Many market commentators and participants have extolled the virtues of the uptick rule for short selling of stocks. Nothing bores me more than someone who blithely suggests something that actually has little or no impact in today's stock market. My goal is to hammer down the notion that re-instituting the uptick rule will somehow avoid "bear raids" or short sellers taking advantage of a stock that is already in a declining trend. I will also demonstrate the impact of the elimination of short selling on Taiwan stock exchange and compare its performance with that of the Dow Industrials during the same time frame.
Insight on the Uptick Rule
As a person who started my investing career as a short seller, I can say that the uptick rule was a saving grace for me. According to Investopedia.com, the
uptick rule is:
A former rule established by the SEC that requires that every short sale transaction be entered at a price that is higher than the price of the previous trade. This rule was introduced in the Securities Exchange Act of 1934 as Rule 10a-1 and was implemented in 1938. The uptick rule prevents short sellers from adding to the downward momentum when the price of an asset is already experiencing sharp declines.
What this meant for me is that I could get the benefit of the stock price rising before my order to sell short was executed by my broker. As a short seller this is exactly what you want as a means of avoiding the common mistake of selling low and buying high.
As the current bear market had gathered its most steam, critics have been saying that the lack of an uptick rule is responsible for the markets free fall decline from October 2007 until the most recent low of March 9th. What these critics fail to recognized is that with stock prices being traded in pennies rather than eighths it almost doesn't matter whether there is an uptick rule or not.
When stocks were traded in eighths a short seller could gain $0.125 on every uptick. Assuming that the stock was going to fall anyway, that actually increases the profitability of the trade. If, on the other hand, the stock trades up by a penny, and then falls, the uptick rule really does more harm than good, for the short seller that is.
Imagine the harm that the uptick rule does to short sellers. With stocks trading on a penny basis, if a stock is in a free fall there is no telling when the stock's price will turn resolutely to the upside. This essentially puts the power in the hands of the big institutional traders to manipulate the market. Notice that when Jim Cramer
describes manipulating a stock's price, he mentions doing the manipulation in the options market and not with the actual shares. Cramer only uses the actual shares after pushing up or pushing down the stock price in the futures market. Clearly, this is where the regulation is needed, not with the short selling of actual shares. If, as a short seller, I'm discouraged about participating in the markets because the rules are stacked against me then I will stay away.
Surprisingly, this is actually harmful for the markets as will be demonstrated in my second piece about the Taiwan stock exchange's ban on short sellers.
With the uptick rule and stocks trading in eighths, as a short seller, at least you get the protection of seeing the price move "significantly" higher before continuing to go lower. At which point the short seller could more accurately decide if they want to hold on to the position. Without the uptick rule the short seller gets no real-time "heads up" as to a possible reversal of the trend as the trade is being placed. This is how money is lost in short selling without an uptick rule. This may also explain why so many people lose money buying stocks without a "down tick" rule. If only I could place an order to buy and it would only be executed after the stock price traded down...I would be so happy.
Short Selling Ban
Finally, I'd like to revisit the idea of whether short selling drives down the stock market. As I mentioned in my
November 22, 2008 article, banning short selling would have no impact on the decline of stocks. As my only way to demonstrate this fact I compared the performance of the Taiwan's TSEC Weighted Index to the Dow Jones Industrial Average.
Starting on October 1, 2008 the regulator for the TSEC banned
all forms of short selling in an effort to stop the decline in the stocks. On November 28, 2008 the ban on short selling was lifted with orders for short sales only allowed based on the end of day closing price. In the
chart below, Oct. 1, 2008 to Nov. 28, 2008, I have compared the performance of the TSEC and the Dow Jones Industrial Average to see if there was any material difference between the two indices. As expected, there was no difference in the amount of the decline in either index. Furthermore, when the global stock markets started going higher on November 20th the TSEC index lagged the performance of the Dow by nearly 5%.
The following is a critical observation, both indices experienced equal declines but unequal increases. Had short sellers been pressured to buy back stocks at the November 20 low the Taiwanese index would have likely had an equal or better increase than the Dow Industrials. Based on this evidence we should be moving away from the regulatory effort to take away this critically important feature to a liquid and healthy financial market.
Learn more about short selling by reading
Bear Markets by Harry Schultz. Touc.
Sources:
"Taiwan to Partially Resume Short Selling of Stocks Today." AsiaPulse News. Nov 28, 2008.
"Uptick Rule." Investopedia. Accessed March 15, 2009.
