Even if you've only been casually following the stock market for a short period of time, it's probably readily apparent that the vast majority of market participants are bulls. That means they want stock prices to rise and they are usually quite steadfast in this belief, wanting others to join them in the effort to keep markets continually moving upward.
Of course there is another side to the coin and that is the bears (or the shorts). Making money when stock prices fall, short sellers are usually vilified in the court of public opinion for profiting while others are losing their shirts. As a result, many investors erroneously believe short selling is immoral or too risky or that short sellers are bad people.
While all of those thoughts are wrong, there have been attempts to make short selling more difficult and they normally emerge during bear markets. The most prominent attempt at inhibiting short selling is the uptick rule, which essentially states a trader cannot short a stock unless its price is going up. That's basically rigging the game because if you're short, you're not likely to stay in a position very long if it keeps going up.
Enough of the commentary for now. Let's take a look at the history of the uptick rule and whether or not it can be helpful to average investors.
History of the Uptick Rule
The uptick rule was implemented in 1938 toward the end of quite possibly the worst bear market in US history. It was a response to heavy short selling in 1937. Another interesting piece of history is that the first Securities and Exchange (SEC) commissioner was in favor of the uptick rule. That man was Joseph Kennedy, father of John F. Kennedy.
One reason that the uptick rule was useful back in the 1930s and 1940s was that groups of investors could conduct what were known as “bear raids.” Meaning they would pool their resources into shorting the same stock, therefore driving its price down. This would force long investors to panic and dump their shares, driving the price down even further.
As markets grew over the years and became more technologically advanced, the ability to stage a bear raid diminished. So in 2004, the SEC experimented with a program to lift the uptick rule for about a third of the largest stocks on US exchanges. By mid-2007, the rule was eliminated altogether as the SEC claimed that it didn't need the uptick rule to weed out price manipulators.
Arguments in Favor of the Uptick Rule
Basically, there is one argument in favor of the uptick rule and that is limiting the ability of large institutional investors, particularly hedge funds, from pounding slumping stocks in a bad market. Many bulls believe that bearish traders latch on to even good stocks in punk markets and drive their prices down, forcing average investors to dump their shares, too.
At the heart of the matter remains the fact that bullish investors do not want a bad market to turn worse and bears want to profit by making things worse. What the argument either refuses to acknowledge or chooses to gloss over is the fact that short selling is a natural function of capital markets and can provide a calming effect in the face of irrational bullishness.
We need only remember the go-go days of the mid to late 1990s where tech companies that made no money saw their stock prices soar. This is a fine example of bulls getting too excited too fast and they wound up punished when cooler heads prevailed and those stocks came crashing back to earth.
In this case, without an uptick rule, shorts sellers could've more easily shorted these bad stocks masquerading as blue chips and called into the question the efficacy of their rich valuations. That leads us to another point. Short sellers, the good ones anyway, are especially adept at spotting companies that are headed for disaster before their stock prices plummet. Let's say you own shares in a company and notice that short interest in the stock is growing. This could be a sign that it's time for you to dump shares before the price declines dramatically.
One more point in favor of the shorts: They have to buy to cover to their positions. This means that when a short seller wants out of his position, he has to enter a buy order. How dire could things get in a bad market if a vast majority of the orders coming were sell orders? The market doesn't discern between buys to cover and regular buy orders, it simply reacts accordingly to the buy orders outnumbering the sell orders.
Reviving the Uptick Rule
For better or worse, there have been efforts to reinstate the uptick rule. Not surprisingly, they seem to reappear in the midst of bear markets. It appears the desire to reinstate the rule is misplaced at best. Market historians will remember that in 2008, the SEC restricted altogether short selling in certain stocks and this did nothing to stave off the bears. And in 1938, when the uptick rule first went into effect, the markets popped briefly only to resume the downward spiral that had begun in 1937. In other words, the uptick rule is no match for an enraged bear.
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