Shorting

This article is an abstract of the book:
The Complete Guide to Daytrading

There are some important points you must know before you short a stock. Shorting means selling a stock when the seller doesn't own the security. You may short a stock if you believe the stock price will drop, and then buy back the stock later at a lower price. This is called covering your position. This way you can make a profit if a stock price is going down.

You can't short stocks as easily as you can buy them. If you short a stock, your broker must lend you the stock for the time you are short and the broker himself must borrow the stock. Brokers therefore provide a list of stocks which are available for shorts. Stocks which are not on the list can't be shorted.

Some brokers haven't many stocks available for shorts, while others have long lists of them. If you are interested in executing shorts in many different stocks you should pick a broker who has a lot of shorts available. The shorts list changes every day and the number of shares a broker has available for shorts also varies.

Down-Bid Rule
You can't short a NASDAQ stock on a down-Bid because of the NASD Short Sale Rule. This rule prohibits short sales in NASDAQ National Market securities at or below the inside Bid whenever that Bid is lower than the previous inside Bid. The rule does not apply, however, to securities traded on the NASDAQ SmallCap Market or the OTCBB. When trading NASDAQ National Market securities, you must wait for an up-Bid, which means the Bid must be higher than the previous one. You can short on a down-Bid only if you enter a short order at least 1/16 above the inside Bid.

Your order execution software usually shows you if a stock is on an up-Bid or a down-Bid, most likely with a red (down-Bid) or a green (up-Bid) arrow somewhere in the Level II window. If the stock is a NASDAQ SmallCap Market or a OTCBB security, you are allowed to short on a down-Bid, in which case the tick arrow is black.

You can't usually violate the short sale rule because your order will most likely be rejected by your software. To get a "legal" short on a down Bid you must enter the trade at least 1/16 above the inside Bid if the spread is 1/16 or greater, or at a price equal to or greater than the Ask if the spread is less then 1/16. A market maker registered in a particular security has the advantage of being able to do short sales on down Bids.

Margin Account
You can't short if your broker account is not a margin account. A normal broker account is a cash account, which means you have to pay in full for all purchases on your account. For example, if you pay $50,000 into your broker account, you can buy stocks for $50,000. With a margin account, however, you may be allowed to buy stocks for $100,000 depending on the rules and conditions governing the account.

If you apply for a margin account, you must sign a margin account agreement which includes all the rules and conditions on how the margin may be used. The most important part of this agreement is the part that allows a broker to liquidate all securities on your account in order to meet the margin call against you - without your approval. Also, the broker may be allowed to call in the loan at any time. There are precise rules about this, and if you don't meet their requirements you get the "margin call", which means you must pay in more cash or liquidate securities to meet you requirements.

You also have to pay interest, but this is usually rather low and for a daytrader these costs are negligible. So why use margins at all? Because of the leverage effect and the ability to do shorts. You may also have some position plays that you don't want to sell. You can use the margin for your short term trades, for example, and keep all your current positions.

If you buy a stock on full margin and the investment is successful, you have twice the profit you would have gained doing it without a margin (assuming you have used all the cash available plus the margin for this trade). On the other hand, you can also double your losses if the trade goes against you. Nevertheless, margins are important to the daytrader, because he is often in several different trades at once or he may want to buy higher priced stocks or just do shorts. If you have a margin account you are not required to use it, but it is useful to have it available whenever you need it.

Read more about shorting (margin example, short squeeze, short patterns etc.) in the book The Complete Guide to Daytrading