No More Naked Shorting of Stocks

Short selling is an arbitrage strategy exercised by short sellers when they believe that a security price will decline. Short sellers borrow the shares of a company, sell them and buy them back at a lower price. Naked short selling is exercised when short sellers sell a company's shares without having borrowed them first and they look for an offsetting position in the underlying asset after the sale.

The Securities and Exchange Commission (SEC) decided to reinstate the uptick rule that was withdrawn in June 2007 to ensure orderly markets. For many, this removal was the reason that initiated the downward trend in security prices causing extreme volatility in the stock markets and contributing to the credit crisis. The original rule ensured that short sales occurred at higher price than the previous sale, i.e. on an uptick, keeping out short sellers from exacerbating the downward momentum of security prices. However, with its removal, bears were allowed to find their way to overvalued stocks.

The reinstate of a modified version of the original uptick rule considers five alternative methodologies to find an answer to the stock market imperfections.

(1) Proposed Uptick Rule suggests - like the original rule - that short sellers are not allowed to trade until a stock ticks at a price higher than the previous trading price.

(2) Proposed Modified Uptick Rule suggests that short sellers are allowed to trade at a price lower than the previous trading price if the price is higher than the national best bid.

(3) Proposed Circuit-Breaker Halt Rule suggests that, if there is a 10 percent decline in the price of a particular security, short selling for this security is banned for the remainder of the day.

(4) Proposed Circuit-Breaker Uptick Rule suggests that, if there is a 10 percent decline in the price of a particular security, a short sale price test is imposed based on the last sale price of the security for the remainder of the day.

(5) Proposed Circuit Breaker Modified Uptick Rule suggests that, if there is a 10 percent decline in the price of a particular security, a short sale price test is imposed based on the national best bid of the security for the remainder of the day.

The reinstate of the uptick rule is an anti-fraud measure that limits short selling by preventing the acceleration of downward momentum. Short selling is largely exercised by investment banks and hedge funds, mainly attracting institutional investors, who are experienced in riding the market when they estimate that a security is overvalued. This explains the reasonable belief that the modified version of the uptick rule can have an effect on stock prices providing protection against abusive short selling.

Besides, historical data show that upside volatility is more controlled than downside volatility when the uptick rule is enacted. Looking at the daily and weekly closing prices of S&P 500 over a period of 25 years one can observe that negative percentage changes are more likely to occur than positive percentage changes. An extreme percentage change of greater than 5 percent occurs more often on the downside than on the upside on a daily basis. Weekly, a percentage of 10 percent occurs almost twice as often on the downside than on the upside.

Conclusively, the reinstate of the uptick rule will help offset the extreme sell off patterns observed in stock market downturns and the effects of upside and downside volatility as a smoothing mechanism to the downside. The uptick rule can also help offsetting the effects of hedge funds that create a bandwagon effect when expecting extreme profitability.

Sources:

http://www.whitecase.com/files/Publication/e2742c4d-c2d5-4aec-a411-7883bd4eed56/Presentation/PublicationAttachment/15b94c2a-dbc7-4117-b0f2-793f9056a3f8/alerts_SEC_Reopens_Comment_Period.pdf

http://www.investopedia.com/terms/u/uptickrule.asp

http://www.investopedia.com/articles/financial-theory/09/uptick-rule-elimination.asp