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When trading of a financial instrument occurs at a higher price than the preceding round, it is known as uptick or plus tick. It is an increase in the market price of a financial instrument over the previous transaction. Even if the market price increases only one cent then also it is considered to be on an uptick. The concept of the uptick is important when it is connected to short-selling stocks. Uptick rule prevents short sellers from putting unfair pressure on a stock’s price.
A Little More on What is Uptick
According to Uptick rule, short selling a stock is only allowed on an uptick. That means short selling can only be done at a higher price than the last traded price of the stock or at the last traded price when the most recent price movement was upward.
The uptick rule was adopted by the United States Securities and Exchange Commission in 1938 to prevent market volatility. It was known as rule 10a-1. The rule was in effect till the introduction of Rule 201 Regulation SHO in 2007.
According to the rule, since 2001 the minimum tick size for the stocks that are trading above $1 is 1 cent. If the trading price of stock raises from $11 to $11.01, then it is on an uptick.
The short sellers, like any other investors, try to buy the stocks at a lower price and sell it at an increased price. However, they try to do it in reverse order. First, they sell at a higher price and then they buy it in low. In this way, they capitalize on an anticipated decline in the price of a stock. If a large number of investors short or sell a particular stock, their collective action can have a dramatic impact on the market price of that share.
Without the uptick rule in place, the traders can engage themselves in short selling to drive down the price of a stock for creating panic among the shareholders. The panicked shareholders would then sell their stocks to avoid further damage. This technique of manipulating the market is called “bear raid” and it is considered illegal. The uptick rule attempts to discourage this by allowing a short sale only when the stock is trading up. So that the investors have less incentive to conduct bear raids.
In 2004, the Securities and Exchange Commission removed the uptick restriction from about a third of listed stock to understand if the uptick rule is at all effective in preventing bear raid. After a yearlong test, they decided that the uptick rule seems to be ineffective in preventing market manipulation, rather it modestly reduces liquidity. Ths, the rule was eliminated altogether in July 2007.
However, the decision of lifting the uptick rule was criticized by some eminent market experts and after the outbreak of 2008 financial crisis, some of them stated that the crisis was triggered by the elimination of uptick rule.
The New England Complex Systems Institute presented a paper that claims to have found evidence supporting the above statement. They said a Bear Raid market manipulation by short sellers against Citigroup in November 2007 actually triggered the crisis.
In 2009, the Securities and Exchange Commission considered reintroducing the uptick rule and voted to seek public comment on this. It prepared a proposal containing 273 pages and released it in public on April 17, 2009. The comment period was open until June 19, 2009.
The proposal published by the SEC states,
“We are proposing two approaches to restrictions on short selling – one is a price test that would apply on a market-wide and permanent basis (“short sale price test” or “short sale price test restriction”) and one that would apply only to a particular security during severe market declines in that security (“circuit breaker”). With respect to the first approach, we propose two alternative short sale price tests: one based on the national best bid and the second based on the last sale price. With respect to the second approach, we propose two basic alternatives: one alternative is a circuit breaker rule that would temporarily prohibit short selling in a particular security when there is a severe decline in the price of that security (a “halt”), which could operate in place of, or in addition to, a short sale price test rule; and the second alternative is a circuit breaker rule that would trigger a short sale price test rule; we propose that such a short sale price test either be based on the national best bid for any security for which there has been a severe price decline or be based on the last sale price for any security for which there has been a severe price decline.”
After this exercise, an alternative uptick rule was adopted by the SEC. Rules 200(g) and 201 of Regulation SHO [17 CFR 242.200(g) and 17 CFR 242.201] under the Exchange Act was amended to introduce the alternative uptick rule. The new rule is applied only when a stock’s price falls 10% or more from the preceding day’s closing price and remains effective until the closing of the next day.
References for Uptick
Academic Research on Uptick
Short selling on the New York Stock Exchange and the effects of the uptick rule, Alexander, G. J., & Peterson, M. A. (1999). Journal of Financial Intermediation, 8(1-2), 90-116. This paper examines the effect of the Uptick rule on short selling of the stocks traded on New York Stock Exchange. It finds that the Uptick rule adversely affects the execution quality of short-sell orders. It holds true even when the trading is being executed in advancing markets. Among other objectives of the uptick rule, one is to allow relatively unrestricted short selling when a company’s share is advancing so that the price discovery does not get affected by the rule. The finding of this paper doesn’t support this claim.
Unshackling short sellers: The repeal of the uptick rule, Boehmer, E., Jones, C. M., & Zhang, X. (2008). Columbia Business School, unpublished manuscript, December. This paper discusses the effect of the elimination of the Uptick rule in 2007. It says after the Uptick rule was lifted no significant effect was evident on the stock price and shorting increased notably in both pilot and non-pilot NYSE stocks (to test the effectiveness of the rule SEC took a pilot project where about 1,000 stocks were exempted). In general, the stock-sale order became more aggressive. Market liquidity was slightly worsened by this decision of the SEC, and on an average, the trading style of the short sellers changed from contrarian to momentum trading. The paper suggests the market volatility of the U.S stock market during late July and early August may have been caused by this switching of their trading style.
Restrictions on Short Sales: An Analysis of the Uptick Rule and Its Role in View of the October 1987 Stack Market Crash, Macey, J. R., Mitchell, M., & Netter, J. (1988). Cornell L. Rev., 74, 799. The Uptick rule was introduced as a response to the stock market crash that took place on October 29, 1929. The US stock market was crashed again on October 19, 1987. This paper analyzes the Uptick rule and its role in the lights of the stock market crash of October 1987.
Technical report on SEC uptick repeal pilot, Harmon, D., & Bar-Yam, Y. (2008). This paper reexamines the SEC’s decision to repeal the Uptick rule and argues that the pilot study was analyzed incorrectly. It says the pilot study actually suggested the uptick rule has a significant economic and statistical effect on the market and the dramatic downfall of the market following the repeal also supports that. The result of this reinvestigation asserts that the uptick rule should be reintroduced to resist market volatility.
Nibbling at the Edges—Regulation of Short Selling: Policing Fails to Deliver and Restoration of an Uptick Rule, Branson, D. M. (2009). The Business Lawyer, 67-94. This article reviews the SEC proposal of reintroducing the Uptick rule or something similar to limit the market volatility. The article concludes there are mainly two issues that need the attention of the SEC, these are Main Street versus Wall Street issues. Limiting the market volatility is important for the Main Street traders, while for professional traders, hedge funds and high-volume short sellers, promotion of informational efficiency is more important. The paper suggests the aim of the SEC should be to formulate a policy that maintains a balance between these two objectives.
The Uptick Rule of Short Sale Regulation: Can It Alleviate Downward Price Pressure from Negative Earnings Shocks, Bai, L. (2008). Rutgers Bus. LJ, 5, 1. This paper examines how the Uptick rule affects stock prices and short selling activities. The price movement and short selling activities of the stocks restricted by the uptick rule is compared to that of the stocks that were exempted from the rule as part of the SEC’s pilot testing. The result of the study shows that uptick rule doesn’t have any positive effect on the price decline of the stocks at times of stress. Also, there are no differences in the short sale volume of these groups of the stocks. It finds that for NYSE and AMEX stocks, the stocks restricted by the uptick rule found opportunities of execution against the upcoming buy orders within 15 minutes of their conversion into limit orders at a legally acceptable price. For NASDAQ stocks, the up bids occurred more frequently after negative earnings surprises. Together with price rise, they offered substantial execution opportunities to short sale orders.
Investigation of price variation limits, short selling regulation, and uptick rules and their optimal design by artificial market simulations, Mizuta, T., Izumi, K., Yagi, I., & Yoshimura, S. (2015). Electronics and Communications in Japan, 98(7), 13-21. This paper examines the impact of price variation limits, short selling regulation, and uptick rules by using an artificial market model. The results show in the absence of the regulations, the price of the stocks fell below the fundamental value, on the occasion of economic bubble collapse. The results suggest, the short sell regulations and uptick rule help to keep the trading price higher than the base value. Thus, the paper concludes that price variation limits have a positive effect on market efficiency.
46. The decline and recent uptick of income inequality in Latin America, 2002–13, Cornia, G. A. (2016). 46. World social science report, 2016: Challenging inequalities; pathways to a just world, 201-205. In the 2000s, a large decline in income inequality was recorded in Latin American nations. The exogenous and policy factors that resulted in this decline is discussed in this article. The paper attributes this development to the progressive policies adopted by the left-of-center regimes that were in power in most of the region. It further discusses whether such a policy model is sustainable in the nations that suffer from slow growth, falling terms of trade, some domestic policy mistakes and a possibly vanishing middle-class support.
Impact of elimination of uptick rule on stock market volatility, Bhargava, V., & Konku, D. (2010). Journal of Finance and Accountancy, 3, 1. This paper examines the impact of the elimination of Uptick rule and tries to determine whether it has increased the short-term market volatility. The paper uses data from DJIA, S&P 500 index, and 30 Dow companies in this study. The results suggest the elimination of the rule has resulted in increased market volatility, both intraday, and inter-day.
The Uptick in Income Segregation: Real Trend or Random Sampling Variation?, Logan, J. R., Foster, A., Ke, J., & Li, F. (2018). American Journal of Sociology, 124(1), 185-222. An increase in the income segregation was observed in the metropolitan regions of the US during 2000-2010. This paper attempts to find out if that is the real trend or a result of random sampling variation. The paper argues, as the effective sample for the American Community Survey is much smaller than it was for the 2000 census to which it is being compared, the observation can be biased.
The Effect of the Uptick Rule on Spreads, Depths, and Short Sale Prices, Alexander, G. J., & Peterson, M. A. (2008). Journal of Trading, 3(2), 38-44. The effect of the uptick rule on spreads, depths and short sales prices of the stocks traded on NYSE is examined in this paper. The results suggest the uptick rule increases liquidity by reducing quoted spreads and increasing ask depths. It also observes that in absence of the rule, the executed short sell orders occur at a price that is, on average, higher than the quote midpoint.