Uptick rule...obsolete?

Yesterday I was watching Federal Reserve Chairman, Ben Bernanke testify before Congress. One of the committeemen brought up the uptick rule to him, and whether we should bring it back. He gave one of those cryptic answers where one wondered whether we should or shouldn't have it.

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(As reported from Bloomberg, on the 25th of February, 2009.)

A primer on the uptick rule

So what exactly is the uptick rule?  Why is it so significant and why did they eventually get rid of it?  To understand that you have to go back to prior Franklin Delano Roosevelt became President and the establishment of the New Deal and the Securities & Exchange Commission.  Back then the stock market was much more wild and prone to manipulation than it is today.

Keep this in mind, prior to the SEC and it's regulations, one could purchase a stock with 90% margin, that is you only had to put down say $10 to control $100 worth of stock.  This gave individuals and groups massive leverage to push prices where they wanted.  It also was much easier to get wiped out. You had individuals like Jessie Livermore and other "stock operators" coming in with massive orders to bring down a stock's prices.  Besides individual "plungers" you also had organized stock pools, were a group of individuals would try and corner the market on a stock to manipulate.  Often these manipulations were of a fraudulent manner, like insider trading.

When you had these bear raids, that is efforts to cause a collapse in the price of a stock, it would often be swift.  But before I continue, I almost forgot one other piece of fundamental trader lingo, that is going "short" and going "long." For the uninitiated, going "long" a stock is simply the classic buy at what you think is a low price and sell at a higher price.  Shorting a stock is the opposite, sell high buy low.  Yes, you can sell something you don't own, but only in the stock markets (actually there are situations where this isn't possible, but that's for a different day).  Bear raids were these shorting episodes.  Back then you could short a stock, say at $50, and then as it dropped to $49, you would short some more.  Rinse...and repeat...rinse and repeat.  Pressure would build and build until suddenly, you had your big drop.  These plungers were so ferocious, that back then, it was not uncommon to see a stock lose half it's value.

It was this type of activity that aggravated the situation during the Crash of 1929.  Every time the market tried to recover, that only made the operators short even more stock (remember, leverage was 10-1 back then).  In the aftermath of the fateful October week, one of the first things the SEC did was enact the Uptick rule.  The Uptick rule stipulates that no shorting can be done on a stock until the price has moved one tick in a positive direction.  Remember, prior to a few years ago, stock prices didn't move in penny increments, they moved in fractions and often the average "tick" was 1/8th (or $.12). If one wanted to short IBM, and it was trading at $100, you had to wait until it traded at $100 1/8th.   The Nasdaq opted for a slightly altered version, that is instead of the last traded price, it had to be the last bid (price one wished to buy at) price.

It was felt that this would serve as a delaying action against the bears. If one had to wait for the price to go up, it was thought, that would possibly discourage shorting.  Indeed, a series of price increases may make a trader think otherwise, why go short if this is the beginning of a bull run to a new high? But also, in situations where you had massive drops in price, say one price traded for XYZ was $50, and then the next one was $40, the uptick rule served as sort of a circuit breaker.  If the market was heading southward, any increase of pressure from short sellers would be put at bay until they could get, say for example, a $40.01 price before they could do anything.

The Uptick Rule in Today's Era of Decimalization

Back in the year 2000, the New York Stock Exchange (NYSE) began a move towards quoting stock price changes in pennies versus fractions.  The SEC had demanded that by April of '01, all exchanges trading equities must move towards decimalization.  The reasoning behind this was so that the average investor could get a better price.  Prior to this, as was mentioned above, the average Bid/Ask spread was essentially $.12.  If you purchased 100 shares of stock, one was essentially starting off with a loss of $12.  Today, the average Bid/Ask spread is between $.01 to $.03 in your most liquid stocks during the normal trading hours.

But because of this, we've essentially cut down the waiting period for the bears to short a stock.  Instead of waiting for that 1/8th move, for example, all they have to do is wait for a penny...a single penny.  Anyone can "bid up" a stock to meet that penny demand.  In this market, the Uptick rule, as it stands, is useless.  But should we even have an Uptick rule?  The SEC wanted to know if the thing was useful anymore and did a pilot program removing it from certain stocks.  What it found was that in it's present form, it was indeed useless.  On July 6th, 2007, the Securities & Exchange Commission eliminated the 70-year old regulation.

The Argument For the Uptick Rule

Almost immediately, there was an outcry, largely from market veterans, to reinstate the old rule.  One of the first was Muriel Siebert, the first woman to own a seat on the NYSE, questioned the decision following the recent market turmoil.

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(As reported in the New York Times on the 26th of August, 2007)

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Speaking of market turmoil, please take a look at the chart above.  The data, courtesy of Barchart.com, is a graph of monthly prices of the S&P 500.  Please note in the middle of '07, that is when the Uptick Rule was effectively gone.

One can immediately tell what began to transpire. July 2007 just about marked the "top" of the post 9/11 bull run.  The first to go was the financial sector.  Oddly enough, the end of the Uptick rule coincided with the beginning of the mortgage meltdown.  Below is a chart of the Financial SPDR (An exchange traded fund that is made up of financial stocks, a good proxy for the sector).

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Crazy, how from July or so, the financial sector hasn't really recovered.  For a small while, one of the rumors or gossip that Bush had friends who knew the you-know-what was going to hit the fan.  That Christopher Cox was made to open up the flood gates to allow the Administration's friends to profit from the incoming doom.  Of course, this is all speculation.  Still, removing the Uptick rule couldn't have come at a better time for someone wanting to take advantage of the financial sector's implosion.

As you probably have guessed, I'm in favor of the Uptick rule.  Don't get me wrong, I'm all for shorting stocks, I do it, everyone does it.  Shorting a stock is natural, if a company is bad or near death, an investor or trader almost has an obligation to take advantage of the situation.  The argument for removing it, was that it was useless (penny move..oooh), and that one must let markets operate naturally.

But I think it's also important to not let volatility to get out of control.  Volatility in itself isn't bad, without it, even the buy-and-hold crowd wouldn't make money.  But the big 'V' is also a double-edge sword.  If something must fall, it will fall, but forcing a fall beyond what it would have normally fell is almost reckless.  Of course the argument then becomes how does one know what the normal rate of a descending stock price?  

At the end of the day, markets are irrational, I don't give a damn what the Ayn Rand crowd things.  Economics, to me at least, has always been psychology with a lot of stats and math thrown in.  Human behavior is one of the largest components in equity and commodities markets.  Fear, be it for something reasonable or irrational, takes hold almost on a daily basis.  People act strange when they see their position suddenly lose X amount.  The Uptick rule allows folks to cool off for a bit, and assess the situation.

I know what you're going to ask.  What about that decimal ruining the effectiveness of the regulation?  Well we can take this one of several ways.  First, we could impose a large Bid/Ask spread, that is instead of a penny difference, we make it something else like say a nickel or even a dime's worth.  Yes, we would be approaching the old 1/8th spread, I understand.  A second thing we could do is impose an artificial advance rate, say no shorting can take place until the stock moves $.05.  You wouldn't have that large spread, but the problem here is that some stocks are more volatile and others just flat. A third option would be to gauge the Uptick threshold to the implied volatility of the individual stock.

Whichever way we go, we should, as Ms. Siebert and others have noted, bring back the Uptick rule.  Markets are volatile enough as it is.  Why make the situation worse for the average investor?

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Cross posted from Economic Populist.

Tags: banks, Economy, stock market (all tags)

Comments

2 Comments

Tips jar for the average investor

Thanks for reading my latest article.  To all of you out there watching your retirement funds face disaster, you're not alone.  To those who don't even have one or can't afford to invest, actually for everyone, I think it's high time we had a new pension plan for Americans.  A pension plan (either a fully-funded Social Security or something in addition to it) that provides a livable monthly stipend.  Retired folks and the disabled shouldn't have to live in dire poverty.

by johnny venom 2009-02-26 01:24AM | 0 recs
Bring back the Uptick Rule!

Nice post Johnny.  As a November blog entry at InvestorGeeks illustrated, the uptick rule would act as a shield against bear raid algorithms.

Here is the trick and it is really apparent in pre-hours or after-hours. Find an equity that is at least semi-liquid, and has upward momentum for the day.  Then look at the time and sales. What you are looking for is an out of place low sale as the one shown as follows:

bear raid algo

This equity was up, and the pattern seems to be that they look at the bid ask spread and do a transaction at a price that does not belong in the structure. The bid ask spread is 10.40, and 10.44, but there is a transaction at 9.81. Don't you find that odd?

Now getting back to the uptick rule. If this was a seller they could sell at 9.81, though I have no idea why they would sell there. Though if this was a shorter they would have to short at 10.41, or something along those lines.

It was reported last year that naked short sales were used in tandem with credit default swaps to crush shares of Lehman Brothers and Morgan Stanley.

In a short sale, which is a bet that a stock will fall, shares are borrowed on the open market and then sold to another investor. To repay the lender, the short seller buys the stock later at what he hopes is a lower price than where he sold it. The short seller profits from the difference.

Credit default swaps trade on an unregulated market that has grown tremendously in the past decade. Some investors have suggested that short sellers could be pushing up the prices of such swaps to cause stock prices to tumble. Others have suggested the reverse, saying hedge funds might have loaded up on the swaps and then tried to manipulate stocks lower so that the swaps, insurance-like instruments designed to protect against a default by a bond issuer, would increase in value.

"To get a complete picture of what market participants are doing, we feel it's important to look at all those areas," said Scott Friestad, deputy director of the SEC's enforcement division. Traders might have manipulated one market to profit in another, a strategy Friestad said was akin to "investing in insurance while other things you might do could be burning down the house."

The SEC has announced the inquiries and regulations this week to try to pull the plug on trading strategies that have been widely blamed for the recent panic that hastened Lehman Brothers' tailspin into Chapter 11 and temporarily crushed shares of Morgan Stanley.

Earlier this week [September], the SEC reinstated temporary rules meant to protect financial firms from "abusive naked short selling," which is when a short seller sells stock before it is borrowed and has no intention of completing the second step of the transaction. Friday's ban went much further, halting all short sales -- naked or otherwise -- in about 800 financial issues.


by IndepEnergy 2009-02-26 06:34AM | 0 recs

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