What is the Short-Sale Rule?
The short-sale rule was a trading regulation in place between 1938 and 2007 that restricted the short selling of a stock on a downtickin the market price of the shares.
Key Takeaways
- Between 1938 and 2007, market participants could not short a stock when its shares were falling.
- The Securities and Exchange Commission (SEC) lifted this prohibition in 2007, allowing shorting to occur on any price movement.
- In 2010, the SEC adopted the alternative uptick rule, which prohibits short selling when a stock has dropped 10% or more.
Understanding the Short-Sale Rule
Under the short-sale rule, shorts could only be placed at a price above the most recent trade, i.e., an uptick in the share's price. With only limited exceptions, the rule forbade trading shorts on a downtick in share price. The rule was also known as the uptick rule, "plus tick rule," and tick-test rule."
The Securities Exchange Act of 1934 authorized the Securities and Exchange Commission (SEC) to regulate the short sales of securities, and in 1938, the commission restricted short selling in a down market. The SEC lifted this rule in 2007, allowingshort sales to occur (where eligible) on any price tick in the market, whether up or down.
However, in 2010, the SEC adopted the alternative uptick rule, which is triggered when the price of a security has droppedby 10% or more from the previous day's close. When the rule is in effect, short selling is permitted if the price is above the current best bid. The alternative uptick rule generally applies to all securities and stays in effect for the rest of the day and the following trading session.
History of the Short-Sale Rule
The SEC adopted the short-sale rule during the Great Depressionin response to a widespread practice in which shareholders pooled capital and shorted shares, in the hopes that other shareholders would quickly panic sell. The conspiring shareholders could then buy more of the security at a reduced price, but they would do so by driving the value of the shares even further down in the short term, and reducing the wealth of former shareholders.
The SEC began examining the possibility of eliminating the short-sale rule following the decimalization of the major stock exchanges in the early 2000s. Because tick changes were shrinking in magnitude following the change away from fractions, and U.S. stock marketshad become more stable, it was felt that the restriction was no longer necessary.
The SEC conducted a pilot program of stocks between 2003 and 2004 to see if removing the short-sale rule would have any negative effects. In 2007, the SEC reviewed the results and concluded that removing short-selling constraints would have no "deleterious impact on market quality or liquidity."
Controversy Around Ending the Short-Sale Rule
The abandonment of the short-sale rule was met with considerable scrutiny and controversy, not least because it closely preceded the 2007-2008 Financial Crisis. The SEC opened up the possible reinstatement of the short-sale rule to public comment and review.
As mentioned, in 2010 the SEC adopted the alternative uptick rule restricting short sales on downticks of 10% or more.
