The Uptick Rule: Does It Keep Bear Markets Ticking?

By John Devcic AAA

Rule 10a-1, better known as the "uptick rule", states that an investor cannot short a security until it has traded higher at least once. To understand fully why the uptick rule was made, you have to go back in time to what was happening on Wall Street as well as on Main Street at the time.

In 2007, the Securities and Exchange Commission (SEC) eliminated the uptick rule to determine whether it worked. The SEC's Office of Economic Analysis concluded that it did not appear necessary to prevent market manipulation. However, the credit crisis and resulting market volatility that plagued the market in 2007 and 2008 had many critics calling for a reinstatement to the rule in 2009. Read on to learn the history behind the creation of this rule and why some people want to see it back in place.

Putting the Brakes on a Bear Market
Through the 1930s, the Great Depression was ravaging both Wall Street and Main Street. On Wall Street, it was common to see "bear raids". A bear raid is a group of traders' attempt to force down the price of a stock in order to cover short positions they have on the stock. But if a company has good fundamentals and a strong balance sheet, then how would you go about forcing the price lower? This was done through the spreading of rumors about a company's future, its management, or with any other negative information that is likely to cause selling. (For more insight, see The Short And Distort: Stock Manipulation In A Bear Market.)

Once these rumors start, they often escalate to out-of-control proportions. When they take hold of the Street, the bear raiders pile on with more short sales, causing even more downward pressure.

Of course, with the great stock market crash of 1929, it didn't take much to get the masses to panic. These panic sellers could cause fundamentally sound companies to lose valuation quickly. Many argued that such bear raids were rampant at the time and there needed to be a way to slow the floodgates of short sellers that would pile on new short positions daily. This is why, in 1938, the SEC decided to add a new rule called the uptick rule. This forced anyone who wanted to place a new short position to wait till the price ticked up one-eighth of a point - at the very least - before a new short position could be made. This process prevented traders from forcing a stock's price down. (To learn how to practice short selling, see the Short Selling Tutorial.)

In order to stabilize the 1930s market, the SEC needed to do something to foster investor confidence again. Bear raids and plummeting stock prices erode investor confidence, so the SEC enacted new rules in response. Its hope for the uptick rule was to make it a little more difficult for new shorts, thus reducing bear raids.

In Defense of Short Selling
To understand the uptick rule, you also have to understand that short selling is not bad. It is often given a negative slant and, while it does allow an investor to profit on stock price declines, it is a vital market tool. The process of selling short requires that a trader go out and borrow shares from a broker and then sell them with the hope that he or she will be able to buy them back at a lower price. As a result, short selling acts to correct euphoric and crazy levels of enthusiasm that may drive share prices higher for no fundamental reason. (For more debate on this issue, see Questioning The Virtue Of The Short Sale.)

Short selling can put a top on irrational values, so the uptick rule slows irrational selling. Both are market instruments that work to maintain a proper flow to trading.

This is part of the reason why the uptick rule is rarely if ever spoken about during euphoric and strong bull markets. The only time you will hear about it is when the market is declining heavily or there are great economic woes (better known as a bear market). (To learn more, read Digging Deeper Into Bull And Bear Markets.)

Besides the uptick rule, exchanges such as the Nasdaq, NYSE and AMEX have their own type of uptick rule on top of the current uptick rule.

The uptick rule was enacted by the SEC, an independent U.S. government agency that works to regulate and watch for unscrupulous market trading and traders. The SEC was created by Section 4 of the Securities Exchange Act of 1934, which was created to increase public trust in the capital markets. This trust would be fostered through regulations on the market level as well as on the company level. It was the dire economic situation of the 1930s era that gave rise to the idea that the government needed to exert some control over the markets to protect investors and the economy as a whole. (For more insight, see How The Wild West Markets Were Tamed.)

The uptick rule rose out of similar sentiment, and was devised to react to what many felt, at the time, was one of the major reasons for the great stock market crash of 1929. Public outcry compelled policymakers to stop short sellers from turning a stock slide into an avalanche.

While the overall effects of the uptick rule have been argued for years, one thing is clear: the rule prevents any trader, big or small, from easily snowballing an already lower price. Adding new short positions when a stock is on margin also makes the trader think twice before deciding on a new short position. (To learn more about how short selling affects the market, see Short Selling Risk Can Be Similar To Going Long.)

Conclusion
Many have argued that the uptick rule is useless and was created in response to panic on Wall Street during a major economic depression. There is no way to know for sure if that is indeed the case. However, it is true that the uptick rule only comes into play when there is heavy interest in the shorting of a stock. Those who favor and believe in the uptick rule say that it adds a level of protection from short sellers gaining too much momentum in any one security, but there are others who argue that the uptick rule really has no effect on slowing down short sellers, as they just have to wait for a downtick. Whether the uptick rule works to combat major volatility is another question altogether.

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