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Tuesday, December 1, 2015
Most penny stocks will go to zero.
That's why short sellers love to target stocks that are trading below $1. These are companies that are usually on life support. They're gasping for air. And the odds favor a bankruptcy and a complete wipeout of the share price.
Just look at the short interest (the percentage of the outstanding shares sold short) for many stocks trading below $1. You'll often see the short interest at 30% or even higher. That indicates a lot of traders are betting on the demise of the company.
For a short seller, there's nothing more enjoyable than watching a $0.90 stock go to zero.
On the other hand... there's nothing more painful than watching a $0.90 stock rally 4,500% in 10 days. That action will wipe out years' worth of profitable short trades. That's what happened to anyone who was short shares of KaloBios Pharmaceuticals (KBIO) two weeks ago.
Here's the story...
In early November, executives of drug developer KaloBios Pharmaceuticals 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 fell more than 50% in the news – dropping from just over $2 per share to $0.90.
It was a short seller's 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.
To many short sellers, that was 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, the market never makes it that easy.
As short sellers were piling into KBIO – 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. That's the company that bought the rights to Daraprim – the treatment for the rare parasitic infection, toxoplasmosis – and then raised the price of the drug by 5,000%.
No one suspected he would do the same thing for shares of KBIO.
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. And the stock shot as high as $16 per share.
Anyone who shorted the stock at less than $1 was now sitting on a 1,500% loss. But that was just the beginning.
Last Friday – the day after Thanksgiving, and 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. It would take possession of its shares, thereby limiting the ability of short sellers to "borrow" stock – which is necessary in order to sell short.
This action created a buying panic in KBIO shares.
Shkreli's action – which was entirely legal – reduced 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.
So, if you were watching the stock ticker on CNBC or FBN last Friday, you probably saw KBIO cross the tape as high as $45 per share.
Shkreli's investment group, which bought its majority position for about $1 million, was sitting on a $44 million gain.
Meanwhile, the average rational-thinking short seller was dealing with a 4,400% loss.
There are a couple of lessons here...
First of all, when it comes to the stock market, there's no such thing as a sure thing. Stocks that are on life support can recover.
Also... and maybe the most important lesson here... no one is safe from manipulation.
KBIO is a worthless company. It has no value, no viable products in its pipeline, and 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 KBIO during this recent run up. And he'll record a $44 million profit on a $1 million investment.
Meanwhile, folks who sold KBIO short – betting on a "sure thing" – got wiped out.
That's how the game is played.
It's not right. It's not moral. But it's not illegal either.
So if you have a spare million dollars just lying around, you might consider doing something similar. Find a stock with a large percentage short interest. Buy up a majority stake in the company. And then take possession of your shares – thereby limiting the amount of shares that can be sold short, and kicking off a huge short-covering rally.
You could turn $1,000,000 into $44,000,000 in less than two weeks.
Frankly... I'm not sure how to feel about this.
I admire the ingenuity of Shkreli's trade. He spotted a flaw in the system and profited well by exploiting it.
At the same time, though, I feel the pain of the short sellers who were right in their analysis but wrong in their execution.
It reminds me of one of the first short sales I made in my career. It was a company called Taylor Gold. The company claimed to have a process that could turn sand into gold. It was a ridiculous claim, and shorting the stock should have been the easiest trade ever. So I shorted the stock at just less than $3 per share.
Two days later, I stopped out of the trade when Taylor Gold gapped above $9 per share. My brokerage firm informed me the stock was no longer available to be borrowed, and I would have to cover my trade. It was a brutal loss to take. But, it was much less than what it could have been.
The stock was at $24 one week later. There was no way I could have handled that sort of adverse move. So I was happy to have covered my short trade for a 200%-plus loss.
Six months later, the stock was trading for less than a penny.
Like I said, the market never makes it easy.
So as our current, seven-year long bull market starts to run out of energy and the bear starts to take over – something that I suspect is happening right now – short sellers still need to be cautious. There's no such thing as an easy trade.
All the logic in the world can't prevent a short squeeze on a bankrupt company like KBIO. There are other influences that can send the stock higher.
So despite your conviction that a stock is headed lower over time, you still have to be aware of the risk/reward equation.
There will be plenty of opportunities to profit on the short side as the coming bear market takes hold. But, traders need to be aware of ALL of the potential risks to a short position. Market manipulation runs rampant in heavily shorted stocks.
Best regards and good trading,
Catch up on Jeff's latest essays right here:
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