A Look at the Short-Sale Uptick Rule

There has been quite a bit of discussion lately about short selling and the "uptick rule." In fact, some believe that the steps towards reinstating these rules have helped bolster stocks of late. What is the uptick rule and why is the mere mention of doing away with said rule possibly creating a rally? Let's take a look.
First, a brief refresher on short selling. The textbook definition is when an investor sells a stock that he/she doesn't own. The seller's investor loans the stock in order for the investor to sell it. At some point, the seller has to buy the same number of shares they sold short (known as "covering") in order to return them to the broker. Money is made when the stock that was sold short falls and is bought back at a lower price.

For most normal "retail" investors, in order to short-sell a stock, they must have a margin account and their broker must "borrow" the stock from another one of its clients long margin account -- so in some cases, no stock is available to short and the retail trader is basically unable to do so. Many Institutions / Professionals / Hedge Funds etc have not had to adhere to this method of "borrowing" in many cases in recent years, but that is a matter for a future article. Let's now turn our attention to the uptick rule.

The uptick rule was instituted back in 1938 (as part of the reforms following the 1927 Crash and Great Depression), stating that a stock may not be sold short unless the trade before the short sale was at a lower price than the price where the short sale is executed. Simply put, selling short is only permissible if the stock ticks higher. The goal of the uptick rule was to keep short sellers from compounding and accelerating a stock's downtrend. Note that the uptick rule does not apply to certain types of investing vehicles, including: market exchange-traded funds (ETFs), currencies, single-stock futures, and futures (but futures do have limit-down rules -- circuit breakers and limit-down rules will also be the topic of a future article).

Why did the SEC repeal the rule? The rationale for lifting the rule was apparently a "test" by the SEC to see the effectiveness of the uptick rule. One would also likely assume there was some lobbying by major financial firms to have it lifted. And general de-regulation of the SEC and its powers over the past years likely contributed as well. Based on the above chart, one could conclude the "test" didn't work very well. Many have attributed the incredibly rapid declines that many stocks in the Financial Sector have seen to the lack of an uptick rule -- but this is a fairly complicated issue with other factors involved.

Nonetheless, recently Fed. Chairman Bernanke proposed examining re-instituting the rule, and Congress has recently acted (on March 10th, no less) to have the rule re-instated very quickly. See the following chart for these news events in relation to the market.

Bottom Line: Regardless of the actual effectiveness of the short-sale uptick rule (and whether it can be manipulated and/or ignored by many traders), the market performance after both the 2007 repeal and since the March 10th plans to reinstate are quite striking. Also remember that as a retail investor, you can participate in down-side speculation and hedging without short-selling stock through the use of Put Options, Short ETFs, and various Option Strategies.