What is an Uptick Rule?
Known as Rule 10(a)(1) of the Securities Exchange Act of 1934, the uptick rule allows investors to short a security only at a price higher than the security's last trade.
How Does an Uptick Rule Work?
Essentially, a short seller is trying to do the same thing a regular investor is: buy low and sell high. However, the short seller is trying to accomplish this in reverse order. In other words, he/she is trying to first sell high and then buy low. It's a way to capitalize on an anticipated decline in the price of a security. When a large number of investors decide to short or sell a particular stock, their collective actions can snowball and have a dramatic impact on the company's share price.
Hence, the uptick rule. For example, if Company ABC is trading at $10 per share, the uptick rule requires investors to short the stock at a price above $10 if the security is down 10% or more from the previous day’s close.
Why Does an Uptick Rule Matter?
Over the years, unsavory traders have engaged in short selling solely for the purpose of driving the share price down to the point where shareholders would panic and sell. This is a 'bear raid,' and it is an illegal form of market manipulation. If investors can only place a short sale when a stock is trading up, they have less incentive to conduct bear raids.
The basic procedure for conducting a bear raid is that speculators execute a series of short sales that convey a 'vote of no confidence' to the company and to other investors. This may incent the company to drop any recently announced plans that it thinks may have inspired the short selling, which could in turn lower the value of the firm. The series of short sales also implies to everyone else in the market that the short sellers have some sort of meaningful insight into the prospects of the company. Other investors start selling their shares or begin shorting the stock as well, creating a self-fulfilling prophecy of a lower stock price.
The uptick rule thus enjoyed decades of steady use since its inception in the late 1930s. But in 2004, the SEC lifted the uptick rule on about a third of listed stocks as part of a year-long test of the rule's effectiveness. After determining that the uptick rule didn't seem to have any effect on market manipulation, the SEC eliminated the uptick rule altogether in July 2007. In 2010, it brought it back, with a twist: It only applies if a security is down 10% or more from its previous day’s close.