Short Sale Rule - Explained
What is the Short Sale Rule?
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Table of ContentsWhat is the Short-Sale Rule?How does the Short-Sale Rule Work? History of the Short-Sale RuleControversy Around Ending the Short-Sale RuleAcademic Research on the Short-Sale Rule
What is the Short-Sale Rule?
The short-sale rule is a rule that restricts the short sales of stock that have dropped by 10% or more from the closing price of the previous day. This rule is a trading rule of the Securities and Exchange Commission (SEC) and it is meant to regulate stock from being placed on a downstick. When a stock is placed on a downstick, it means the stock is trading at a price lower than the closing price of the previous or last trade. The short-sale rule is otherwise called SEC rule 201 or the alternative uptick rule.
How does the Short-Sale Rule Work?
The short-sale rule was first introduced in 1938 before the SEC further advanced it in 2010 to forbid the short sale of stock below the price tick in the market. The short-sale rule requires that short sales are made in an uptick, in which they are sold at a price slightly higher than that of the previous closing price or at the same price. This rule prohibits the short sales of stock at a price below the closing price for the previous day, often called a downtick. The short-sale rule is not applicable to all types of securities, it specifically addresses securities whose price is 10% or more below the closing price of the previous trading day.
History of the Short-Sale Rule
The short-sale rule was first used as a regulation on trading during the Great Depression. During this period, there was a practise in the market in which conspiring investors would pool their capital with the expectation to buy shares when shareholders engage in panic selling. The investors leverage panic selling to buy more stock at a reduced price, even at a price lower than the previous closing price. The short-sale rule was introduced then to curb the excesses of these conspiring investors. In the 2000s, however, the SEC considered removing the rule in the 2000s owing to the fact that it was not needed at that time. After different examinations, the rule was dropped in 2007.
Controversy Around Ending the Short-Sale Rule
The short-sale rule was re-adopted in 2010 and also took up the name 'the alternative uptick rule.' There some certain controversies that arose from the dropping of the rule in 2007 by SEC, especially because the rule was ended not long before the global financial crisis occurred. The controversies that arose led to the SEC creating a room for review tailored towards reinstating the short-sale rule.
Academic Research on the Short-Sale Rule