Since the stock market crash in 1929 and the ensuing Great Depression, short selling has been the scapegoat in many market downturns. In a short sale, an investor sells shares in the market, which are borrowed and delivered at settlement. The intent is to make a profit by buying shares to repay the loaned ones at a lower price. After the Great Depression, the U.S. Securities and Exchange Commission, or SEC, placed limitations on short-sale transactions to limit excessive downside pressure.
For many years after its creation in 1937, the uptick rule prevailed. This rule allowed short selling to take place only on an uptick from the stock's most recent previous sale. For example, if the last trade was at $17.86, a short sale could be executed if the next bid price was at least $17.87. Essentially, this rule does not allow for excessive sales pressure from short-sellers and helps keep the market in balance, at least in theory.
Several studies have been performed over the years, revealing no additional relief comes from the uptick rule in a bear market. In 2007, the SEC repealed the uptick rule, giving free rein to short-sellers who soon took advantage in the next stock market crash in 2008. The SEC has since revised the rule again, imposing the uptick rule on certain stocks when the price drops more than 10% from the previous day's close.
An essential rule for short selling involves the availability of the stock to be sold. It must be readily accessible by the broker-dealer for delivery at settlement; otherwise, it is a failed delivery or naked short sale. Though in a stock trade this is deemed a renege, there are ways to accomplish the same position through the sale of options contracts or futures. (For related reading, see "The Truth About Naked Short Selling: Commentary.")