Description

My basic trading philosophy can be summed up by one simple quote:

"Trade the ticker, not the company" - Nate Michaud


Tuesday, February 4, 2014

Question: "What is the $2.50 rule?"

After my post about brokers that I use and recommend, a few people were asking what exactly the $2.50 rule is. Fair enough; let me clear that up.

The $2.50 rule applies when you are short selling stocks that are priced under $2.50. Basically, the rule states that for every share you are short, you still need to put up $2.50 of capital, even if the stock is priced lower.

Why does this matter? Let's say you have a $1000 account and you want to short sell pennystocks. If the stock is under $2.50, you will not be able to take a full $1000 position, even if you wanted to. Here's the math:

You have a $1000 account;

For ANY stock under $2.50, you must still put up $2.50 in capital.

Divide $1000 by $2.50, and the MOST shares you can short is 400 shares, REGARDLESS of price.

This can be a huge frustration for small accounts. You might have the perfect supernova chart and the stock is trading at $1, but you can't short 1000 shares. You can only short 400 because of the $2.50 rule.

Here are a few examples of the MOST shares you can short based on your account value:

$1000 account   -   400 shares max
$2500 account   -   1000 shares max
$5000 account   -   2000 shares max
$10,000 account -  4000 shares max
$25,000 account -  10,000 shares max

The cheaper the stock, the larger a disadvantage this is because of the smaller $ position size you will ultimately wind up taking. Unfortunately, it's one of the realities of short selling but as your account grows, it will become less of a nuisance. I hope this helps clear up any confusion!

21 comments:

  1. I really appreciate the information, it is really helpful. It really makes things easier for us newbies, and even more so for the newbies who are in a similar situation as you. I will have the site on watch from now on for sure.

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  2. it helps a ton thanks, could you also explain why it exist ?

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    1. The 2.50 rule mainly exists to help brokers protect themselves from taking on too much risk. Sometimes it is very easy to short too early on these parabolic charts, and if you're stubborn rather than cutting your loss it's very possible to be down 100% or more on the position. Brokers enforce the 2.50 rule because the cheaper the stock, the easier it is for it to have big moves that could crush a short seller's account. So the 2.50 rule keeps clients from being able to go all in short on a $0.10 stock, and the broker is better protected

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    2. Good quality penny stocks are actually less risky than the more expensive stocks. What a pity these guys in the brokerages don't keep up with reality. See Forbes’ Asness review: ‘Big News From AQR: Size Matters, If You Control Your Junk, Forbes, 2015.
      http://www.forbes.com/sites/phildemuth/2015/01/26/big-news-from-aqr-size-matters-if-you-control-your-junk/#ecdb3e522c3c

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  3. Tim great post! This makes so much more sense now! Thanks.

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  4. Tim - is this refereed to Freeriding?

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  5. Any chance you could explain why a stock like SOUL goes from $1.50 to over $14 on relatively low volume, and there has been significantly higher volume since mid-December, yet the stock has barely moved (see 1 year daily chart). Thanks

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  6. SOUL had a stock split, meaning they increased the # of shares outstanding which also made the price cheaper. At the time SOUL wasn't really that expensive, the chart just got altered because of the split

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  7. What about larger accounts? Should/does this rule remain the same?

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  8. Great post, I am going to be reading your blog on the daily basis. You have great information. Thank you for sharing your knowledge.

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  9. Say you purchase 10,000 shares of a stock at $1.00 a share and the $2.50 rule causes your account to be charged $25,000, ($15,000 more than the share price). My question is when you sell the stock (ex. $1.15) is your account immediately credited the $15,000 so you can trade immediately or do you have to wait the 3 day period for your funds to become settled? Thanks, Tim.

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    1. The extra money that was tied up should become immediately available

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  10. Hey Kroy, I notice you short some StockMister picks (ITCC).. I'm looking to short all his pumps this summer, but what broker do you use? I am thinking SureTrader, but I don't know if they will have shares of his obscure picks

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  11. Tim, when you started trading you said you had $1,500.. Did you go all in every trade?? or did you use 50% of your money? how long did it take you to go from $1,500 to $10,000??

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  12. My broker is applying the $2.50 rule to going long!!!!!!!! Can you believe it?

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  13. Thanks for the information Tim. How much did you learn from Tim Sykes?

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  14. Hi Tim, what happens when a stock above $2.50 say, a $10 stock crashes and falls below the $2.50?

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