What is the Short-Sale Rule?
The short-sale rule was a Securities and Exchange Commission (SEC) trading regulation that restricted short sales of stock from being placed on a downtick in the market price of the shares.
Understanding the Short-Sale Rule
Under the short-sale rule, shorts could only be traded at or above the most recently traded price of the security if the most recent price movement was upward. It forbade with only limited exceptions the trading of shorts on downticks in the share price. The rule was also known as the "plus-tick rule," "tick-test rule," or "uptick rule."
The rule went into effect in 1938 and was lifted by the SEC in 2007, allowing short sales to occur (where eligible) on any price tick in the market, whether up or down. However, in 2010 the SEC adopted an alternative uptick rule. It does not apply to all securities, and restrictions in trading on downticks are generally only restricted in narrowly-defined circumstances, such as when the price of a security has dropped by 10% or more from the previous day's closing price.
History of the Short-Sale Rule
The SEC adopted the short-sale rule during the Great Depression in response to a widespread practice in which shareholders pooled their capital and shorted shares, in the hopes that other shareholders would panic and sell their shares quickly as well. The conspiring shareholders could then buy more of the security at a reduced price, but they would do so by driving the value of the shares even further down in the short term, and reducing the wealth of former shareholders.
The SEC began examining the possibility of eliminating the short-sale rule following the decimalization of the major stock exchanges in the early 2000s. Because tick changes were shrinking in magnitude following the change away from fractions, and U.S. stock markets had become more stable, it was felt that the restriction was no longer necessary.
The SEC ran a test program of stocks in 2003 to see if removing the short-sale rule would have any negative effects. After reviewing the results it was decided that the rule no longer needed to exist, and it was dropped in 2007. However, naked shorting – selling shares short that don't exist or can't be verified – is still illegal.
Controversy Around Ending the Short-Sale Rule
The abandonment of the short-sale rule was met with considerable scrutiny and controversy, not least because it closely preceded the 2008 financial crisis. The SEC opened up the possible reinstatement of the short-sale rule to public comment and review. As mentioned, the SEC adopted the alternative uptick rule restricting short sales on downticks of 10% or more in 2010.