The Modified Uptick Rule Debate

Coming Soon!
Coming Soon!

The following is not an argument for or against shorting, as that is a non-debate.   The presence of short-selling is a necessary component of a free, liquid and healthy market.  The question we’ll focus on here is what type of form the safeguards against abusive short-selling should take when the discussion by regulators takes place on April 8th.

First, a bit of background on the uptick rule:

The uptick rule, implemented during the last depression in the 1930’s functioned for 7 decades as a curb against most forms of abusive short-selling tactics.  Essentially, it forced thos who wished to short a stock to wait for a buyer to come in before executing the sale.  For no apparent reason, this rule was done away with at the peak of the 2007 bull market, and the end result was a field day for shorts who were now able to “slam dunk” a stock lower, meaning short more shares on each successive tick.

This led to cascading share prices for many stocks, specifically financials, a sector where the stock price action actually did have a very real effect on the underlying business of the company; if the shares of a fast food restaurant were being pummeled, that wouldn’t stop people from eating there, but would anyone want to deposit money into a bank whose stock was down 50% in a week’s time?

The heads of several regulatory bodies and major exchanges, including the NYSE and the SEC, have issued a joint statement that they will be bringing back some form of the uptick rule, albeit a modified one to take into account the fact that the original was written in a time before electronic order entry and day trading.

The main objection that many trading entities seem to have to the new proposal being kicked around is that there is language in there about restricting shorts from operating when a stock is down 10% or more in a single session.

I happen to agree with the detractors of this proposal.  If you don’t restrict the buying of a stock that is up 10% or more, then imposing price restrictions on shorting would be hypocritical and would probably create more distortions of price and what one skeptic has called “synthetic short activity”.

An alternate proposal would be a push for more disclosure from shorts on their positions and trades so that regulators can detect and punish those with patterns of abuse and manipulation.

One other factor that should probably be included in any serious discussion of abusive short-selling tactics is the role that derivatives play in the manipulation of stocks.  Many players don’t even bother shorting stocks when, with less capital, they can sell S&P futures contracts and e-minis, as well as use the credit default swaps market to produce the same effect.  If you can sell enough call option contracts or spike up the put options, you can create the perception that something is “wrong” with the company.  This leads to panicky shareholders and momentum traders doing the heavy lifting for you by obliterating the stock’s price on the way out of it.

As someone who does business with high net worth retail clients, I am often asked about the mechanics of shorting stocks and even criticized for shorting, as to some, the idea of betting against a company is un-American.  My retort would be that shorting stocks, which theoretically carries a greater degree of risk because of the undefined downside (a stock can go up forever), should only be done by sophisticated investors.  Further, nothing is more American than capitalizing on yur research and beliefs, and if this happens on the short side of a trade, so be it.  Profits are profits so long as you are within the boundaries of good taste and the law.

And for the wingnuts arguing for no uptick rule at all…the Dow lost 8000 points give-or-take since the repeal.  Granted, there were a host of factors involved that had nothing to do with abusive short-selling, but it certainly didn’t help matters that a handful of hedge funds were able to create panic at will.  Don’t be a schmuck, we’ve learned about the consequences of a zero-regulation environment….10% unemployment and a 10 kajillion dollar deficit that your grandchildrens’ sperm and eggs will be paying off long after you’re gone.

I’ll be watching with interest and updating The Reformed Broker as news on the modified uptick rule develops.  In the meantime, feel free to chime in below with your two cents…

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