Uptick Rule Definition
The uptick rule is a law created by the Securities Exchange Commission to impose trading restrictions on short sale transactions of securities. It required the short sale transactions of securities to be entered at a higher price than in the previous trade.
It’s formation was under the Securities Exchange Act of 1934 Rule 10a-1, and the implementation of the rule took place in 1938. The main purpose of this rule was to ensure that short sellers did not accelerate prices on the stock that was already facing a sharp downward movement.
A Little More on What is the Uptick Rule
Implementing the short sale order with a higher price than the current one ensures that a short seller’s order is entered on an uptick. However, the rule is usually not put into consideration when you are trading in a given type of financial instruments such as single stock futures, futures, or currencies.
Note that such financial instruments can be shorted on a downtick because of their high liquidity status. There are also enough buyers always ready to enter into a long position, meaning that the chances of driving the market prices to unreasonably low levels are rare.
The uptick rule generally recognizes that short selling is capable of negatively impacting the stock market. So, it ensures that there is efficiency in the stock market and that there is a preservation of investors’ confidence. It is used in the stock market to ensure that there is a certainty, especially during volatility and periods of stress.
In short selling, there is the selling of the security that is either borrowed or not owned by an investor. So, during the shorting of the stock, the seller expects that he will be able to buy the stock back at a price lower than the previous selling price. It is a contrast to the usual way of trading where you buy a stock at a lower price and sell it later at a higher price.
Generally, it is true that short selling is useful, especially when it comes to ensuring market liquidity and efficiency in pricing. However, if not well controlled, it can accelerate the decline of security prices in the stock market.
How Uptick Rule Works
The uptick rule works this way: Let’s assume that a stock has triggered a circuit breaker where it has started experiencing a decline in the stock’s price at least 10% every day. In this case, short selling will be allowed only if the price of the security transacted above the current market selling price.
Remember, short sell is a way of capitalizing on the expected security’s price decline. So, when a significant number of investors decide to engage in short selling of a given stock, this action may escalate and later have a great negative impact on the stock price of the company.
Uptick Rule (Rule 201) Features
The uptick rule has the following features:
- Short Sale-Related Circuit Breaker
When there is a decline in the price of the security by 10% on any given day, the circuit breaker is triggered.
- Duration of Price Test Restriction
After a circuit breaker is triggered, the uptick rule will come in to restrict short sale orders of securities on the next day, including the remaining days, until it comes to closure.
- Securities Covered by Price Test Restriction
The uptick rule applies to all listed equity securities on a national securities exchange. It also applies to those securities traded on over-the-counter and on the exchange market.
According to the rule, the trading centers should establish written procedures and policies and ensure that they maintain and enforce them. The policies and regulations should be designed in a way that they bar short selling from taking place in the security exchange market.
The Origin of the Uptick Rule
In 1937 there was a selloff during the Roosevelt government. The selloff was as a result of the government raising both corporate and personal taxes that later hiked the interest rates, breaking the already declining economy. Short sellers took advantage of this, a situation that greatly affected the securities’ prices in the market.
Following the market break of 1937, an inquiry was conducted to establish the effects of concentrated short selling in the security exchange market. The uptick rule was then created under the Securities Exchange Act of 1934 Rule 10a-1. The United States Securities and Exchange Commission (SEC) adopted the rule in 1938. The implementation of the uptick rule took place during the tenure of Joseph P. Kennedy, who was then the SEC commissioner.
Why was the Uptick Rule Eliminated?
In 2005, there was a six months’ pilot study which involved an investigation on the effect of the uptick rule. After the interpretation of the data collected from the investigation, the SEC came up with the following conclusions:
- That the rule did not have a significant impact as far as market behavior is concerned
- The uptick rule did not actually prevent manipulation of prices in the market
- The uptick rule restrictions reduced liquidity in the market
Following the above recommendations, the SEC finally got rid of the uptick rule in 2007. However, in 2008-2009 markets in the United States went through a crash such as the one experienced in 1829-1930. The situation raised concerns among the investors in the United States who felt that the elimination of the uptick rule came at a very bad time.
Reinstating the Uptick Rule
The termination of the rule was later followed with a discussion between the Representative Barney Frank of the House Financial Services Committee and Mary Schapiro, who was then the SEC chairperson. The two said that the rule could be reinstated.
The conversation by Representative Barney Frank was supported by the members of the Congress who were hopeful that they would bring back the rule. The reinstatement of the uptick rule was later reintroduced in 2008 by the legislation. Its reintroduction was debated on in 2009, where proposals of its reintroduction by the SEC, was put in a public comment period. The modified rule was later adopted in 2010.
A recent testimony that was placed before the House of Finance Services by Ben Bernanke, the Fed Chairman said that reintroducing the rule should not be on financial stock alone but also across all stocks. He said that this is likely to bring benefits to the value of the stock during a decline in the market prices.
References for “Uptick Rule”
Academic research for “Uptick Rule”
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). Restrictions on Short Sales: An Analysis of the Uptick Rule and Its Role in View of the October 1987 Stack Market Crash. Cornell L. Rev., 74, 799.
Short selling on the New York Stock Exchange and the effects of the uptick rule, Alexander, G. J., & Peterson, M. A. (1999). Short selling on the New York Stock Exchange and the effects of the uptick rule. Journal of Financial Intermediation, 8(1-2), 90-116.
[PDF] Unshackling short sellers: The repeal of the uptick rule, Boehmer, E., Jones, C. M., & Zhang, X. (2008). Unshackling short sellers: The repeal of the uptick rule. Columbia Business School, unpublished manuscript, December.
The Uptick Rule of Short Sale Regulation: Can It Alleviate Downward Price Pressure from Negative Earnings Shocks, Bai, L. (2008). The Uptick Rule of Short Sale Regulation: Can It Alleviate Downward Price Pressure from Negative Earnings Shocks. Rutgers Bus. LJ, 5, 1.
Nibbling at the Edges-Regulation of Short Selling: Policing Fails to Deliver and Restoration of an Uptick Rule, Branson, D. M. (2009). Nibbling at the Edges-Regulation of Short Selling: Policing Fails to Deliver and Restoration of an Uptick Rule. Bus. Law., 65, 67.
Short-sale constraints and short-selling strategies: the case of SEC’s revocation of the uptick rule in 2007, Zhao, K. M. (2014). Short-sale constraints and short-selling strategies: the case of SEC’s revocation of the uptick rule in 2007. Applied Financial Economics, 24(18), 1199-1213.
[PDF] Impact of elimination of uptick rule on stock market volatility, Bhargava, V., & Konku, D. (2010). Impact of elimination of uptick rule on stock market volatility. Journal of Finance and Accountancy, 3, 1.
Short sales, stealth trading, and the suspension of the uptick rule, Blau, B. M., & Brough, T. J. (2012). Short sales, stealth trading, and the suspension of the uptick rule. The Quarterly Review of Economics and Finance, 52(1), 38-48.
Nibbling at the edges-regulation of short selling: stock borrowing and restoration of an uptick rule, Branson, D. M. (2009). Nibbling at the edges-regulation of short selling: stock borrowing and restoration of an uptick rule. U. of Pittsburgh Legal Studies Research Paper, (2009-10).
[PDF] Regulation of short selling: The uptick rule and market stability, Bar-Yam, Y., Harmon, D., Misra, V., & Ornstein, J. (2010). Regulation of short selling: The uptick rule and market stability. Report presented at the SEC (22 February 2010).