The recent decline of the U. S stock market and financial markets around the world, since the Dow Jones reached record high of 14,000 in July 2007, attributed by many investors and financial analyst by the substantial loss of value of securities or bonds linked to sub-prime rate mortgage investments. However, decline of the Dow Jones and other markets magnified by the Securities and Exchange Commission eliminating the ‘up-ticket rule’ or ‘tick test’ (Rule 10a-1 of the SEC 1934 Act), for short sellers on July 6, 2007, (TheStreet.com – August 2, 2007, How to Handle the ‘Uptick Rule’ Removal by Stockpicker Guest Columnist.) Shorting a stock provides a financial method by which the short seller borrow shares of a stock, and expects the value of the shares to depreciate and then covers the short position at lower price, thus profiting the difference after any commission. However, the short position can be covered at higher price, thus incurring a loss. Eliminating the ‘up-tick rule’ made the process of shorting a stock easier for short sellers including hedge funds.
Many investors and financial institutions suffered tremendous financial loss during the stock market crash of 1929, much of the decline blamed on short sellers, who profited when stocks declined and had no over sight regulations. In the 1930s, the Securities and Exchange Commission implemented the ‘up-ticket rule’ for shorting stocks: Short sellers could only short a stock, when last price of the stock moved up to the price to be shorted, thus providing a temporary stabilizing feature and an orderly movement on the downside, during a stock market crisis. For example: If a short seller wanted to short 100 shares of ‘XYB’ stock at $15.00 a share, the price of the stock would have to go up to at least $15.00 a share or on an ‘up-ticket.’ If ‘XYB’ stock was currently trading at $14.99 and next asking price (purchase price) $15.00 for 100 shares. Once the stock price increased $15.00 a share then the execution of the short sale order would be executed. Also, the ‘up-ticket rule’ is applied to short sellers when covering their short position or entering an order to sell the short position. This means short position can only be covered (sold) when the stock price is ‘up-tick’ to a price given by the short seller.
In 2005, Securities and Exchange Commission examined the positive and negatives implications for removing the ‘up-ticket rule’ during a pilot program of 1,000 stocks. Ingrid Werner, a professor of Ohio University’s Fisher School of Business and two colleagues studied this pilot program of 1,000 stocks and their findings where published. Conclusion of the study found: “Short selling did increase and the pilot stocks did experience higher-term volatility immediately after the suspension. But the study also found that return from the stocks and daily volatility were unaffected.” (USATODAY.COM – August 9, 2007- Rule change may be adding to volatility by Emily Chasan, Reuters.) Unfortunately, the study did not examine the consequences for low float stocks (stocks with few number of shares traded daily) and small cap stocks, which are targets for manipulation. (Ant & Sons (Charting the Financial Seas) – Uptick Rule to Blame for Market Volatility – August 14. 2007 – Posted by Thomas Catino). No doubt, hedge fund managers (and short sellers) must have applauded, after the ‘up-ticket rule was rescinded by gaining an easier financial hedge or profit, against the downside movement by selecting those stocks which could be shorted without any infringement upon the ‘up-ticket rule.’
However, hedge fund managers and short sellers over estimate their potential gains: Many situations short sellers have to cover their short positions when market volatility changes to the upside or stocks which were shorted report better than expected earnings or get up graded by analysts, as result investors buy those shares, appreciating their stock price value, and short sellers have a loss either on paper or take a loss.
Ttime will tell, if the removal of the ‘up-ticket rule’ can be linked directly or indirectly for increased stock market volatility and increase momentum for stock market declines, for stocks which can be shorted. Also, when a stock can be shorted (including day trading), declines based upon false information or erroneous information listed on stock message boards, fast profit taking occurs, without any hindrance of regulation or ‘up-ticket rule’. Unfortunately for most investors, buying stocks for the long or short term may have to endure times when their stocks decline further because of no ‘up-ticket rule’ for limiting downside price depreciation.