In Defense of the Uptick Rule

A Background to Short Selling

There are two dominant ways of making money off of a stock price change. The most obvious way is to go "long" on the stock, meaning that the investor believes that a stock is undervalued and the price is destined to rise in the future. So the investor buys this stock on the market, waits for the price to rise before selling the stock. The profit is in the spread.

However, how would an investor make money off of a stock if he or she believes that a stock is overvalued? The investor can "short" the stock, by borrowing the stock from a lender (usually a broker at an investment bank), giving collateral, usually in the form of bonds, cash or blue-chip stocks, in return. The investor then sells the stock at the currently assumed "high" price in the market, waits for the price to drop, repurchases the stock from the market and returns it to the original lender. The profit is in the spread between the price the stock is sold for and the price for which it is repurchased (minus the fees paid to the lender for lending the stock each day). Short selling is an extremely common investment strategy among hedge funds and represents a significant portion of prime brokerage business within investment banks.

Within the world of short selling, there are two concepts to grasp. The first is described above. The second is the concept of "naked" short selling, a variation of short selling that was made illegal last fall. Naked short selling is the practice of selling a stock that you do not yet own and have not yet borrowed. For traders this process is functional and not overly risky because open trades may be filled even after the settlement date, when the trade is considered to have "failed." Thus, traders have significant time after making a sale to borrow in the stock and fill the order.

At first this may sound like a reasonable way to create liquidity; however, many argue that the practice influences supply and demand dynamics of stock prices by generating artificial supply and, therefore, diluting stock prices. The SEC enforces the naked short selling ban by comparing trades flagged as "failed" with a banks/funds inventory at the time of sale.

Short Selling on Financial Stocks

After the failure of Lehman Brothers in September 2008, the SEC and the UK's Financial Services Authority (FSA) temporarily restricted short-selling on several financial stocks. This was done in response to assertions that both short selling and naked short selling were too widespread and influenced the collapse of Lehman. The ban was lifted in October 2008 and many now regard the ban as unproductive, arguing that it reduced market liquidity and, thus, exacerbated price swings. This is evidenced by comparing the smaller market swings in Hong Kong, which enforced strict regulations on short selling without issuing a ban, with swings in markets like London, where a full ban was in place.

Bank of America presents a good example of negative volatility on a financial and systemically important stock caused partly by short selling. Much of the drop-off occurred after October 2008 when the short selling ban was lifted (with no uptick rule in place).

Some would argue that short selling (including the practice of naked short selling) was the key culprit in bringing down Bear Stearns and Lehman Brothers. In both cases, investors learned of the fallibility of the financial firm and began shorting. A rapid stock price decline can incite panic and eliminate the issuer's access to capital (through the forms of loans, deposits and trading activities).

Lehman Brothers filed for bankruptcy on September 15, 2008, just after seeing an enormous spike in short interest. As you can see from this chart provided by seekingalpha.com, the percentage of Lehman's Market Cap on loan (%MCOL) increased from 10% to 18% between September 5 and 11. Utilization jumped from 35% to 63% in the same time frame.

Short selling was a factor in Lehman's failure, the last straw on an edifice built of glue and twigs that appeared to be sturdy. Shorting speeded the collapse of Lehman's stock price. That, in turn, helped spread doubts about Lehman's ability to survive, and that doubt led to a run on the bank. The negative feedback loop continued until the bank's access to credit disappeared, dooming the institution. Lehman may have failed anyway, but shorting helped rush it over the cliff.

That said, short selling may not deserve all of the vilification it has received in recent months. In normal circumstances, short selling often generates increased trading activity - often making accurate price discovery easier. Nonetheless, the valuable role of short selling in stable markets does not preclude the need for regulation. In a panic, the danger is that unrestricted shorting will drive a stock well below its reasonable price, with damaging effects all around.

Further market regulation is in the works at the SEC, this time on the general practice of short selling. The "uptick rule" has generated impassioned debate among free market theorists, hedge fund managers, stock issuers and regulators.

The Uptick Rule

In 2007 the SEC suspended the Depression-era regulation on short selling known as the "uptick rule." Today, the commission is debating whether to reinstate a similar rule in order to reduce the kind of downside volatility that hit stock prices, most notably in financial stocks, during late 2008. If enacted, the uptick rule would require that a short sale be made only at a price higher than the last price. (There is some debate as to whether the "last price" should reference the last sale price or bid price). Therefore, when an investor enters a short sale order at a price above the current bid, a short seller ensures that his or her order will be filled on an "uptick."

There is a dearth of solid research of the uptick rule's effectiveness. This may be due to the fact that comparing today's non-uptick rule volatility with the volatility generated while the uptick rule was in place is a little like listening for the dog that didn't bark. Who knows how bad the 1987 stock collapse could have been had the uptick rule not already been in place? The same could be said of the dot com bust. Arguably, no downturn is the same - they often affect different industries differently. The most recent, marked by a total loss of confidence in an over-leveraged financial industry, is most likened to the Great Depression, in response to which the uptick rule was first put in place, 1934.

The Case for the Prosecution

Some deny that short selling exacerbated the financial crisis at all. TFS Capital portfolio manager Eric Newman was quoted in the Wall Street Journal Online, "I think [the uptick rule is] a feel-good thing so Congress and everybody involved can act like they're doing something concrete...I don't think the short-sellers have made it any worse."

A more common argument is presented by Herb Greenberg in his blog post "No Uptick Rule: Convenient Scapegoat?" He argues, "If they were to reinstate the uptick rule, shouldn't there be a downtick rule? Wouldn't it help eliminate the stock melt-ups and bubbles?" This case is usually posited by market stalwarts and hedge fund managers. The idea is that the uptick rule represents an inflationary bias - volatility is okay on the way up, but not on the way down. And the result would be artificially high stock prices.

But can the two sides of the market really be compared and equated?

There is an innate pathology of markets that dissimulates the up and down sides. Therefore, the uptick rule actually functions to liken the two.

In Defense of the Uptick Rule

If enacted, the uptick rule will serve to create bumps in stock market slides, thereby making the shape of declining stock prices more similar to that of rising prices. The uptick rule will help, in some small measure (the extent of which will never be truly known), bridge the gap between the way stock prices tend to rise and fall.

Specifically, the uptick rule will help counteract the extreme sell off patterns occurring during times of stock market panic and the effects of hedge funds, which often jump on each others' shorting bandwagons when profitable.

Is the upside as volatile as the downside? When one looks at the closing price of the S&P 500 over the last 25 years, both daily and weekly, it is significantly more likely for there to be an extreme percentage change in closing price on the negative side as compared to the positive. The graphs below demonstrate this pattern. An extreme daily percentage change of greater than 5% occurred one quarter more often on the downside than on the upside. Weekly, a percentage change of greater than 10% occurred nearly twice as often on the downside as it did on the upside.

Short selling is dominated by institutions (hedge funds, investment banks and money managers). Individual investors, who trade less often and in a more stable profile, are often focused on long-side investing. Therefore, short selling attracts the institutional investors that are more apt to ride the market rather than trade solely on well-researched belief that a stock is overvalued.

Intensive short selling has not only affected important financial stocks. In fact, Alcoa Inc., a major aluminum miner and manufacturer that is subject to London Metals Exchange aluminum price forecasts, presents a prime example of the fact that positive volatility is rarely as intense as negative volatility.

In 2007 Alcoa's stock price shot up to $47 after hovering around $30 over the previous few years. The sudden boom was caused by rumors of a takeover by Rio Tinto. The acquisition was not realized, as Rio chose to take-over Alcan instead; as a result, Alcoa's stock price dropped more than $10. In contrast, between September 2008 and February 2009 Alcoa lost a whopping $27. The cause was a pessimistic LME outlook for aluminum price coupled with a decline in projected aluminum consumption during the commencing recession.

During boom times of optimistic LME outlook, Alcoa's rapid stock price increases were usually less than half the negative price change that occurred in late 2008. Alcoa's share price history exemplifies the fact that upside volatility is usually not as extreme as downside volatility.

The Alcoa example also shows the piggy-backing effect of short sellers after a pessimistic report. In January 2009, the value of Alcoa rose somewhat, most likely because long-term focused individual investors saw the post-recession potential in Alcoa, not to mention that it had an extremely low P/E ratio of 5.75. Such a P/E ratio gives credence to the idea that Alcoa was over-shorted. Therefore, one potential benefit of the uptick rule is that it could reduce this problem of overshooting on the downside.

The uptick rule may not completely even the playing field between negative and positive volatility, but it is a helpful mechanism to smooth the downside.

As Jim Cramer, an ex-hedge fund guru, prophesized in 2005:

Without the uptick rule "hedge funds can sell shares short just like they sell them long: with reckless abandon...I know I would have done it because I know I can process this stuff [shorts] faster than the longs. You could see some real nasty things happen to companies that mess up. You will see them banged down harder and faster than you would ever believe... This rule is enough to make me want to get back into the hedge fund game."

Emily Gallagher was an analyst on the trading floor at Deutsche Bank - London in the stock borrow/loan department.