By: Spencer Israel
Following the Financial Crisis, Congress put into place many new rules that they hoped would prevent another near collapse of the global financial system. One such rule, the Alternative Uptick Rule, was enacted in 2010 and is actually the direct descendant of a previous rule that had been in place from 1938-2007. Here’s how the Alternative Uptick Rule works:
The Alternative Uptick Rule, also known as Short Sale Restriction, is designed to prevent short sellers from driving the price of a security downward. The hope is that in doing so, this will limit downward volatility, prevent flash crashes, and preserve market stability.
The rule states that if a stock falls 10% from the previous day’s close, the only way to short it is on an uptick. In other words, traders are not allowed to short this stock while it’s falling. The only way to get short is to wait for the stock to go up (hence: uptick). This restriction applies through the end of the trading day and for the following trading day as well.
The Rule In Practice
Here’s an example. Let’s say shares of XYZ close at $10 on Tuesday, and open on Wednesday at $9.50. One minute later at 9:31 am, it trades down to $9. XYZ has now fallen 10% from Tuesday’s close, triggering the Alternative Uptick Rule.
Traders wanting to go long XYZ are free to buy the stock as they see fit. Traders wanting to short it, however, must wait for the stock to trade above the current national best bid. So, if XYZ trades down further to $8.58 at 9:32 am and then up to $9:05 at 9:33 am, only at 9:33 will short sellers be able to get their short sale orders executed.
In practical terms, this makes it impossible for traders to short a stock that’s down 10% via a market order. They must instead place a limit order above the current bid, and hope the order gets filled.
Criticisms Of The Rule
Predictably, this rule can make it difficult to short a stock in some situations (this is especially true during periods of lower liquidity, such as the after-hours and premarket sessions). Critics have argued that this can in turn create temporary upward buying pressure that is unnatural, with the rule acting as an artificial gatekeeper that literally prevents a stock from falling.
Some critics, like famed hedge fund manager Leon Cooperman, argue we should go back to the original Uptick Rule, which prevented short sales on any stock at any time of day regardless of performance.
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