The Impact of Short Sale Restrictions

The U.S. Securities and Exchange Commission defines a short sale as an operation that begins with the sale of a stock that an investor doesn’t actually own. In many cases, it’s borrowed from the investor’s brokerage firm. The borrowed stock is quickly sold and is later returned to the lender in the form of new shares purchased on the open market, possibly at a lower price than the original shares were sold. Investors who engage in short sales hope to make a profit through the price difference in the stock. If the price rises in the course of the short sale, the investor will incur a loss.

Short Sale Example

A short sale begins when an investor believes that the stock of a certain company will soon decline in value. For example, the investor borrows shares of the company's stock at the current price of $40 per share and quickly sells them in a short sale for around the same price. Subsequently, the company's stock declines in value to $30 per share. The investor then buys shares at that price on the open market as replacements for the borrowed shares that were previously sold. The investor realizes a $10 profit per share, minus fees and commissions. When conducted on a large scale with a significant number of shares, a short sale can be a very profitable transaction.

Introduction Of Short Sale Restrictions

In 1938, in response to the Wall Street crash of 1929 and the subsequent Great Depression, the U.S. Securities and Exchange Commission (SEC) passed a restriction on short sales during a downtick in the market value of the stock. This became known as the uptick rule since it restricted short sales to stocks that were sold for more than their previous selling price. The rule was implemented in response to market manipulations by aggressive investors that drove down the price of securities to create sell-side imbalances. These so-called “bear raids” are seen by many as a cause of the 1929 crash.

Alternative Uptick Rule Adoption

In 2007, the SEC issued a decree that rescinded the uptick rule. The relaxing of this restriction is seen by many as contributing to the international financial crisis of 2008. Within months, legislation was proposed to reinstate the rule. In 2010, the alternative uptick rule was approved. It restricts short sales using a circuit breaker that is triggered when a stock has lost more than 10 percent in value in one day compared to the previous day’s closing price. The restriction helps keep short sales from driving down the price of a stock and stays in place for the remainder of that day and the following day. According to the SEC, the purpose of the restriction is to promote stability in volatile markets while avoiding bear raids.

Impact Of Uptick Rules

Uptick rules attempt to decrease the momentum of a stock’s loss in value and thwart market manipulations. Despite studies showing that removing the uptick rule would have few negative consequences, the SEC reversed its decision to remove the restrictions in 2007 due to aggressive short selling. The introduction of the alternative uptick rule in 2010 indicates that some form of control is still required to cut down on short sale abuse.

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Resources (3)

  • SEC Approves Short Selling Restrictions
  • "The New Sell and Sell Short: How to Take Profits, Cut Losses, and Benefit From Price Declines": Alexander Elder
  • "Foundations and Applications of the Time Value of Money (Frank J. Fabozzi Series)"; Pamela Peterson Drake, Frank J. Fabozzi

About the Author

Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.

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