What is the Uptick Rule?

Mary McMahon
Mary McMahon

The uptick rule is a rule which states that people cannot short sell stock during a downtick. In other words, the value of a stock must be rising when someone makes a short sale. This practice is designed to prevent a cascading effect in which short sellers “pile” onto a stock to drive the price down for the purpose of profit. Like many regulations in the financial industry, the goal of the uptick rule is to prevent unfair market manipulation which still facilitating open trade.

The uptick rule is a rule which states the value of a stock must be rising when someone makes a short sale.
The uptick rule is a rule which states the value of a stock must be rising when someone makes a short sale.

Short selling is a complicated process, and it's easy to get in big trouble as a short seller. When someone makes a short sale on stock, he or she borrows the stock from someone else, and sells it to another person at a set price. When the price of the stock falls, the short seller buys back the stock at the lower price, gives it back to the original owner, and keeps the difference in price. If the value of the stock rises, the short seller will be forced to pay extra to cover the sale, which is what makes the practice dangerous, because it's easy to take a loss on a short sale.

In a simple example of the way the uptick rule works, John decides he wants to short sell stock in Acme Corporation. He is not allowed the short sell the stock, however, until the prices are following an uptick pattern, indicating that the price of the stock is rising. The uptick rule places John at a disadvantage because if he short sells during the uptick, he may be forced to pay the difference in price if the stock goes up. However, it prevents him from taking advantage of a situation in which Acme's stock is experiencing a downward price spiral.

This rule was instituted in the United States in 1938 as Rule 10a-1, in response to concerns that short selling practices might have driven the Great Depression. The rule remained largely unchallenged until 2005, when the Securities and Exchange Commission (SEC) quietly lifted the uptick rule on some select stocks to determine how much of an impact it really had. In 2007, the SEC abolished the rule altogether, but by the end of 2008, people were already clamoring for a return of Rule 10a-1.

One of the interesting things about the demands for the restoration of the uptick rule is that studies failed to suggest that the rule actually had that much of an impact on stock prices. Financial analysts suggested that short sellers would not be well served by piling onto stocks and driving the price down, and that the only companies which might suffer when no uptick rule is in place are those which are already struggling. Economists and pundits debated the value of the uptick rule fiercely, and despite questions about its value, in early 2009, the SEC announced plans to restore the rule in order to cope with the extremely volatile American economy.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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