What is a Short Sale Rule?
This is an SEC rule where short sales are only executed on an uptick or when someone pays up to your price where your short order is; you can’t hit the bid on a stock with an SSR. According to the SEC, a short sale refers to the sale of a stock where the seller does not own it.
This type of sale is usually settled through the delivery of a security that is borrowed by or on behalf of the trader.
As a result, the short seller closes the position by returning borrowed security to the stock lender. This means that the trader has an opportunity of purchasing the security on the open market.
History of Short Sale Rule
In 1938, the SEC passed the short sale rule to prevent the short selling of shares in a declining market. At the time, modern trading technology was not available and traders used brokers who were located on the floor of the exchange to buy or sell.
Since the SEC had not placed market mechanisms which guaranteed the prevention of outright manipulation, the short sale regulation helped to seal the loop hole.
In 2007, the SEC rescinded on this regulation via a decree. It led to short sales occurring at price tick in different markets. It is believed that the decision came about following the decimalization of major stock exchanges.
This happened in the early 2000’s. Back then, the tick changes were shrinking following the changes. To ensure the stability of the US stock market, it was felt that the regulation was not necessary.
A test program of stocks was run in 2003 to determine if the removal of the regulation would have any adverse effects to the market. The results gathered led to the decision of doing away with the rule.
Restoration of the short sale rule
As said earlier, the SEC eliminated the short sale rule which is also referred to as the uptick rule. This happened in 2007. After the 2008 Financial Crisis which is believed to have been triggered by a bear raid market manipulation by short sellers in late 2007, the SEC felt the need to reintroduce the short sale rule.
The rule today is known as the alternative uptick rule.
The alternative uptick rule was formulated to restrict short selling which was seen as a factor that drove stock prices down by more than 10% in a single day. The rule was formulated to enable long sellers to be on the front line when it comes to selling their shares.
This is supposed to happen before short sellers begin their trading activities.
According to the SEC, the alternative uptick rule is designed to preserve investor confidence as well as promote market efficiency. This is in line with the recognition of short selling as an opportunity that has a beneficial and a harmful impact on the market.
The alternative uptick rule was approved to impose on short selling once a stock has triggered a circuit breaker. This happens only when prices decline at least 10% within a day and at that point, short selling is permitted only if the security’s price is above the current bid.
Features of Alternative Uptick Rule
Rule 201 or the alternative uptick rule has the following features:
i. Short sale related circuit breaker
This refers to a factor that would be triggered by a security during any trading day when its market price declines by 10% or more.
ii. Price test restriction duration
When the circuit breaker is triggered, Rule 201 will apply to short sale orders for that particular security for the remainder of the trading day. This may even extend to the following day.
iii. Coverage of securities by price test restriction
This regulation covers all equity securities listed on national securities exchanges whether they are traded over-the-counter or via an exchange.
iv. Application
According to an SEC press release modified on February 24th 2010, this feature requires trading centers to establish, maintain and implement written policies and regulations. Which means it should be designed to prevent execution of a prohibited short sale.
Final Thoughts
The uptick rule helped to prevent any aggressive short selling thus eliminating chances of market manipulation. While it was eliminated in 2007, the alternative uptick rule was enacted in 2010 in order to act as a protective mechanism.
As a result, traders and investors have the first priority when trading before short sellers.