owner of more than 10% of the total shares outstanding, or any family members of the officers, directors and 10% control persons.
What are low float stocks?
Low float stocks are often highly sought after because of their ability to move rapidly with any catalyst. Again, when there is a smaller supply any uptick in demand can trigger the stock to move quickly – offering investors the opportunity to capture 100% or even 1000% gains in a penny stock’s run up. Thanks to Lee Pharmaceuticals (OTC: LPHM) extremely low float of 2.3 million, the stock saw a 224% run up after announcing its shift to the lucrative technology and security industries.
In general, if a stock has a float between 20 million and 250 million (many consider the 250 to 500 million range as relatively low), most traders would consider it a low float stock. Unlike the outstanding shares – which is only the total number of shares issued by the company – the float does not include shares held by institutions or restricted shares. This means that the float is subject to change depending on share buybacks or dilution.
How to find low float stocks?
Many traders will use scanners to find low float stocks, but it can be as simple as checking the security details of a company on its OTC Markets page to find a breakdown of the stock’s share structure.
Toxic Funding
This brings us to toxic funding also known as dilution. Its often called toxic funding because it is a way for companies to increase their capital but in a manner which negatively affects its shareholders.
What is stock dilution?
One of the first things to look for when considering trading a penny stock is share dilution. This is the act of changing a company’s share structure to add more shares – thereby increasing the float. Adding more shares to the market decreases the percentage that existing shareholders own resulting in a lower price per share (PPS) which more often than not triggers a sell off.
Imagine that a company has 100 shares and each person owns 1 share worth $1, that makes the company’s market cap worth $100. If the company issues another 100 shares, the company’s overall value remains the same because just issuing more shares does not add value, but the original shareholders will see their investment halved making each share worth $.50.
One company that has suffered as a result of dilution is IFAN Financial, Inc. (OTC: IFAN). IFAN witnessed a 94% decrease in its PPS since the start of October thanks to months of dilution. The stock’s accumulation also suffered as shareholders gave up hope on the company’s management.
Unconfirmed dilution concerns can also create enough panic to cause investors to sell off. One example of this was HUMBL, Inc. (OTC: HMBL) which experienced a brief sell off thanks to rumors that the company’s CEO and Co-Founders sold their Series B preferred shares. Once the management team clarified that this was not the case, HMBL recovered from the dip.
Why does stock dilution happen?
What makes dilution especially hated by traders, is that companies tend to dilute at the height of a run i.e when the stock price is deemed to be at its highest value, this gives the company the best opportunity to raise capital. Sometimes this is referred to as an offering and this can be beneficial for the company in the long term because the cash raised can improve operations, fund acquisitions, as well as other activities that will help the company grow. However, in the short term most people abandon their positions as they do not want to hold the stock long term or do not trust that the company will use the funds efficiently. This is especially common with penny stock companies with laxer regulations and audits.
On the flip side, an offering sometimes can be a positive catalyst for blue chip companies like GameStop Corp. (NYSE: GME) whose management was trusted to utilize the cash from an offering to grow the company and clear its debts.
Because dilution happens when the company issues shares, it will affect the share structure and can be done in several different ways. This change in share structure can occur when the company moves shares from the total number of Authorized Shares to its Outstanding Shares which adds to the supply of tradable shares thereby dampening demand. A company’s share structure is a very important aspect to consider when looking for investment opportunities because based on the number of Authorized and Outstanding Shares, there may be little room for dilution caused by moving shares from the AS – creating a tight SS. Shares can also be added to the unrestricted Outstanding Shares when a company releases some of its restricted shares after a certain period.
But an important form of dilution is also share issuance through convertible notes. Dilution often occurs when convertible note holders redeem the value of their note on the open market. Because note holders are typically the company’s lenders – who agreed to the loan with a number of shares specified as collateral – once the note reaches its maturity date the noteholder will have the opportunity to collect on their original loan.
It’s in the noteholder’s best interest to redeem their note when the PPS is high to maximize their gains which is why runs can be abruptly halted by convertible note redemption. To learn how to use dilution and convertible notes in your trading strategy read our guide here.
Mergers and Acquisitions
Two of the most common catalysts people encounter while penny stock trading are mergers and acquisitions (M&A). One of the reasons why these catalysts are so common is because they are an easy way for companies to add value to their operations through additional revenue, intellectual property, and other assets.
Mergers vs Acquisitions
Merger transactions are often paid for through a combination of shares and cash. Meanwhile, an acquisition is essentially the takeover of one company by another. The main difference between a merger vs. an acquisition is that an acquisition is initiated by a company that is financially stronger than another which it acquires by purchasing more than 50% of its shares. Both are usually preceded by a Letter of Intent or LOI which – like its name says – is an agreement announcing both parties’ intention to complete either a merger or acquisition.
However, it usually takes several months to finalize an M&A as companies perform due diligence and financial audits. During that time, the company will learn as much as it can about its merger or acquisition target to reduce risk and negotiate terms.
How mergers and acquisitions news affects a stock?
After the release of mergers and acquisitions news, the stock could see higher than average trading volume and/or an increase in the stock’s price. But it could be a bumpy ride depending on how long the final negotiations take. After the merger is complete, the stock will typically be valued higher than pre-merger because of the additional value the acquisition brought to the company. This is why it’s useful to keep up with upcoming mergers and acquisitions 2022 to prepare for these catalysts.
An example of how this due diligence can pay off is JPX Global, Inc.’s (OTC: JPEX). Investors who have monitored its merger progress have profited along the way as anticipation for the merger caused a 463% increase from September into October. At the time of its official merger announcement, JPEX stock reached 4 cents and continues to trade around 3 cents thanks to the value the merger is expected to bring to the company.
On the other hand, Sphere 3D Corp. (NASDAQ: ANY) is working towards a reverse merger with the green crypto miner – Gryphon Digital Mining. Waiting on a shareholders’ meeting, the stock is currently trading at $2.06, but could be valued much higher once the merger is complete.
But SMC Entertainment Inc. (OTC: SMCE) is an example of how acquisitions can benefit a company. Thanks to its acquisition of Genesis Financial Inc. for $45 million, SMCE gained control of Genesis’ subsidiaries – Ballast and Financial Link – which had combined gross revenue of almost $15.7 million and a derived EBIT of a little over $1 million. The acquisition also positioned the company in Australia and SMCE gained Genesis’ 120 financial consultants and advisors in the process. This example demonstrates how a growth by acquisition strategy can bolster a company by bringing new assets on board.
Reverse Stock Splits
Reverse stock splits (RS) have become less common among OTC stocks as more and more institute clauses preventing reverse stock splits for a period of time thanks to shareholder demands. However, reverse stock splits are definitely perceived as negative catalysts which could dramatically affect penny stocks as opposed to large cap stocks.
What is a reverse split?
When a company executes a reverse split aka a forward split it is essentially dividing the total number of outstanding shares by a number – anywhere from 2,5,10, etc. – to reduce the total number of tradable shares. Halving the number of shares available increases the value of each individual share, but reduces an investor’s total number of shares.
For example, if you own 400 shares valued at $1 each and the company did a 1: 2 reverse split, that would leave you with 200 shares valued at $2 per share. In this way a reverse stock split means almost exactly as the name implies – rather than splitting the shares apart, the shares are being combined to create higher-value shares. If a shareholder owns an odd number of shares, they may be cashed out by the company as compensation.
Is a reverse split good or bad?
While this does not result in dilution, it is something which investors avoid because it inflates the stock’s value without creating any real, underlying value. However, companies often do a reverse split in times of distress to keep the PPS high or as a way to meet a national exchange’s higher PPS requirement.
The General Electric reverse stock split is one example of how large-cap stocks use reverse splits. As GE explained at the time, “The purpose of the reverse stock split is to reduce the number of our outstanding shares of common stock, and to increase the per share trading price of our stock to levels that are better aligned with companies of GE’s size and scope and a clearer reflection of the GE of the future, not the past”. This why in July of 2021, the company effected a 1-for-8 reverse stock split which caused its shares to trade above $100 or 8 times their original value. For GE this move was intended to make to make the stock more attractive to institutional investors, but it also affected how retail investors traded the stock because fewer traders were able to afford the higher PPS.
Dividends
How does a company thank its shareholders? One of the most basic ways a company can reward long-term investors of its stock – besides quarterly growth – are dividends. While its rare that penny stocks provide dividends, they are definitely catalysts which investors watch for and take into consideration when planning their trading strategies.
What are dividends?
Dividends are simply a share of a company’s profits which are distributed to its shareholders. Occasionally, a company will decide to reward its shareholders during a prosperous quarter by announcing a dividend. Well-established companies with predictable profits can provide dividends more regularly than emerging companies. Stocks that pay monthly dividends are definitely appealing to investors, but dividends are typically not that consistent.
How do stock dividends work?
First, a dividend will require the Board of Directors’ approval and input as to when the dividend will be released and to which class of shareholders it will be rewarded to. Based on this, the initial announcement will include when the dividend will be executed and specify how long investors must be shareholders to be eligible.
For example, Tytan Cybernetics (OTC: NIHK) announced a special one-time dividend of 439,097,990 shares of its stock for both common and preferred stockholders. Stockholders of common stock received 1 additional share of its acquisition Drone Guarder, Inc. (OTC: DRNG) for every 10 shares owned.
After the initial dividend announcement, the stock may spike in anticipation, however, because money is essentially leaving the Treasury to pay for the dividend, the stock will often decrease after the ex-dividend date.
Typically, OTC companies will commit to dividends using its subsidiaries’ shares rather than cash dividends. One example of this is Global Fiber Technologies Inc. (OTC: GFTX) which recently outlined its plans for a shareholder dividend through its two subsidiaries EcoTek 360 and FiberChain.
Investors looking to capitalize on dividends must be mindful of the ex-dividend date aka the last day a shareholder can buy the stock to be eligible for the dividend. But one thing to consider before investing, is why the company is issuing a dividend in the first place.
Why do stocks pay dividends?
Besides rewarding shareholders, a dividend can be one way to encourage current shareholders to increase their investments or attract more investors. When a company provides a dividend using its subsidiary’s shares this can be a method for creating publicity for the stock as well.
Some investors believe that long-term it’s better for companies to invest their profits back in themselves to foster growth rather than hand out profits in the form of dividends. On the other hand some investors practice “dividend investing” which means they rely on companies that regularly release dividends such as Apple (NASDAQ: AAPL) to generate capital for living expenses or trading.
For penny stocks, dividends are almost always one-time events that offer shares of the company’s subsidiaries as a way to attract more investors to the parent company. In this way, dividends serve as an advertisement for investing in the company rather than a reward for its shareholders.
What stocks pay dividends?
Usually only well-established companies trading on the NASDAQ or NYSE pay recurring dividends but this is not always a reliable source of income because companies may cut their dividend plans in the case of financial hardship. A well-known example of this is General Motors which canceled its annual dividend in 2020 due to the pandemic. Previously it had paid an annual dividend of $1.52 per share and the cancellation was expected to save General Motors upwards of $1.6 billion.
This illustrates that when high-yield companies face recessions, supply chain issues, or an unexpected disaster like the Covid-19 pandemic, their financials can crumble – leading them to cancel quarterly dividends. Therefore, dividend stocks with a solid income and a positive growth outlook are the best bets for dividend investors.
Possibly one of the best catalysts out there are share reductions and share buybacks because they have short and long term benefits for the stock. Its common for penny stocks to undergo share reductions because of changes to their management structure, dilution, and their many years of operation which often leads to improperly issued shares or shareholders who can no longer be contacted.
Just as the name implies, a share reduction occurs when the company takes back issued shares – reducing the OS. This does not add shares to the AS, but merely reduces the number of shares available to buy and sell. When the number of tradable shares is reduced, there is less supply but there is also greater demand because the share reduction will make the company more attractive to investors.
At the moment, Aqua Power Systems Inc. (OTC: APSI) is pursuing a share reduction of roughly 32 million shares which belonged to the company’s former CEO who abandoned the company. Since then APSI’s new management has been unable to contact him and is going through the court to finalize the retirement of his shares.
Depending on the number of shares reduced, share reductions can have a dramatic affect on the stock. Not only does anticipation for the reduction encourage higher than average volume, but it also reduces the stock’s float.
A share buyback is exactly as it sounds – an instance where the company buys its own shares back from the shareholders. If the company believes its shares are undervalued at the current price, they could buy them back at a fixed price which effectively reduces the number of outstanding shares and float.
A share buyback is a sign that the company sees itself as undervalued but they usually occur at a time when the economy is strong or during a period of strong cash flow. Typically, as share buyback announcement will buoy the stock, but it can expose the company to financial risk in the long run because the company is spending money to buy its shares.
After a series of announcements, One World Universe Inc. (OTC: OWUV) excited investors even more when its CFO announced plans to buyback approximately 5 million shares before the end of the year – sparking a roughly 1,342% run in December. Since then the stock has consistently traded at a higher price level compared to before the buyback.
Financial Disclosures
As all publicly listed companies are owned by the ‘’public’’ they are legally required to disclose their financials to the public. This is why all the information you need regarding a publicly-traded company’s financial position can be found in its quarterly reports (10-Q) and annual reports (10-K). The OTC Markets shares these disclosures on its website but they can also be found on the SEC’s filing tracker.
The main difference between an annual report and a quarterly report is that the 10-K is more comprehensive – outlining the company’s business model, risks, stockholders’ deficit, cash flows, and other financial statements. Some of this information is not included in the 10-Q which looks at the company’s financial position in that quarter alone. A 10k is released at the end of the companies’ financial year and includes the 4th quarter results.
How to read quarterly reports:
Key things to look for in the annual and quarterly reports are the company’s cash on hand, revenue, profit, assets, convertible notes, and net operating loss. Comparing these metrics to the company’s performance in previous quarters is a way to identify stocks that are showing solid financial growth. These reports are also useful for identifying whether the company has a history of dilution because the share structure is reported in each filing.
Breaking down where cash is allocated will tell you whether this company is spending its money wisely. If the biggest operational expense is salaries – this is a bad sign. Instead, companies should be showing quarter over quarter (QOQ) or year over year (YOY) growth in terms of revenue, profit, and cash on hand.
But no investigation is complete without noting who owns shares in the company. If a company’s officer such as its CEO or CFO holds a large number of shares that were not issued as payment, then this is a positive sign. Because officers have intimate knowledge of what the company’s future plans, if the filings show heavy insider ownership – then many traders will read this as a positive catalyst for the stock as it shows the management has faith in the company and expect it to grow in the future. Similarly, if it reports institutional investors such as Wells Fargo or Goldman Sachs, then this is an indication that their very well paid analysts see promise in holding shares in the company. Occasionally, well-known entrepreneurs or investors hold shares in a penny stock company which could be a sign that it won’t be a penny stock for much longer. You can check whether insiders have bought or sold shares using websites like this but the insiders holdings are also reported in the quarterly filings.
In the case of Marpai Inc. (NASDAQ: MRAI) the company’s heavy inside ownership was one of the driver’s for the stock following its IPO and quiet period ie. a period of time during which the company’s management and marketing teams cannot share opinions or additional information about the company. In December, the company’s CEO bought 17,500 common stock shares of MRAI at an average PPS of $4.2 for a total investment of $73,500. Only a few days later, the company reported other share purchases from MRAI’s management including 25,000 shares purchased by the company’s co-founder, 5,000 shares bought by its CFO, and 5,730 shares purchased by a member of the board. The total $1.1 million worth of MRAI common stock was purchased for between $4.17 to $4.42 per share. This means that insiders owned 31% of the total shares.
Setting a precedent by holding such a large number of the outstanding shares indicated that the company had big plans ahead of it which it could not disclose during the quiet period which helped sustain the stock after its IPO.
Lastly, the 8-K form is a useful tool for keeping track of a company’s major events that could affect shareholders. Under SEC rules, every company is required to file an 8-K in the case of acquisition, bankruptcy, or changes in management.
It’s easy to see how the release of any of these documents could be a catalyst for investors eagerly waiting for the next update on a company’s performance. If the 10-Q shows positive Q-O-Q growth, then the stock could see an uptick based on investors’ optimism. However, poor results could have an adverse effect on the stock – though this is often muted in penny stock companies.
Short Squeeze
Most traders have heard of short squeezes thanks to their popularity following the AMC short squeeze, Volkswagen short squeeze, and GameStop short squeeze which collectively shook hedge funds. For GameStop (NYSE: GME), short interest had reached 100% of the outstanding shares and the following short squeeze caused GME to skyrocket from $5 to $325 over less than six months. However, these short squeezes were only possible because of a high degree of coordination between retail investors via Reddit’s Wallstreetbets community.
This has made Reddit short squeezes one of the most looked for catalysts among investors because the biggest short squeeze in history came from this forum. Now, many investors use a short squeeze scanner or short squeeze screener like Fintel’s to identify the short squeeze potential of different stocks. With so many investors watching for the next short squeeze candidate, even the potential of a stock becoming squeezed can bring tremendous attention and volume to the stock.
What is shorting?
Before diving into how short squeezes work, its important to first understand shorting. Unlike investors who take a “long” position hoping that their shares increase in value, investors who are “short” will only profit if the stock’s value decreases. For example, an investor borrows shares in a company through their broker, predicting that X Company will see a decline for some reason. This investor shorts the stock by selling their shares at market price to a buyer with the expectation that they can buy back their shares to return to the broker at a lower price. This means that if they borrowed the shares at $10 and sold them at $10, they will then buy the shares back at only $5 – giving them a $5 profit when they return the shares to the broker.
However, if they bet wrong and the stock increases in value, then they will lose money by buying the stock back at $15 or higher in order to return the shares to their broker.
It is worth noting that retail investors are not allowed to short OTC stocks.
What is a short squeeze?
Essentially, a short squeeze begins when a group of investors – usually hedge funds which have the capital to short a stock on a significant level – take a short position. This means that they are betting the stock will decrease in value due to a flaw in its business model or a natural disaster. For example, GameStop was shorted by hedge funds because its business model was not adapting to modern technology. This led to store closures and declining financials which hedge funds used as a way to make money.
How does a short squeeze work?
This opens the door to a short squeeze because investors who notice increasing short interest on a stock can then band together in order to invest in the stock – driving the share price higher. As the stock increases, the shorts will be forced to cover or return their borrowed shares within the limited timeframe of their agreement. When shorts cover their positions, the share price will increase even more because they are purchasing shares at the now higher price.
If there is enough short interest and coordination among investors, this can create a cycle driving the share price higher and higher. Hedge funds might have the capital to outlast a short squeeze based on the premise that the stock will eventually fall once the short squeeze loses momentum. If their underlying theory for shorting the stock is accurate, then there is even greater motivation for them to hold out their short position.
One of the best examples of how retail investors use short squeezes against hedge funds is the AMC Short Squeeze Saga which has made the term very popular among investors. Rising short interest can be a catalyst for a stock as a result. However, it’s important to recognize that short squeezes are actually quite rare because they require a great deal of coordination and determination. More often than not, hype regarding a short squeeze fizzles out into nothing.
For penny stocks this is especially true because – unlike small cap or big board stocks – in reality there are very few investors shorting penny stocks. There are some boutique hedge funds that are able to short penny stocks, but due to the incredible volatility of penny stocks, shorting a penny stock will almost always return a profit in the long-run.
However, for larger stocks such as Tesla (NASDAQ: TSLA) this can have incredible outcomes. Because the company was relatively new and had a poor financial record in 2020, short sellers were betting heavily on its failure – making it one of the most-shorted stocks in the history of both exchanges. Over 18% of its outstanding shares were shorted, but the company surprised investors thanks to its innovative approach to electric vehicles which led the stock to increase 400% over only a few months. As a result, short sellers collectively lost almost $8 billion. But the tables turned in their favor in March 2020 when TSLA fell with the market – giving a $50 billion pay off to short sellers over a few days.
TSLA’s story illustrates how risky short squeezes can be and why these moves are best done when there are clear catalysts or logic behind them. A short seller’s loss is theoretically infinite because the stock can continue increasing in value but it cannot go below $0.
Influencers
At first, it might be easy to overlook the importance of stock market influencers, but in the social media age their role is undeniable. When an influencer on FinTwit shares DD about a stock with their 100 thousand followers – there’s a high probability that a few of them will buy shares. This is especially true when they alert a stock from within their trading group.
One of the most famous “furus” is @MrZackMorris 597.6 thousand followers to-date.
The FinTwit community is essentially a sample of the overall market sentiment and if several influencers are regularly posting about a stock, there is likely significant momentum driving the stock. While this kind of catalyst should not be overlooked, it does present some risk because it’s difficult to know when momentum will die out – potentially leaving you holding the bag.
Conclusion
The first step to start penny stock trading is understanding the catalysts that move stocks, while there are more catalysts which can affect penny stocks this guide has given you a helpful starting point. Reviewing everything from short squeezes and uplisting to dilution and more, will prepare penny stock traders to capitalize on the news rather than lose out on it.
Using these catalysts, penny stock traders can time their entry and exit points to avoid becoming a bag holder. But searching for these catalysts should be a part of every trader’s due diligence because it will help minimize the risks associated with trading – to learn more about how to do your due diligence read our guide here.
We hope this guide has provided some useful strategies to incorporate into your own techniques as you become a better trader day by day.
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