Short-Selling and the Uptick Rule

By Max Mastrella

What do you think of stocks and how to invest in them? Most people think of trying to buy stocks at a low price and hope that a bull market, one in which market prices are rising, will bring up the price and make you, the investor, a profit from your investment. The problem faced here is that it's tough to figure out how to invest when the economy is in a bear market, one in which market prices are falling, and prices are already high. The solution to this is a simple strategy of short selling stocks.
A seemingly confusing investment strategy, short-selling stocks is really quite simple. First, there must be an investor who wishes to short sell stocks in the market. The objective he or she is trying to accomplish is to bet that the market will continue to go down compared to the normal investing strategy of hoping the market will rise. The investor borrows stocks from a stockbroker with some sort of contract or agreement to return them. Borrowing stocks on credit is called borrowing stocks on margin, which is a loan you are promising to pay back. Once in the hands of the investor, he or she sells the stocks for the high price that they are worth in the stock market. The investor receives the payment for the stocks and then must wait while he hopes the stock price will fall. After a certain amount of time the investor buys back the same number of stocks hopefully at a lower price. The investor has just bought high and sold low in the opposite order than most investors. With the same amount of stocks the investor originally borrowed, he or she can now return them to the stockbroker from whom he or she borrowed them. The act of giving back the borrowed stock is called covering. Once the stock has been returned to the original broker the investor profits on the difference between the high price at which he or she sold the stocks and the low price at which he or she bought them. Short selling stocks can be a very rewarding strategy, but with a high reward comes a high risk. By short selling, an investor is betting on the market and price of the stock to go down. If the market and stock price go up, the investor will lose money.
It is easier understand the strategy of short-selling stocks using an example. Take a risky investor named Jack for example. Jack wishes to short sell stocks in the bear market in order to make some profit so he borrows 10 stocks each from his stockbroker, Jill, on margin. Jack is betting that the price of his stocks will go down. Jack then goes out and sells all 10 stocks for $56 to another investor named Dow. Over the next couple months the market goes down and the price of the stocks Jack sold to Dow go down to $20. Jack then buys them back from Dow at the $20 price and returns them to Jill, his stockbroker. The original sale of the 10 stocks at $56 each earned Jack a profit of $560. Jack then spent $200 of this profit to buy the 10 stocks back at their $20 price. Jack’s final profit is the $360 difference between the price he originally sold the stocks at and the lower price he bought them back at.
As seen, since the price went up, Jack was able to make a profit. However, if the price had gone up Jack would have needed to buy the stocks back from Dow at a higher price and therefore lose money. Also, as seen in the example, Jack had to sell the stocks at a price ($56) higher than the last trade price ($55). In order to prevent short sellers from further pushing prices down in the already downward moving bear market, the SEC established a rule known as the up-tick rule. The up-tick rule required every short selling transaction of a stock to be entered at a price higher than the previous trade. On July 6, 2007 the SEC eliminated the up-tick rule. The suspension of the up tick rule has caused a steady decline in the market for some stocks by making it easier for short sellers to short the market because the stock can now be sold continually lower, without waiting for a sale at a higher price to stop the downward momentum. The episodes of a rapid decline in the stock price of financial companies over the last year have been attributed to the absence of this uptick rule.

Source:
"Uptick Rule." Investopedia. http://www.investopedia.com/terms/u/uptickrule.asp. Internet; accessed 6 October 2008.