This Blog Has Moved!

My blog has moved. Check out my new blog at

Your Ad Here

Friday, March 20, 2009

The Uptick Rule

The comedians on the Communism Channel are making a big deal about "The SEC should re-implement the uptick rule!"

The uptick rule is a restriction on short sellers. A short sale may only occur on a plus tick or a zero-plus tick. If the last sale of a stock was for $9.99, then it's legal to short sell at $10 (a plus tick). It's illegal to short sell at $9.98, because that's less than the previous sale (a minus tick). If the order of trades was $9.98, $9.99, $9.99, then it's legal to short sell at $9.99 (a zero-plus tick; the last variation was increasing, followed by no change).

Allegedly, the uptick rule prevents someone from driving down the price of a stock by short selling.

The uptick rule is a separate issue from "naked short selling". In a genuine short sale, you borrow shares of stock from someone else. You post collateral equal to the fair market value of the shares sold short. With naked short selling, you short sell without any intention of ever borrowing shares. The person buying the stock gets a "failure to deliver" instead of shares. The stock clearing/settlement system treats "failure to delivers" as logically equivalent to actual shares. This encourages the fraud; buyers would be angry if they received formal notification that they were victims of a "failure to deliver". The SEC does not fine violators, nor does the SEC publish a list of violators. If something is illegal, but there's no penalty for doing it, then it's effectively legal.

Naked short selling is literally fraud, because the naked short seller is printing new shares of stock and selling them, driving down the price. Having driven down the stock price, other people sell, and the naked short seller can than buy/cover for a profit. In a market where hype counts for more than substance, driving down a corporation's stock can itself cause bankruptcy. If the stock rises rapidly, then the naked short seller can declare bankruptcy and default, leaving the buyers or clearing firm SOL.

In practice, the uptick rule provides negligible protection against market manipulation. Suppose the last sale is at $9.99. I want to manipulate the market downward. I can publish a large order "sell 100,000 shares short at $10". This large public sell order would drive the stock price downward. Other traders would gladly sell at $9.99, knowing they could buy back from me at $10. Once the stock trades at $9.98, I can re-adjust my sell order from $10 to $9.99. I could have just said "sell 100,000 shares short at market", and then the order would be executed on the next legal upticks. The other traders would let the market go down, knowing they could buy back from me for a profit.

When I worked at an options trading firm, they were trading stock to hedge their option positions. They had a weird conclusion. They were getting better prices on their short sales than on their long sales! Paradoxically, the uptick rule made short selling less risky! They were only allowed to short sell on upticks, which led to a better price on average compared to when they were selling long! They weren't trading to manipulate the stock price; they were trading to hedge their option position. Their goal was "lowest cost execution".

The uptick rule was implemented after the market crash during the Great Depression. Instead of placing the blame where it belonged, saying "The Federal Reserve manipulated the money supply, causing a boom and crash!", regulators blamed greedy short sellers. The uptick rule was implemented to prevent such problems again in the future.

With penny pricing and electronic trading, people were saying "The uptick rule is irrelevant!" When stocks traded in multiples of 1/8 or 1/16, the uptick rule was a substantial restriction. With penny pricing, the uptick rule doesn't matter as much.

Now, the Communists are blaming the repeal of the uptick rule on the recent decline in bank stocks. Instead of saying "The Federal Reserve caused the boom/bust with artificially low interest rates!", the uptick rule is blamed. The true cause of economic problems is a fundamentally defective monetary system. Other scapegoats always take the blame.

The repeal of the uptick rule is blamed for economic problems (or various other regulations), rather than the fundamentally corrupt nature of the US monetary system.

1 comment:

Anonymous said...

very nice explanation.

This Blog Has Moved!

My blog has moved. Check out my new blog at