Investing > How the Uptick Rule Works

How the Uptick Rule Works

 The uptick rule is a legal requirement for shorting stocks—but it's also quite easy to understand and navigate.

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Updated February 11, 2022

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Sometimes investing in the stock market can seem like the wild west.

There are many different paths you can take, and very few restrictions and regulations when it comes to taking those paths. But hold your horses, as there are some serious rules established by the SEC for certain types of investing. 

One of these rules is called the uptick rule, and it governs how and when a short sale can take place. While this may put a damper on your short-selling fun, this rule is around to prevent investors from having too much power when it comes to the price of a stock. 🎯

Recent history has shown why regulations like the uptick rule are necessary, as when the rule was removed in 2007, it wasn’t much later that the stock market crash of 2008 occurred.  This led the SEC to quickly blame the relaxation of the uptick rule and reinstate a new version of the restriction not two years later. That same rule is still in effect today.

So before you jump the gun and start shorting, keep reading to find out what rules you have to obey when it comes to short selling stock.

Ready. Set. Go! 🚀

What you’ll learn
  • What is the Uptick Rule?
  • History of the Uptick Rule
  • The Alternative Uptick Rule
  • Exemptions to the Uptick Rule
  • How Effective is the Uptick Rule
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is the Uptick Rule? 📚

The uptick rule is a regulation imposed by the SEC (Securities and Exchanges Commission) to control the rate and frequency of short selling happening within the stock market. 

As a particular stock or market begins to crash, it doesn’t do so linearly, rather it has many small ups and downs over the course of the downward trajectory. And this is where the uptick rule comes in, as it states that short sellers can only short sell a stock during one of these upticks which may occur multiple times throughout the day.

Now you’re probably thinking that this makes it seem impossible to short sell stock. Well, there is an easy way to satisfy this rule by simply ensuring your price to sell the stock you are shorting is at least a penny higher than the current market price. This creates an uptick, making it perfectly legal to short your stock. 

Uptick Rule
Short selling a stock on a strong downtrend is illegal unless you do it on an uptick, which are common during bearish periods—or before a downtrend. Image by TradingView.

Investors and brokers have been doing this for decades in order to short sell stock while also satisfying the uptick rule. 

The Purpose of the Uptick Rule 👨‍🏫

Wonder why they have such a rule if it is so easy to bypass?

When the stock market first began to take off in the 1920’s, there were barely any short sale restrictions on trades. This led to many people becoming wealthy during the decade. So when the markets took a turn for the worst in 1929, the government began looking into why this crash occurred.

Although there are a combination of causes behind the Great Depression that go far beyond short selling stock, it was found that short sellers were able to quickly drive down the price of a stock by executing multiple large short sell trades at the same time. 

Therefore the SEC imposed the uptick rule for the purpose of preventing these stock brokers from having the ability to negatively impact the price of a stock for their own gain. They hoped that this would stabilize the market when the U.S. so desperately needed it. 

Thus the official purpose of the uptick rule is to increase market stabilization overall and prevent traders from going all in on shorting a particular stock for personal gain, meanwhile crashing the price of the stock as collateral damage. 

History of the Uptick Rule 📖

The uptick rule was put into effect in 1938 following a secondary market crash in 1937. While this wasn’t a large crash, it hit harder than usual on American citizens who were already facing the Great Depression. 

The government knew that they needed to get a hold of the volatility of the stock market if they were going to be able to pull the country out of the depression. Thus it established the uptick rule, also known as regulation 10a-1 for the purpose of stopping traders from being able to crash the price of a stock with a large short sale order. 

Whether it was by chance, or the beginning of World War II, the rule seemed to work, as the Great Depression came to an end just one year later. Thus, the SEC kept the rule in place, and traders obeyed the rule for decades, even as trading transitioned to free stock trading platforms

In the early 2000’s, many investors began to ask whether they even needed the uptick rule anymore because life had changed so much since the 1930’s. As a result, the SEC ran a test in 2004, eliminating the uptick rule on a certain set of select stocks on the market.

They found that the stocks didn’t seem to be affected by the regulations of the uptick rule. Rather than stocks crashing and burning as traders were constantly short selling stock, the market continued in it’s upwards trajectory and seemed to flourish with the increased liquidity. This led the SEC to lift the uptick rule on July 3rd, 2007.

removal of the uptick rule
Even though the removal of the uptick rule coincided with the housing market crash in 2007, it is not certain whether it contributed to the long bear market that followed. Image by TradingView.

After the elimination of the rule, the stock market in the United States became increasingly volatile. Although this was due to the subpar mortgages being given out, and a whole host of other problems, many people began to blame the lifting of the uptick rule, as its timing came just before the increased volatility. 

Reinstatement 📝

When the market officially bottomed-out in 2008, everyone began pointing fingers, many of which were aimed at the banking industry. The general population believed that the banking industry had been given too much leeway for too long, and although the rule had only been repealed less than a year, the SEC began to look at reinstatement. 

It took them a few years to debate on how to reinstate the rule in a way that would help modern society while they faced a lot of pressure from the media. They finally settled on a rule which has come to be known as the alternative uptick rule. This was put into effect on February 24th, 2010 and is still in effect today. 

The Alternative Uptick Rule 📜

The new uptick rule put into place in 2010 imposed similar restrictions to the original 1938 rule, with a few major changes. Most notably that it only implies on certain days. 

What does this mean? Well, the alternative uptick rule states that the short selling of a stock is prohibited after the stock has decreased in price 10% in one day. This means that if you wish to sell a stock after it has declined over 10% in one day, you have to create your own uptick, just as in the original uptick rule. 

Additionally, the rule carries on to the next day, so a stock that had dropped 10% in price on Monday cannot be short sold for the rest of the day, nor for the entirety of Tuesday either. But remember, investors can still sell the stock, they just must do so at a price that is higher than the current listed market price

This rule was imposed for the purpose of restricting traders from causing further price decline in a stock that may already be in trouble. Even the top top online short-selling stock brokers have restrictions that will automatically turn on when someone tries to short sell a stock that has already declined 10% in one day. 

Exemptions to the Uptick Rule 🛡

Like any rule in life, there are always exemptions, even to the uptick rule. 

Exemptions to the alternative uptick rule are specifically required to be labeled as such on stock broker platforms. A trade that doesn’t need to adhere to the rule will always be labeled as ‘short exempt.’

Stock Ownership ☑

The number one exemption to the alternative uptick rule is that the trader owns the stock they are trying to sell. Remember that most short sales of stock are done on borrowed shares. Thus this exemption is meant to keep professional brokers adhering to the rule while letting the average citizen sell a commodity that may be crashing fast. 

To Solve an Odd-Lot Position ☑

In trading, there are several positions where a trader must buy and sell a certain number of shares of a stock, say 100 shares and this is called a lot. If an investor who has borrowed shares is trying to sell shares to close out an odd-lot position, as in they had 123 shares when the lot size is 100, this trade is exempt from the alternative uptick rule. 

The Sale is in Connection to a Layoff ☑

Sometimes, when companies hit hard times, they are required to release employees, and along with it, sell stock to stay afloat. When it is the institution itself selling the stock in response to a negative event like a lay off, this trade is exempt to the regulations. 

It is Executed at a Certain Price ☑

The SEC allows investors to skip the part of the regulation where they must sell the stock for higher than the market price if they sell at a volume-weighted average weighted price. This is basically the average price the stock has sold at over the course of the day. 

This is typically only allowed for highly volatile stocks which fluctuate noticeably over the course of one day. There are also additional restrictions to this rule, which is why many platforms don’t allow this exemption to the uptick rule. 

Has the Uptick Rule Been Effective? 👨‍⚖️

So has the uptick rule prevented stockbrokers and market makers from crashing the stock market?

There is no easy answer to this question unfortunately, as much of what has happened with the uptick rule and the alternative uptick rule has happened because of chance and other factors.

After the financial crash of 2008, financial analysts began to look deeply into the effect of the uptick rule on society. They eventually came to the conclusion that the uptick rule has no large effect on the stability of the stock market as a whole. Unsurprisingly, they concluded that short selling is beneficial to the market–because it exposes overvalued assets and that much of what happened in 2008 was due to poor market health overall, not just a short-selling regulation.  📉

This study came after the one the SEC carried out in 2004 which generally found the same thing before they eliminated the rule. There simply is no proof that the uptick rule stops or prevents market volatility as there were multiple market crashes, such as the dotcom crash of 2000 while the rule was in place. 

But there are still people out there, like Leon Cooperman, who believe that many of the problems experienced by the market are caused by short selling. He even believes that the alternative uptick rule isn’t enough to prevent investors from being able to crash the market with their short sales. 🚧

According to Cooperman, reinstating the uptick rule would prevent securities from experiencing wild swings in price. But many have argued back against his position, saying the alternative uptick rule has allowed trading to flourish in a way that would not be possible under the original uptick rule. It has also helped to reveal companies whose stocks are overvalued

When it comes down to it, whether or not the uptick rule has done what it was established to do depends on who you ask. 

Conclusion 🚩

Overall, the uptick rule was put into place to help keep large scale short selling investors from crashing stocks regularly. Whether it actually serves this purpose has yet to be proven one way or another.  

Although the rule was removed for a short period of time, it does seem that it is here to stay. So if you are interested in short selling stock, be sure your trades adhere to all the rules of the alternative uptick rule, or else you could face an audit by the SEC. 

Uptick Rule: FAQs

  • What Triggers the Uptick Rule?

    The uptick rule in trading is put into effect when the price of a single commodity has dropped more than 10% in a single day. 

  • Why Was the Uptick Rule Removed?

    The uptick rule was removed in 2007 because it was believed it hindered market liquidity and didn’t actually prevent stocks from crashing as originally intended. 

  • Is it Legal to Short More than 100% of a Stock?

    Shorting more than 100% of a stock is known as naked shorting, and it is prohibited in the United States. 

  • Can You Short a Stock on a Downtick?

    You can short a stock on a downtick as long as the price of the stock has not decreased 10% or more during the current day, or during the day prior. 

  • How Long Do Shorting Restrictions Last?

    If a commodity has dropped 10% in price, traders are restricted from shorting that commodity for the rest of the day, as well as for the following day. 

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