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.
FAQs
Short selling rules
Why is short selling controversial? ›
2. Why is short selling controversial? Short sellers play an important role in price discovery by deflating bouts of euphoria and identifying flaws that analysts, auditors and investors have overlooked by doing their own meticulous research.
What is 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."
What is the history of short sale? ›
The practice of short selling was likely invented in 1609 by Dutch businessman Isaac Le Maire, a sizeable shareholder of the Dutch East India Company (Vereenigde Oostindische Compagnie or VOC in Dutch). Short selling can exert downward pressure on the underlying stock, driving down the price of shares of that security.
How do you explain short sale? ›
Short selling involves borrowing a security whose price you think is going to fall and then selling it on the open market. You then buy the same stock back later, hopefully for a lower price than you initially sold it for, return the borrowed stock to your broker, and pocket the difference.
Why was short selling banned? ›
Global financial crisis (2008): During the 2008 financial crisis, several countries temporarily banned short selling to protect their financial markets. In the U.S., the SEC temporarily banned short selling in financial stocks in September 2008.
Was short selling ever illegal? ›
In 2008, U.S. regulators banned the short-selling of financial stocks, fearing that the practice was helping to drive the steep drop in stock prices during the crisis. However, a new look at the effects of such restrictions challenges the notion that short sales exacerbate market downturns in this way.
Is a short sale good or bad for buyer? ›
In short, short sales are a good idea if you have plenty of time and money. A short sale buyer may get the property at a reduced price, but the property (in all likelihood) has its share of problems — think “fixer-upper” — and the deal needs to go through considerable red tape to make it happen.
Why short selling is not allowed? ›
Key Takeaways. Short selling involves the sale of a borrowed security with the intention of buying it again at a later date at a lower price. The practice was banned by the Securities and Exchange Board of India (SEBI) between 2001 and 2008 after insider trading allegations led to a decline in stock prices.
Can you walk away from a short sale? ›
After Short Sale Approval
Buyers may back out based on due diligence, appraisal, or financing at this point, just like any other contract. If it's within the guidelines of the contract, they're free to do so. If it's not, you'll get to keep their earnest money deposit as damages.
Advantages and Disadvantages of a Short Sale
Short sales allow a homeowner to dispose of a property that is losing value. Although they do not recoup the costs of their mortgage, a short sale allows a buyer to escape foreclosure, which can be much more damaging to their credit score.
What is the purpose of short selling? ›
Short selling is when a trader borrows shares and sells them, hoping the price will fall after so they can buy them back for cheaper. Shorting can help traders profit from downturns in stocks and protect themselves from losses.
Why is it called a short sale? ›
A short sale is a situation where a homeowner is unable to continue making their mortgage payment and must sell their property when the balance of the mortgage exceeds the current value of the property. It is called a short sale because the sale proceeds will be short of the outstanding mortgage balance.
How does short selling work for dummies? ›
Short selling is—in short—when you bet against a stock. You first borrow shares of stock from a lender, sell the borrowed stock, and then buy back the shares at a lower price assuming your speculation is correct. You then pocket the difference between the sale of the borrowed shares and the repurchase at a lower price.
Is short selling a good thing? ›
Short selling ensures liquidity in the market resulting in lower stock prices, improves bid-ask spreads, and helps in price discovery.
Which is the best definition of selling short? ›
Short selling—also known as “shorting,” “selling short” or “going short”—refers to the sale of a security or financial instrument that the seller has borrowed. The short seller believes that the borrowed security's price will decline, enabling it to be bought back at a lower price for a profit.
Why do short sellers have a bad reputation? ›
Why Does Short Selling Have Negative Reputation? Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators who have used short-selling strategies and derivatives to deflate prices and conduct bear raids on vulnerable stocks artificially.
Why is short selling not allowed? ›
Key Takeaways. Short selling involves the sale of a borrowed security with the intention of buying it again at a later date at a lower price. The practice was banned by the Securities and Exchange Board of India (SEBI) between 2001 and 2008 after insider trading allegations led to a decline in stock prices.
Why should short selling be illegal? ›
1) Profiting from company failures is immoral. 2) The practice is damaging because it artificially lowers stock prices. 3) It's a privileged investment tactic that is not available to everyday investors. 4) Short sellers manipulate the market, by conspiring.
What are the arguments for short selling? ›
Proponents argue that short sellers can add liquidity, reveal stocks that are priced higher than their actual worth, and help bring their prices closer to their true value.
