The Uptick Rule
The Smart Profits Report: Issue #439
Wednesday, July 18, 2007
The Uptick Rule: The Biggest Regulatory Change In A Decade & What It Means For You
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
On July 6, 2007, the biggest change in decade took place in U.S. stock market regulation… and nobody noticed.
So while everyone is wrapped up in the loud noise coming from the market, let’s take a look at how this “quiet” rule change could turn out to have some interesting effects for investors…
Just two days after America celebrated freeing itself from the shackles of the Brits, the SEC got rid of a 73-year old uptick rule that required an “uptick” in the stock price before a stock can be sold short.
Down With The “Uptick”
First things first… an “uptick” is the common name given to Rule 10a-1 under the Securities Exchange Act of 1934. This rule basically allowed short selling, but only following a trade where the price was higher than the previously traded price (called an uptick).
As you can imagine, the uptick rule was the enemy of many investors who tried to short a stock, only to be unable to get a much worse price than desired. It was one of the rules that made stock trading tilted to the favor of the long side.
But now, the SEC has removed the “price test restrictions” (as it says) on short sales and prohibited any other organizations, such as local exchanges, from imposing price tests.
What the Elimination of the Uptick Rule Means for Investors
There are some well-publicized disadvantages to limiting the practice of short selling. For example, blow-off tops occur more frequently in markets where short selling is restricted.
So now that the SEC has ditched the uptick rule, how does this affect the market’s major players? Let’s see…
- Individual Investors: Longer-term investors, especially those that only go long, will see little change in their activities. But for anyone shorting NYSE or AMEX stocks, the change could have a significant impact on the ease of getting filled in those short sales, since investors will no longer have to wait for an uptick. However, there won’t be much change for Nasdaq stocks, since earlier changes allowed legal workarounds for Nasdaq traders.
- Institutions & Funds: A common practice for “big money” on Wall Street was to craftily put in a significant amount of buy orders to move a stock to an uptick before then placing their real short sale order. But now that the SEC has eliminated the uptick rule, short selling will now be more efficient for these institutions and funds.
And the end of the uptick may also be affecting the Tick Index…
Tracking The Tick Index
The NYSE Tick Index gives the number of stocks on the NYSE that are trading on an uptick, minus those that are trading on a downtick. This is a broadly watched index, especially among short-term and intermediate-term traders. But since July 6, when the end of the uptick rule went into effect, many commentators have noticed that the maximum tick reading of the day has been depressed.
For example, in the seven days before July 6, the average high Tick of the day was 25% higher than during the seven days after July 6. This has happened despite the market’s upward climb, including the extremely strong move on July 12. In fact, the seven-day moving average that tracks the high Tick of the day is now at its lowest point since the selloff in May 2006. (Thanks to Jason Goepfert for his insights into changes that are affecting the Tick Index).
The bottom line is that investors who use the Tick Index in their analysis need to be aware and wary of the skew that is occurring in the index. Monitor the Tick Index over the next couple of weeks to see if the this trend continues, and adjust your analysis accordingly.
Great trading,
D. R. Barton, Jr.
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Today’s Smart Profits Action Center
- While “buy low; sell high” is the traditional motto for making money in the stock market, it’s not always the case - not when you’re short selling. When you short a stock, you’re basically selling at a high price, with the intention of buying it back when it moves lower.
- One of the most famous cases of a short sell that worked perfectly is when George Soros made about $1 billion in a day shorting the British pound in the early 1990s, driving the currency to a disastrous low. No wonder he was subsequently dubbed “The Man Who Broke The Bank of England.”
- With the stock market blazing to new highs, bearish short sellers are having a tough time making money right now. But when the market inevitably turns back down, there’s a good chance that short sellers will be back in business, shorting stocks that have become overvalued, that have inflated expectations, or which no longer have catalysts that can drive them higher. Investors who hold short positions would lower their risk, since they would rise as the market falls, offsetting losses from long positions. But beware… short selling is one of the most difficult strategies to execute and can leave you on the hook for some big losses if your chosen laggard decides to rise instead.
Related Articles:
- Short Selling: Beating the Government By Going Short
- The Short Squeeze: Don’t Get Squeezed When Investors Rush to Sell
- Limit Orders: Dodging The Market Maker’s Bullet & Side Stepping The Liquidity Trap
The Chart Of The Week
The Dow Industrials made new all-time highs in October of 2006 to much fanfare. But on July 13, the S&P 500 made new all-time highs in a much quieter fashion. And despite significant recent strength, the Nasdaq 100 is still far from its March 2000 highs. Take a look at the chart below and you’ll see that it’s only clawed back 1,200 points since its drop from all-time highs. That’s a 30.8% move. So only 2,800 (237%) left to go then!
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