The U.S. Securities and Exchange Commission (SEC) 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 actually borrowed from the investor’s own brokerage firm. The short sale progresses through an immediate sale and an eventual return to the lender in the form of new shares purchased on the open market. The investor's goal is to purchase these new shares at a lower price than he sold the original shares to turn a profit. But the SEC imposes restrictions on short sales, which help maintain stability during a potentially volatile market.
Without the SEC's short sale restrictions in place, aggressive investors could cause a stock's price to plummet inordinately.
Exploring a 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. Although some short sales such as this example can be profitable transactions, other short-sale transactions can lead to significant losses if the price rises in the course of the short sale.
Introduction Of Short Sale Restrictions
In 1938, in response to the Wall Street crash of 1929 and the subsequent Great Depression, the 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In 2007, the SEC issued a decree that rescinded the uptick rule.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.