The UpTick Rule
A: I want to discuss the uptick rule, being that the ban on short selling expires today. I don't listen to Fast Money as much anymore, but I just happened to have it on last night and overheard a discussion on re-instating the uptick rule as the ban on short selling expires. Assuming the ban does expire as planned, I agree with this 100% and actually argued on this side of the debate many months ago with a wall street insider who happens to be a compliance attorney working on short sale ban implementation! Now, my general feeling on short selling is that I think it has a place in the free markets, so it should be restored. Then again, I'm a trader deep down inside. Let me explain this uptick rule for those that don't know what it is and more importantly, how trading firms used to get around it.
First, a quick stock trading 101: Stocks are traded on exchanges. There are bids and there are offers; just like in any trade. The inside market for a stock consists of two prices; the highest bid & the lowest offer! . The difference between the highest bid and the lowest offer that make up this inside market is known as the spread. The image below shows you the highlighted inside market (highest bid & lowest offer) of the stock JPM with both an uptick and a downtick (refer back to this image as you read on):
There are two ways to sell short:
1) hit the bid and sell short (not taking advantage of the spread)
2) place an offer and have a third party execute the sell trade (buy from you taking advantage of the spread)
Now, to understand how the uptick rule worked you first need to grasp one very simple concept regarding how the inside market changes as stocks trade.
To sum up the basics, an uptick occurs as the stock is on its way UP (with price rising); as evidence by a new high bid coming into the inside market. A downtick occurs as bids leave and the stock is on its way down (with price falling). Now lets get on with the official definition of the uptick rule, that on its own, probably would be confusing for someone who doesn't trade or familiar with the rule.
UPTICK RULE - A rule established by the SEC that requires that every short sale transaction be entered at a price that is higher than the price of the previous trade. This rule was introduced in the Securities Exchange Act of 1934 as Rule 10a-1. The uptick rule prevents short sellers from adding to the downward momentum when the price of an asset is already experiencing sharp declines.
I bolded that last part because that really is the reason for the uptick rule. That is, to prevent massive selling pressure from being applied as a stock is falling which would increase the downward momentum of the move. You see, if a stock is falling, there will be no chance to short it because the stock will experience mostly downticks as bids are either removed or hit by the selling trader (look at the left trading box of JPM which has a downtick).
Without this rule in place, you could just sell all you wanted as the stock fell, putting more force onto the down move. With the rule there, the downrun has probably ended and the stock will see new high bids come in (allowing me to short again as the downtick changes to an uptick) making the short trade less likely to be immediately profitable.
When I was trading with stocks in fractions, the uptick rule was in place. But traders got around it using something called bullets. In those days, bullets had to be setup for any one individual stock that you wanted to trade. To set it up, you had a 2nd account where you bought X shares of the stock, with X being the ultimate number of shares you could short on the stock with a downtick. Then, you buy puts on the stock. I forget the formula used but the idea was that the put option contract always offset the losses or gains in the stock that was held long in the 2nd account; making the trade net out to zero or very close to it.
Once this was setup, bam, you could short on a downtick the number of shares that you bought in that 2nd account, because technically you were selling shares of a position that you were long in; when in reality you were day trading it short and bypassing the uptick rule. Another less complicated way was for the trader to do two simultaneous trades; first you place a small high bid order creating an uptick and then you quickly hit the bid underneath you to take the short position. This required very fast hands.
I'm not sure if bullets exist anymore or if they caught on to it, and for the record, I never used them because I only focused on trading long positions. But it proves that if they re-institute the uptick rule, wall street will likely find a way around it! So they better be on top of it. And there you have it, the uptick rule explained for those that didn't quite understand the official definition.
Posted by Noah
Wed Oct 8th, 2008 11:01 AM
FYI - Part of the motivation for this was in response to questions and debates I got in with colleagues about what is causing this mess. Ironically, a colleague actually blamed the stock selloff on the ban on short selling, because now shorts are not around to cover, and buy stocks; and argued with me over this for a few minutes
This could not be further from the truth. Yes, the ban on short selling is removing a bit of buy side pressure that would have come to cover short positions, but in no wway is the adjustment in equity prices caused by the ban. If the ban was not there, a 500 pt down day could have been a 800pt down day. The cause of the adjustment in stocks is from:
1) bust of the credit bubble; credit deflation
2) troubled balance sheets of banks
3) illiquid secondary mortgage market and the market value placed on toxic assets held
4) bust of housing bubble; housing deflation
5) extinction of MEW
6) strapped consumer
7) consequences/counterparty disruptions of bail outs, bankruptcies, rescues, credit events
8) lack of trust amongst banks
9) lack of confidence
10) lack of transparency in unregulated markets such as credit default swaps with notional value of some 65 trillion
11) global slowdown
12) rising credit costs
13) disruptions in commercial paper market
14) deleveraging/liquidations
15) natural response to tighten lending standards
16) destruction of shadow banking system money supply; BS accounting rules
17) loose fed policy following dot com bust leading to credit boom and irresponsible lending
18) govt subsidizing housing via CRA, FHA, Fannie/Freddie with goal of keeping rates low so everyone could afford a home
19) creative loan products with short term rate fixed, higher adjustments
20) gross oversupply of homes
well, you get the point! Lack of shorting resulting in lack of buying to cover did not put us where we are!
Posted by anon
Wed Oct 8th, 2008 01:21 PM
Great explanation Noah w/ only one problem. If your company found a way around the uptick rule when you were trading, what is to stop firms from doing the same thing this time around?
That would make the uptick rule simply not strict enough to combat the problem of short sellers adding as you say "more downward pressure" to falling stock prices????
And what about naked short selling? How is that different?
Posted by Noah
Wed Oct 8th, 2008 02:28 PM
anon - Well I would like to think the SEC is on top of this, but they likely arent. They have to restore short selling, they cant just ban it permanently. It has a place in free tradable markets. So they need to work on oversight and restrictions on the short selling, and I think the uptick rule was fine before, so I dont know why they removed it to begin with. I stopped trading, bt when I heard they removed it, I knew many traders loved that as it allowed them to really pile on stocks that are negative for that particular trading day.
Stopping rumors and such is impossible. So I dont know what else they could do to tighten the belt
Posted by drtomaso
Wed Oct 8th, 2008 03:56 PM
Why would we need an uptick rule, as long as all shorting was covered?
I remember (I worked in IT for IBs at the time) when they were considering removal of the uptick rule- and it was removed as a trial on a basket of stocks. It clearly showed that the uptick rule had little to no impact on asset prices.
Force a borrow to remove systemic risk. Require trading to be done on margin, not credit, if you're feeling paternalistic. But shorts are viable players in the market place- they provide liquidity for those with longer time horizons, floor protection for asset prices through covering and profit taking, reduce trading costs, and provide a profit motive for good old fashioned investigative accounting.
Posted by Noah
Wed Oct 8th, 2008 04:08 PM
anon - naked short selling is shorting without borrowing, or locating the borrowed shares first. To sell short, the stock you are selling must be allowed to be borrowed, or exist. I believe there is a 3 day settlement period where the stock must be delivered to the buyer.
There are 3 parties to a short trade:
THE SHORT TRADER - selling stock he does not own
THE BUYER - buys the stock that the short trader sells to him to get short
THE LENDER - lends the stock to the short trader for the short sale; since you cant sell what you dont have, you have to borrow it somewhere
Posted by Noah
Wed Oct 8th, 2008 04:17 PM
drtomaso - when was that experiment? Clearly we are in very volatile times and I think if the experiment was done today, they would find much different results.
When you mean covered, do you mean that the shares are located/borrowed first before the sale? Sorry, I really am no expert on short selling and the intricacies of different types. Please explain.
What I do know, is that the uptick rule did have an impact on trading when I was actively day trading with high BP in the markets from 1998-2004.
Posted by drtomaso
Wed Oct 8th, 2008 06:02 PM
Yes- by covered I mean having a borrow/locate on the issue.
Certainly there will be an impact on trading if there is an uptick-rule. It will be more expensive to short since I have to pay someone to implement all that technology to wait for the uptick, etc. It doesnt mean you cant short- and thus it also doesn't mean there is a measurable effect on prices. Also recall that all during this time, naked shorting, prohibited by law, was allowed to continue virtually unchecked, and that arguably had a greater impact on asset prices.
I'm not sure that the volatility would have any effect either- at least not as intended. If the market is more volatile, with wild intra-day swings, wouldnt that imply greater instances of "upticks" and thus greater frequency of short-trading opportunities?
I recall them easing the uptick rule on a sample basket of securities back when I was leaving Morgan Stanley, so sometime around summer, 2005. I'll have to search around on Google to see when this happened.
My whole point on this topic is that short sellers have been unfairly maligned in this most recent downturn. Show me a CEO blaming shorts for his companies current stock price, and I will show you a desperate CEO, grasping at every available straw to salvage himself from his poor leadership and lack of risk management. And the fix- outright banning of short sales, introduced for the first time a concept to traders/investors in the world's most developed market, a concept usually reserved for those investing in the third world and developing nations- political risk. Is it any wonder that no one is investing long term? I'd hesitate to hold a position over night when Uncle Sam could step in and wipe me out at any time.
Posted by jeff
Wed Oct 8th, 2008 06:12 PM
While bullets let you get around the uptick rule...they actually created a prior short position that would not have been there. It is essentially a time shift of the short sale. Let me explain. The trader bought stock, and bought puts to hedge it thus setting up the bullet....but the dealer who sold the puts also went out and shorted the stock themselves in order to hedge their exposure on the put (all dealers do this, they are not in the business of directional bets, they play the spread and in the case of options still get a decent commission). The short sale transaction done by the dealer is done on an uptick. Days later when the trader unwinds the bullet to "get short" he sells the stock he owned, re-exposing himself purely short with the put option he still holds. So you see a short on an uptick by the option dealer is converted to a synthetic short of stock on a downtick by the trader later. When you unwind your put option...the dealer covers their short and actually buys stock again. So people may "get around" the uptick rule again...but it will still create a time shifted short on uptick and future stock demand.
Posted by anonymous
Wed Oct 8th, 2008 06:19 PM
Decimalization and program (computerized) trading were what really killed the impact of the uptick rule, though drtomaso is right that there is a lot of evidence out there that it didn't have much of an impact even before then. The SEC actually did a lot of its own research on this during the experiment phase (which I think started around 2004) and came to the conclusion that it was useless. Those SEC studies/conclusions are a big reason why they didn't re-introduce it now in an emergency order.
Posted by Noah
Wed Oct 8th, 2008 06:23 PM
anon & tomaso - great stuff thanks! I was not aware of the SEC's investigations as I stopped trading in 2004. Decimalization killed it for me as a trader! Spreads tightened so much. Not that its bad, but as a trader who likes volatility, I enjoyed the fraction days
Posted by Noah
Wed Oct 8th, 2008 06:25 PM
Jeff - Ahhhhhhhhhhhhhhh! Now let me re-read that. Thanks for the clarification! Are you a LOST fan?
Posted by jrd
Wed Oct 8th, 2008 07:14 PM
"Another less complicated way was for the trader to do two simultaneous trades; first you place a small high bid order creating an uptick and then you quickly hit the bid underneath you to take the short position. This required very fast hands"
In order for this to work, you actually have to trade against the small high bid and then through the stack against the size below. Most exchanges won't let you trade with yourself so this strategy requires a buddy to put the small high bid for you to trade against (If you try to trade against yourself, most exchanges will cancel your resting order, which in this case generates a downtick.)
This practice constitutes market manipulation.
Posted by Noah
Wed Oct 8th, 2008 07:24 PM
yes, and I also discussed how bullets were used to bypass the uptick rule so traders could sell on downticks.
We are not talking about institutional trades here involving hundreds of thousands of shares. We are talking about a day trader who sets up to short say 1,000 or 1,500 shares, quickly in and out.
The point was that wall st found a way around it. You want to talk about manipulation, look at the guys that do it on a large scale and may actually have an impact on a stocks performance. What I refer to doesn't impact the stocks movement because it is on such a small scale.
Posted by jrd
Wed Oct 8th, 2008 07:28 PM
In the equity options markets, you are far more likely to trade with a market maker than with a dealer. Market makers are continuously on the bid and offer of options and keep their book of options hedged. If you buy puts or sell calls (or both to create a synthetic short position) the market maker will sell the underlying to hedge his options position.
Note that market makers are exempt from the recent SEC rules forbiding both naked short sales and short sales of specific equities (http://www.bloomberg.com/apps/news?pid=20601087&sid=a6vYdD7V5sB4&refer=home).
So even today, if you sold 1000 at the money calls and bought 1000 at the money puts on GS, the market maker that took the other side of your trades would hedge with a short sale of roughly 10,000 shares of GS.
Posted by jeff
Wed Oct 8th, 2008 08:47 PM
Thanks for the clarification JRD...market maker was the proper term...rather than dealer.
Posted by Randy Reis
Thu Oct 9th, 2008 07:41 AM
Hi Noah, great post as many of yours are. Just to add a bit to the whole discussion. I was an option market maker on the floor for too many years, and here's how the whole bullet thing would take place:
A broker for an upstairs trader, who might be flat or already short 50,000 shares would come into the crowd and ask at what price he could buy a paired combination of deep in the money puts and stock, so lets say the stock was trading at $50 and the 70 strike put had an intrinsic value of $20. The market makers in the crowd would sell the combination for what seems like fair value, $70, which market makers usually don't do. So now the upstairs trader had his long position, protected with puts, this position is fully protected and could even produce a profit if an unlikely rally toward the 70 strike would occur (and a corresponding loss for the market maker, though he would adjust his position as the rally occurred...usually). A lot of these traders were doing this only for day trading purposes. They would put it on in weak stocks, relatively high priced stocks where there was the likelyhood of a big seller coming in to the market place, as the market was in a decided down phase, like now. And when one did they would wait for a big seller to show up and race that big seller to hit any bids in sight, knowing the weakness in the stock and the market might drop the stock 4-5 points or even mnore, then their position could be covered.
The market maker was willing to put on this position ...short put, short stock because they collect interest, not only on 80-85% of the money coming in from the short stock sale but also, the sale of the $20 put reduces their capital interest charge on the option part of their account. So a $50 sale on say 10,000 shares brings in $500,000 in short stock funds on which interest is collected on $400,000 or 80% of it. Rates were higher, lets say 8% was the short rate (traders, pay a higher rate on long positions than they collect on short positions, clearing houses do very well in time like those). So 400,000 x .08 = 32,000 interest / 365 days per year = $87.67 in daily interest. Lets say the options weren't exercised (another discussion)the market maker made $1753 on the trade. Now they didn't just do 10,000 shares, they would literally do as many as possible all around the floor in any stock that they felt had little chance of returning to the strike price. There were guys making hundreds of thousands of dollars monthly just doing these trades. No trading ability required, just good math and good contacts with the brokers bringing these paired trades to the floor.
Back to short selling. It provides neither more selling or buying pressure over time, one cancels out the other, but it can exacerbate both a nasty selloff as the bids that would be hit by natural long sellers are often hit first by these short sellers, when they cover it can do the same to the upside in a short squeeze. But it can also dampen volatility as it adds to the liquidity when shorts are placed on the offer or above (the uptick works here) or as they cover their shorts by placing orders on the bid or lower.
Ok, now another reason why the lack of an uptick rule didn't have all that much effect. Most of the financial stocks that had the new rule enacted on them have options trading on them. Anyone can get a short position just by buying puts. When they create these positions they will make money if the stock goes down (with certain exceptions and other risks). The option market maker doesn't want to be naked short the puts sold (effectively long stock) so he goes and sells the stock short ( the uptick rule doesn't apply to him or her) so effectively the same thing ends up happening, except for the rise to unprecedented levels in VIX, a direct result of the uptick rule changes, but thats another story also.
Posted by Noah
Thu Oct 9th, 2008 09:02 AM
Randy - excellent excellent excellent comment! Thank you for sharing these intricate details. Come back!
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