How Elimination of the Up-Tick Rule Profits Short Sellers and Increases Volatility

An up-tick is simply an upward movement in the price of a financial security such as stock price. This rule affects traders of financial securities such as stock options. In the summer of 2007 an interesting event occurred in the regulation of securities exchanges, specifically the Securities and Exchange Commission (SEC) eliminated the requirement for what is called the up-tick rule. Since then, the combination of the financial crisis coupled with the elimination of the up-tick rule led to increased scrutiny of the rule despite the SEC's initial reasons for implementing the 2007 amendments to rule SHO.

The elimination of the up-tick rule profits short-sellers who are locking into sales prices they think will be higher than the actual future price. Since the up-tick rule required there to be an upward movement in price(s) before a short sale can be initiated, the rule made it more difficult for prices to move downward as fast as they could have the rule not existed. With the elimination of the up-tick rule, short sellers of financial securities have the added advantage of downward price movements in the event of a low buy to sell price ratio.

Illustration of the uptick rule

To illustrate the above with an example, if you know the price of 100 cattle is $2000.00/head and you want to profit off the price movements of those cattle, you may enter into a short-sale contract at the Chicago Mercantile Exchange (CME). The reason you might do this is because you think sales of beef are on the decline and that will cause downward price movement on the price of cattle. If no up-tick rule is in place and lots of other futures traders also think there will be a downward movement in the price of cattle, then there is one less obstacle in the way of declining cattle prices.

Elimination and reinstatement of the uptick rule

The up-tick rule was eliminated from securities regulation after the bursting of the housing prices bubble had begun and during the early phase of the credit-crisis. Financial observers of the up-tick rule removal postulated the move aggravated and exaggerated the decline in market prices that helped develop the credit crisis into something worse causing the ensuing financial crises. In other words, the timing of the up-tick rule elimination might explain why some IRA's or 401K's might have experienced shocking losses of value.

Had the up-tick rule been in place during the credit-crisis, the massive 1-day declines seen in the stock market might not have been so volatile and steep. In light of mounting evidence and pressure to reinstate the up-tick rule, both the SEC and some legislators within the U.S. House of Representatives reconsidered the idea of reinstating the up-tick rule in the January 2009 bill 302 of the 111th Congress, after the July House of Representatives Bill 6517 appealing to the same thing failed. Similar but not exactly the same calls for reinstatement of the up-tick rule were designed by NYSE-Euronext and other stock exchanges in 2009 as reported by Marketwatch.com in March of 2009. This in theory would add stability to the economy during periods of economic decline or slowed growth for the same reasons the up-tick rule was implemented after the great economic depression of the 1930's.

Summary

The elimination of the up-tick rule profits short sellers and increases volatility because it is essentially removing an obstacle to downward price pressure. If everyone can't sell at once, it leads to less steep declines and more even securities price movements because the prices have to go up before each short-sell can be initiated. In other words, for every step back, a step forward must be taken first necessitating the step back in price movement to be larger than the step forward. Moreover, if long positions in securities decide to sell off, the possibility of amplifying this sell off with short selling becomes more limited because of the up-tick rule. Hence, elimination of this rule can lead to both unrestrained dumping of long positions in addition to leveraged selling through short sales contracts.

Sources:

1.http://www.foxbusiness.com/story/markets/industries/finance/sec-reinstate-uptick-rule-calm-markets/
2.http://www.investopedia.com/terms/u/uptickrule.asp
3.http://www.investopedia.com/terms/s/shortsale.asp
4.http://seekingalpha.com/article/74825-no-uptick-rule-a-convenient-scapegoat
5.http://www.marketwatch.com
6.http://www.govtrack.us/congress/bill.xpd?bill=h111-302
7. http://tinyurl.com/66yetxk (SEC.gov)