Changing of the Short Uptick Rule: Bad Timing for a Bad Idea

Jim Cramer is currently discussing the SEC's change in the "uptick rule" for short selling. Ticker Sense and Birinyi Associates has focused on this rule change since November 15, 2007 when we first highlighted that this rule change was causing fundamental changes in market activity.

We continue to agree with Mr. Cramer, although we may say that he now agrees with us. Nothing illustrates the underlying change better than the peak in the Dow's non-block money flow chart. Birinyi Associates is known for its money flow analysis, which is an analysis of each transaction in a stock and shows underlying activity behind seemingly small price moves. As shown, the Dow's money flow peaked in July of 2007 and has declined ever since. Short sales that can now be executed on any trade have caused the money flows to turn and this is also a reflection of the rule's impact on market activity.

click to enlarge

In addition to the dramatic declines in money flow, the VIX and average daily change for S&P stocks have also increased since then.

Changing the uptick rule certainly did not cause the subprime meltdown, and would not have prevented a decline, but it has caused increased volatility and declines in stocks that would not have been so dramatic. In essence, short sellers are now able to sell stock that did not previously exist. While there is a buyer for the stock, essentially increasing the number of shares outstanding and offering those shares at a discount has caused stocks to fluctuate wildly. Since large amounts of capital are required to play this high-stakes game, many players have been driven out of the market. Investors have taken refuge in gold (peaked at $1,000/oz), and treasuries (10-yr yielding 3.31%).

Comments

[rdial54]

The current uptick rule is fine. Let us not mess with again. If the stock is bad let it fall. Free market. How much do we have to monkey with our laws. Let the market set its prices.

[guilfordglobal]

I am glad someone is talking about this debacle. The change of the short uptick rule was the biggest reason for our recent market downfall and volitility. I think it is the people who made the decision to change this rule who should be under investigation!!!
I would not be a bit surprised if some big short fund was tied to the change in some way. I think if it were not for the change in this rule, the market would not be down as tremendously as it is and this story does not get the attention it deserves. I think the change was just as much a factor in the recent market downfall as any of the negative doom and gloom news.

[SeanB]

I agree that it increases volitility, but i think its a great thing.... you just got to have faith in your stock. Look at LEH... they shorted the stock to $20 bucks and two days later its trading at $49.00. If you had faith in your stock you are a lot better off. I think the rule removal is a great thing... It will slingshot the market up in a bull market because the true investors will SQUEEZE the shorts out. Just have faith...and if the company is a bad company that should be ou... the shorts will make that happen faster saving the average investor the mistake of ivesting in something it should not. Think about it... Bear Stearns is one of them.. now no one will make the mistake with Bear Stearns... there gone. and should be.

[Britishsteel]

You all are missing the point in my opinion, this rule was implemented tostop the kind of crap that happened to bsc and countless others . To protect Mom and Pop 401k and keep the criminals at bay. Now the TIMING of this change is whats more important! lets list some changes in rules regarding the financial world.

#1 The credit card companies lobbied to change bankruptcy laws to make it harder for the average person to declare Bankrupty. WHY!

ANSWER: BECAUSE THEY LOOKED INTO THE FUTURE AND KNEW THE SUBPRIME DEBACLE WAS REAL AND IMPLODING THATS WHY ,AND THEY WANTED TO MAKE SURE THEY COULD SQUEEZE EVERY PENNY OUT OF THOSE THEY LENT TO.

# 2 uptick rule removed WHY?

ANSWER: TO ALLOW HEDGE FUNDS AND BIG GUYS ON WALL STREET
THE BREATHING ROOM TO ESCAPE THE BAD POSITIONS THEY WERE IN AND ALLOW THEM TO GET AS MUCH RETURN ON CAPITOL AS POSSIBLE THATS WHY. ALTHOUGH THEY DID NOT THINK IT WOULD IMPLODE SO FAST.

#3 The NYSE removed curbs on Trading on their exchange WHY?

BECAUSE THEYKNOW THIS QUANT FUNDS AND BOT TRADING PROGRAMS HAVE BUY AND SELL ORDERS PROGRAMMED AT THE VARIOUS MOVING AVGERAGES AND CAN GO ALONG FOR THE RIDE IN ANY DIRECTION AT WILL AND HELP RECOUP LOSSES FROM THEIR PORTFOLIOS. THATS WHY.
Anyone who invests in this casino at this juncture or in the future is risking all they have worked for in their lives . If you cannot trade and watch what you trade you should invest in the safest veichles you can . And right now the bond market is teliing us 13 week short term treasuries or cash spread out [ less than 100,000 per bank} is the safest place to be.

[jeffb]

If a minor bad news event for a company or the economy generally can drive prices down an outsized percentage because of large hedge funds shortselling without such uptick rule restraint (or naked shorting) and panicking others into believing such news is worse than it is, some people will be and have been driven from the market who will not return (because they are unwilling to take such risks).

Simple economics says lower demand (because of those investors leaving) means lower prices and sustained lower stock valuations. It also means more challenges for companies that need to raise capital, especially smaller ones, and more dilution for shareholders of such companies due to the incremental number of shares that need to be issued at lower prices to raise a given amount of money - if it can be raised at all.

This Wild West environment encouraged by the SEC through its actions (or lack of them) on naked shorting, failures to deliver and the uptick rule is not good for either our markets or our economy.

[joenobody02]

Without the uptick rule in place, a hedge fund manager with enough "other peoples money" can kill a small company by selling short all the way to 25 cents if he wants(and profit handsomely). Biotech companies , for an example, are prime targets, a tiny bad news can drive the stock price to zero, depriving the drug that could have been developed.

[Britishsteel]

Hey cramer told you that in a video posted on youtube. this clown was lucky enough to get TV show?
Has any one folowed his bsc call form last thursday? This guy is nothin but a shill for all his friends from the hedge fund world and his former employer goldmnan sachs. Their should to be a law against guys like this and cnbc cheerleaders telling Mom and Pop 401k to buy the dips and do not sell. Actually their is BUT SOMEONE MUST ENFORCE THE LAWS!

[Britishsteel]

By the way it has come to my attention that margin requirements were increased last week by certain brokers which is deflationary, it also clears the way for the big guys to get short finacials and is porbably why finacils popped last week due to shorts covering because of increased margin requirements. Differnt rules for institutions than retail HUH? Is this market not rigged you be the judge.

[carol b]

It about time something was said about the demise of the uptick rule it has been diasterous for the market

[Medici]

Has anyone here ever heard of "Bullets" or Synthetic Options.....LONG before the Uptick rule was eliminated large hedgefunds, prop firms and all the "players' were shorting downticks through the use of these instruments, the downtick rule being removed is a blessing. Even if there is a sharp downturn due to selling pressure of "shorts" the rally back when the rumor is dispelled is just as furious. Good Riddens Uptick rule and please please please dont come back-

[Purl Gurl]

Ticker Sense writes, in part,

"Since large amounts of capital are required to play this high-stakes game, many players have been driven out of the market."


This is much needed. My personal guesstimate is one-third or more of stock traders need to be removed from our stock markets. Today, our stock markets are plagued by naive gullible online traders who simply are not qualified to trade stocks.

Since the advent of online trading, our markets have become more volatile than what your charts display but over longer terms. Typically, there are gradual upward price swings in any given stock followed by a dramatic one to three day crash of share prices. These gradual ramp up movements in share prices, followed by a near vertical chart crash in share prices, are caused by emotional online traders who truly believe they can become rich overnight. These are people who know little about stock market dynamics, who do not perform good research, who buy and sell based only on speculation generated solely by positive hype or negative hype. These are online traders whose trading activities are guided by talking heads and hyped up news releases from companies.

Today’s online traders, a majority, have no business trading stocks. These people serve only as a source of profits for scam artists and savvy seasoned traders. There seems to be an endless supply of online traders, which I like, but this is not good for market stability.

Removal of the uptick rule is beneficial. A greater ability to short leads to better moderation of fabricated upward runs in share prices of a given stock. Yes, there is an increase in volatility of stock prices but this is not detrimental for talented stock traders who perform good research, who well track the markets and who make prudent trading decisions.

Removal of the uptick rule will eventually lead to better stability in the markets through removal of unqualified stock traders by means of their loss of capital.

You comment about a need for “...large amounts of capital are required....” to engage in effective stock trading. This is highly beneficial. A golden rule is “Never invest more than you can afford to lose.” A very common mistake made by naive online traders is entering the stock markets with a relatively low amount of capital. This is a reflection of poor money management. Far too many online traders are risking money they cannot afford to lose. Capital used for playing stocks should only be truly excess money which well exceeds what is needed for a comfortable family budget. Other words, money which can be thrown away without causing family financial harm.

Being successful at stock trading requires periodically losing money while earning profits which exceed the amount of money lost. There are none who are active traders who earn only profits. Success is only earned by having a large amount of capital to cushion losses while growing capital through profits. Most online traders do have not sense enough to maintain a loss cushion.

These naive and gullible online traders, who could not be bothered with performing good research, would be better off contributing a monthly amount of money to a guided investment vehicle such as a traditional mutual fund. These are people who cannot successfully manage their money and need to give over control of their money to reputable professionals.

Successful stock trading requires a cold, calculating and cutthroat attitude. Earning consistent profits in the stock markets is a full time and half job. A large majority of today’s online traders simply do not have available time needed to be successful traders nor have needed excess capital to place at risk. Not only do naive online traders not have time nor have excess money to play the stock markets, they also are not willing to invest in the hard work needed to be successful traders.

I am enjoying this increase in volatility through removal of the uptick rule and through emotional panic caused by failure in the financial sector; my profit margins have increased by an amount equal to this increase in market volatility. However, I am one of those few who are willing to work really hard at being a successful stock trader.

During my rural Oklahoma farming childhood, I learned to keep a flock of chickens healthy, you must periodically cull out unhealthy chickens. There is a need to cull out unhealthy traders from our stock markets to keep our economy healthy.


Okpulot Taha
Choctaw Nation

[gordon]

HERE'S CRAMER VIDEO,
www.thestreet.com/_yah...

ask yourself WHO this rule change benefited?
HEDGEFUNDS! Now, ask yourself if it was PROBABLE that PAULSON lobbied Chris COX !!!!! I'm going to say it again , PAULSON SHOULD BE IN PRISON! This is the greatest conflict of interest in history. Goldman is the largest hedgefund in the world. He sold his GS stock to a "blind trust" TAX FREE! to work for Bush. Wake up people. Paulson now is pulling strings with the Goldman Sachs Commodity Index to crash commodities, flushing out the hedgefunds short the Dollar. In 2006 Paulson crashed the unleaded gasoline contract prior to Bush's re-election, by not rolling over to the new contract, underweighting unleaded 35% in the GSCI.

[Britishsteel]

Purl gurl, I think that the increased volaitility is what is bringing more of your unqualified traders into the market, and that is what you are trying to cull ? after the dot com bubble burst day traders left the arena.Its the volatility that brings them in.

[Indexor]

The SEC is currently BROKEN. The have continued to make one bad decision after another. While they continuously harass brokerage firms and RIA's, they also create new compliance rules they aren't required to communicate and punish firms with "deficiencies&quo... over mundane paperwork and rules that do nothing to protect investors. They are never held ACCOUNTABLE for their own actions.

The removal of the Up-Tick rule was simply another in a long list of extremely bad decisions made by the NYSE and the SEC, with no accountability. The ongoing kowtowing to hedge funds and institutional investors with such blatant disregard to individual investors is stunning. These transgressions need to be addressed.

Regulators need greater industry insight, potentially by a group of praticing brokers, advisors, institutions and hedge funds to foster a more realistic view of the differences in each of our businesses. We need to scrap the 34 Act, 40 Act, etc., and create new rules that are more specifically applicable to each of the different businesses we currently operate in 2008. We also desperately need a new standard of regulatory accountability. Potentially, securities regulators should be subject to the same lawsuits, fines and criminal laws that the rest of us in the investment business are subject to. That may deter some of the poor decisions that continuously rain down upon us and create the level of accountability that the industry so desperately needs.

[Britishsteel]

So when are Americans going to wake up? Who is willing to pass the good word? Who is willing to stand up to the politicians who only represent the interests of corporations? Their is ac oming revolution in this country, Americans just do not realize it yet. Does government serve the people or do people serve the government? Only You can answer this question. Remeber history repeats itself.
Their is a book called The fourth Turning quite an intersting read.
Their is a gentlemen named Peter Savich who has a blog about his analysis of the book its quite interesting. Her is his website and some exerpts from the book.
petersavich.com/Duck/A.......


According to Fourth Turning, the previous six crises in American, and pre-American, history are:

War of the Roses (1459-1487)
Spanish Armada Crisis (1569-1594)
Glorious Revolution (1675-1704)
American Revolution (1773-1794)
Civil War (1860-1865)
Great Depression and World War II (1929-1946)
Concerning patterns of similarity among these crises, Strauss & Howe had this to say about the last three:

[E]ach of the past three Crises resolved aggravating value struggles that had been building up over the prior saeculum [100 year cycle]. The American Revolution resolved the eighteenth-century struggle between commerce and citizenship. The Civil War resolved the early-nineteenth century struggle between liberty and equality. The New Deal resolved the industrial-era struggle between capitalism and socialism. [page 300]

Note that, in these previous three crises, citizenship gained on commerce, equality gained on liberty, and socialism gained on capitalism. In other words, in every case, distributed power gained on concentrated power.

“Distributed” and “concentrated” here refers to the arrangement of power among people. The most concentrated sort of arrangement places one person on top, with the supreme and arbitrary power of life or death over everyone else. This is known as “totalitarianism”. At the other extreme is “populism”. In that structure, every person is of equal power and authority vis a vis everyone else. Obviously, there are many middle structures between pure totalitarianism and pure populism. But this gives the flavor.

Actually, this battle between distributed power and concentrated power describes not only the nature of the American Revolution, the Civil War, and the New Deal, as Strauss & Howe explained. It also seems to describe the nature of every other major crisis identified in the Fourth Turning:

World War II was fought between the Allies (Americans, British, and Russians, plus local resistance) against the collection of totalitarian regimes known as the “Axis” powers (under the supreme and arbitrary rule of Hitler, Mussolini, and Hirohito). So this was a war between distributed power and concentrated power. Distributed power prevailed.
The Glorious Revolution (1675-1704) was a “pre-quel” to the American Revolution. In that revolution, the English colonists rebelled against their imperial overseers. The rebellion didn’t result in a Declaration of Independence. But as Strauss & Howe explain: “English-speaking America entered the Crisis a fanatical colonial backwater; it emerged a stable provincial society whose learning and affluence rivaled the splendor of its European home.” [page 45] Again, the side of distributed power prevailed.
The Spanish Armada Crisis (1569-1594) was a war between Spain and England. Spain was the most powerful nation of the day and the main defender of the Catholic faith, while England was a Protestant nation of moderate power. At the time, Protestantism was in its early, tentative, and precarious days. In the Armada, Spain was attempting to return England to the Catholic fold. Since Protestantism was a revolution against the concentrated power of the Catholic Pope, and since England relied heavily on privateers like Francis Drake to defeat Spain, we can conclude that in the Spanish Armada Crisis, distributed power prevailed over concentrated power.
The War of the Roses (1459-1487) is a tougher case. That war was actually a series of two or three (depending on how ones counts) English civil wars. These wars were about claims to the British throne. First, the House of York rebelled against the ruling House of Lancaster. Later, the House of Tudor rebelled against the ruling House of York. Henry VII was the Tudor king who ultimately secured the British throne for the Tudors. Reading the BBC’s take on these wars, the most I can say is that the underdog challengers won their wars. Strauss & Howe say that: “England entered the Crisis a tradition bound medieval kingdom; it emerged a modern monarchical nation state.” [44] Also, the son of Henry VII was Henry VIII, who brought Protestantism to England. From these facts, I tentatively conclude that the War of the Roses can be characterized as relatively distributed power consistently defeating more concentrated power.
Stepping back and looking at this 500+ year pattern of major wars, the notion known as “America” emerges. “America” is the inexorable force of history chipping away at concentrated power, breaking it up into smaller pieces, and distributing those pieces among the People. True, the forces of history in between the crises exhibit the opposite dynamic at play. During these times of “peace”, distributed power is collected from the many and concentrated in the hands of the few. This counter-dynamic reaches its apex just before the next crisis. But then the next crisis comes along and busts up the concentrated power once more.

[pharma]

Naked shorting has nothing to do with investing. It is a criminal act.

If a company intends to issue additional shares, the company management has to be responsible for its actions to its shareholders and and its actions must be public [known to its shareholders and investment community in general].

At the same time, naked-short selling allows to a third party, totally outside the company management and its shareholders, at-will and in secret, issue new shares in an entity it has no ownership what so ever.

Nobody should at-will and in secret issue non-existing company shares and deliberately dilute companies shareholders value they have no position in. These activities are criminal in nature.

If someone owns a house, does it mean that a bank or somebody else for this matter have a right to sell the house or any part of it to somebody else without even informing the owner?

Unfortunately, the US government, its agencies, and the Congress knowingly and deliberately legalized criminal activities. Well, what else is new in America?

[MattBlackman]

Blaming the change in the uptick rule for this bear market is like blaming slaves for the Civil War. Sorry TickerSense but your argument lacks credibility, substance and details to explain your point...

[dumass99]

I find it incredible that so many people think that short selling is evil and un american. Sure "evil" hedgefunds can drive a stock price down if they have enough capital, but to make money on the position, they still have to cover on someone. The covering makes the stock price go up if noone is there to sell. Saying short selling is bad is like saying closing your long position is bad because it makes the stock go down. Thats just plain illogical.