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How Does the Uptick Rule Affect Stock Prices?

Posted on Saturday, May 30th 2009

By Guest Author Tim Smith

[More than 5,000 people signed a petition calling for the reinstatement of the uptick rule that was prepared by Jim Cramer, William Furber, Eric Oberg and Scott Rothbort and sent to the SEC earlier this week. In today’s guest post, Tim Smith of SunGard’s Astec Analytics weighs on the effects of the removal of the rule, which forbid short sellers from selling securities before a share price increase, and its possible re-introduction.]

True or false: The removal of the uptick rule helped create the environment of falling stock prices

There has been much debate around the possible re-introduction of a form of the uptick rule that is seen by some as a panacea for all evils that have befallen stock values. Some argue that the removal of the original uptick rule in June 2007 was the catalyst that started, or at least exacerbated, the downward trend in prices and allowed the bears to have their way with what were perceived to be over-valued stocks. It is a generally held belief that the decision to remove the uptick rule had been a relatively quick one, implemented without much planning or aforethought. This, however, was not the case. There had been a lengthy pilot scheme (August 2005 to July 2007) involving about one-third of the Russell 3000 Index being exempt from the rule which showed over that period that those in the pilot and those not in the pilot moved in similar ways, thus proving the point, it was thought, that the uptick rule was no longer relevant.

There are misunderstandings on both sides in the current debate. Firstly, those who argue that this is the answer to all the stock market woes are wrong because the uptick rule, or rather a form of uptick rule (about five methodologies are being considered), is just one element in the array of weaponry that the regulators have to ensure orderly markets. There are also other more mundane controls such as collateral types and margin for securities lending (the thing that takes the “naked’ out of “naked shorting”), the ability to ban short selling in groups or all stocks and the current wide-ranging legislation covering market manipulation, Reg SHO etc. In other words, it is the sum of the whole that may work and not only one of the constituent parts. Secondly, for those arguing vociferously against the re-introduction, we can lay the accusation of being pre-judgmental. There are five different methodologies being looked at and there will be a sufficiently long time to analyze them before any decision is made – and also a sufficiently long time to find ways of coping with any new rule as well. It is only prudent for regulators to analyze every option available to them.

One way of starting to see whether any re-introduction of an uptick rule might have an effect would be to analyze what went on after the last rule was withdrawn. The chart below shows how the pilot securities moved in the securities lending world (the current best proxy for short selling we have) against the non-pilot securities over the period of the test and after the removal. It can be seen that there was an increase in the amount of borrowing activity and thus short selling for the period after the uptick rule was removed. However, there was an increase for those securities that were already free of the rule previously. Consequently, the initial view is that there would appear to be no difference between the groups before and after but the amount of securities being lent did shoot up. This could mean that the removal of the uptick rule provided the environment within which short selling became more acceptable and “standard”, thus pulling everyone up, even those on the pilot scheme. Alternatively, perhaps other market events may have driven the activity; for example, Bear Stearns or Lehman Brothers.

Thus, in the best traditions of viewing statistics and data, it can be argued that the removal of the uptick rule both did and did not affect market activity and stock prices, which implies that it would be the same for any re-introduction. Potentially, there may be same effect as seen when the introduction of a short selling ban and the removal of the same were promulgated; namely, that there might be an initial surge in activity as people seek to secure their supply or position which then eases off to more “normal” levels, whatever they may be, once the full ramifications or lack thereof sink in. In the final analysis, we are drawn back to the inevitable conclusion that it will or may be just one rule that everyone will have to live with; one of many that already exist. It will be coped with just as it was before and it may be withdrawn if implemented at some unknown future date, when the next generation of traders and experts mature into seasoned bankers, analysts, investment managers and regulators. And thus the cycle continues…

 

 

Median Change in Share Borrowing per Stock

Change from:

Pilot Stocks

Non-Pilot Stocks

Before the pilot to just after the pilot

+17%

+14%

The last months of the pilot to just after the uptick rule was completely eliminated

+18%

+16%

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Uptick is a red herring to distract folks from the real question which is – should ALL shorting be abolished? As the public gets angrier about this meltdown, they will come to realize that legal shorts hide naked shorts — make it harder to detect since all shorts are naked for the first while (until stock is located, usually 3 days). Shorting destroys wealth, creators, jobs, companies and the economy by creating duplicates (or replicated owners) with out having the decency to publish data on how many extra shares exist in the market (affects market cap data), undermining trust in the whole system. Folks who are as disgusted as I am can do something about it here
http://www.petitiononline.com/shortNOT/petition.html

Links are given therein for background information

Cheers

Bob Saturday, May 30, 2009 at 5:51 PM PT

Short Selling should be completely illegal. There is no benefit to the practice beyond the fattening of a greedy gambler’s greasy wallet. If you are a short-seller you should be ashamed of yourself. Go to confession and repent your evil ways or go back to the eighties when coccaine and selfishness were acceptable.

If you haven’t invested in a company to begin with, you have no business betting that it will go down. A share of stock represents a piece of a company. That company is probably trying to succeed. If it fails, a lot of people lose their life savings and their life’s work. If that is how you want to make your money, you have serious problems. Tell it to your shrink. Don’t come out here to wallstreet and make innocent, hard-working people lose their retirement savings because you are working out mommy and daddy issues.

Saying short-selling is good because it adds liquidity to the market is like saying “It’s a good thing the polar ice caps are melting because they add water to the oceans and the oceans can always use more water.” Who is the idiot who thinks more liquidity is a good thing for a market that is already swimming in itself?

That’s enough for now.

freethestates Monday, June 1, 2009 at 8:07 AM PT

Below is my blog post on this topic.

This financial crisis has destroyed a lot of wealth for many investors. There are many who are blaming it on Short Selling and the abolished Uptick Rule. Uptick Rule was abolished by SEC in June 2007, after being in place since 1938. Currently, SEC is encouraging a debate, if or not to put Uptick regulations back in place.

What is or rather was Uptick Rule? Uptick Rule prohibited short sale of securities, except on an uptick. Meaning, a short seller could only sell equities at a price higher than the last transaction price (higher at least by the defined uptick amount).

To me, I will take it as a market distortion rule and would support its abolition. Short Sales are important to keep markets healthy by keeping underlying prices close to their true equilibrium values. Without short sales, securities would mostly have an upward bias and be over valued. So, any regulation which discourages short sales as a correction instrument is not healthy for markets as a whole.

Having said that, it is important to understand difference between a ‘Short Sale’ and a ‘Naked Short Sale’.

In a Short Sale, seller borrows security from security owner for a short period and sells it at the market price. He is betting negatively on that company and stock, and is expecting it to be overpriced. At the end of period, seller buys it from the market (at lower prices if his bet has played correctly) and returns it back to its owner. Owner is usually an individual or institution (e.g. pension funds, ETF etc), who anyways wants to keep that security for longer term. Owner receives interest on his lending and borrower (short seller) gets to play on his bet. (If I were the owner, I would also charge premium for impairment risk on my security)

In a ‘Naked Short Sale’, seller is short selling securities without borrowing them. This is a clear distortion of market factors. He is selling something, he does not have (or no one has). His action is artificially increasing supply of that security and if the volume of this artificial supply is critical enough, it will anyways bring down the prices. This is Basic Economics; Things have value because they are scarce.

To summarize, I will take Short Selling as a healthy correction tool and ‘Uptick Rule’ and ‘Naked Short Selling’ as two factors distorting its correction properties. ‘Uptick Rule’ by discouraging short selling and ‘Naked Short Sales’ by abusing it.

Sandeep Rastogi Wednesday, July 22, 2009 at 12:20 AM PT