The Uptick Rule Debate

By Christina Granville AAA

There has been a lot of discussion about the uptick rule and whether it should be a part of the financial markets. First instituted by the Securities and Exchange Commission (SEC) in 1938 as Rule 10a-1, the uptick rule prevents securities from being consecutively short sold without the stock trading higher at least once between short selling orders. The rule was first instituted after the Depression-era turmoil in the financial markets and was maintained until 2007 when the SEC eliminated it. This article summarizes the history of and debate surrounding the uptick rule. (For background reading, see The Uptick Rule: Does It Keep Bear Markets Ticking?)

Institution and Elimination of the Uptick Rule
Prior to instituting the rule in 1938, the SEC performed a study of the New York Stock Exchange (NYSE) and found that of the 20 securities it studied during two periods of 1937, short sales accounted for a significant portion of the overall trades. Based on that study, it was concluded that the rule should be instituted in order to prevent short sellers from adding to the downward spiral of specific securities - and the overall market - to protect stocks and the NYSE in periods of sharp decline. (Read about historical declines in A Review Of Past Recessions.)

In 1963, the SEC established three objectives in order to assess whether the uptick rule continued to be effective. Those guidelines stated that the rule should accomplish the following:

  • Allow relatively unrestricted short sales in an advancing market
  • Prevent short selling at successively lower prices, thus eliminating short selling as a tool for driving the market down
  • Prevent short sellers from accelerating a declining market

Keeping those guidelines in mind, the SEC's Office of Economic Analysis established a pilot program in 2004 to determine whether the uptick rule was still effective. In doing so, it suspended the uptick rule for one-third of the stocks in the Russell 3000 Index while maintaining the rule for the remainder of the stocks. In doing so, it was able to compare results from two groups of securities under identical market conditions - one group for which the uptick rule was suspended and one group for which the rule was upheld. (For more, read The Uptick Rule: Does It Keep Bear Markets Ticking?)

Results from that pilot program demonstrated that although the elimination of the uptick rule increased the volume of stocks that were shorted, it did not increase the overall short interest in a security. And since the interest in shorting a particular security remained undiminished, the study concluded that the uptick rule had no real ultimate impact. Following the results of this study, the uptick rule was repealed in 2007. (Find out how this figure can be a real eye-opener on market sentiment of a given stock in Short Interest: What It Tells Us.)

Outcry Following Elimination of the Uptick Rule
Following the repeal of the uptick rule in 2007, widespread mortgage defaults caused the housing bubble to burst, and the economic ripple effect rapidly spread to financial institutions and their stock prices. Financial institutions that were over-leveraged with toxic mortgage-related assets such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) became a target of market short sellers. (Learn more in The Risks Of Mortgage-Backed Securities and Collateralized Debt Obligations: From Boon To Burden.)

While the uptick rule was repealed in 2007 without significant attention, by 2008-2009 there was a loud clamor to reinstate the rule to provide protection from bear raids, not just the share prices of financial stocks, but for rapidly declining market averages as well.

Those that are in favor of the uptick rule argue that the conditions of the 2004-2006 markets under which the pilot program was tested are far different from the dramatically down market conditions of 2008-2009. They maintain that the rule was implemented after the Great Depression in order to protect companies and the financial markets specifically in dire economic circumstances, whenever they arise.

They argue that reinstating the rule will protect the share prices of struggling companies, some of which are artificially driven down past their fair market values during bear raids. And, because the markets are often driven by psychology, proponents of the uptick rule suggest that having it in place not only hinders bear raids against stocks in struggling sectors, but may also impede a bear market from spreading into healthier sectors of the economy. (To discover what on-balance volume, accumulation/distribution and open interest can tell you about the market, see Gauging The Market's Psychological State.)

Tinkering With the Uptick Rule
Some proponents of the uptick rule in general argue that if it is instated, it needs to be adjusted to reflect the fact that the markets have changed in the 70 years since it was first instituted. One of the big changes is that equity markets began quoting prices in increments as small as pennies in 2001. This is relevant to the rule because after markets began pricing in pennies, short sellers needed to wait only until the price of a stock went up a single penny to short the stock again.

Many believe that that is why the 2004-2005 pilot study showed little difference between having the rule in place and removing it - because a stock could be shorted again after only recovering a single cent in share value. Those that follow this theory believe that if the uptick rule is reinstated, it will have to raise that penny interval if it is to have a significant impact. (Learn about the advancements in trading in The Birth Of Stock Exchanges and The Global Electronic Stock Market.)

The Other Side to the Argument
There will be those opposed to placing the disadvantage of a raised interval upon short sellers and hedge funds, specifically because they derive discernible profit from shorting strategies. And even if an effective uptick rule - whatever that may be determined to be in the future - can protect companies from bear raids, there will always be those that argue that it impedes the freedom of the markets and that the markets naturally balance themselves out when short sellers eventually buy long positions to cover potential short losses. (To learn more, read Questioning The Virtue Of The Short Sale.)

One thing that is certain, however, is that the debate over the uptick rule is one that will continue to burn brightly and echo loudly in the investment community in the years to come.

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