The Uptick Rule and Its Pilot Period

There have been a number of headlines in recent weeks on whether or not the elimination of the uptick rule (a stock no longer has be shorted on an uptick) in July of last year has contributed to the market's declines or at least the pickup in volatility.  While it is hard to argue with the fact that volatility has picked up since July, it's important to remember that the no-uptick rule was in place for a large number of stocks as the market charged higher from the middle of 2005 to 2007. 

Way back in 2004, the SEC announced that it would suspend the uptick rule on designated securities in the Russell 3,000 as a pilot to see how the stocks and the market would react.  The pilot ended up consisting of about 1,000 stocks and didn't go into place until May 2nd, 2005, with an expiration in April 2006.

While the pilot didn't get much coverage when it was announced or finally put in place, here is an article from the Wall Street Journal back in 2004.

If the no uptick rule was really the root cause of the market's declines and increased volatility, shouldn't the market have struggled much more than it did from mid-2005 to mid-2007 when the pilot was in place?  The pilot consisted of 1,000 highly-liquid stocks that all had associated options.  Below we highlight a chart of the Russell 3,000 from 2004 to present. Had you looked at the chart in July 2007 right before the uptick rule was officially eliminated, one could make the argument that no upticks across the board could make the market go higher!

Jim Cramer has been all over this issue in recent weeks as an opponent to the no uptick rule.  While some may think he's irrationally blaming the market's declines on the no uptick rule, he has in fact been criticizing it for some time now, and his commentary definitely suggests that other issues are contributing to the fall.  But after a Google search, we did find an ironic article that he wrote just prior to the pilot period.  Below are some excerpts from the article that he wrote on April 29, 2005:

"Just when you thought it couldn't get nastier for the "longs" out there, the people who just play from the long side, the SEC passes the Hedge Fund Relief Act, and it goes into effect Monday. Oh, it's not called that. It is just the suspension of the "uptick rule." But it certainly will have that impact, for both the hedge funds and the market.

This rule change, of course, couldn't come at a worse time. The market's terrible. Longs are beleaguered, shorts are emboldened. I think it is fair to say that things are about to get a lot worse, a lot faster for the stocks of bad companies without the slowdown circuit breaker of the uptick rule. But the SEC, in its non-infinite wisdom, dreamed this little doozy up and all I can tell you is that you ain't seen nothing yet."

As shown in the chart below, his "couldn't come at a worse time" comment actually came at a great time to buy stocks, all but disproving his argument for the next few years.

While the no uptick rule might be contributing to some increased volatility, it's hard to blame it (and not the other glaring issues) for the downward pressure on the market.

We're in the process of analyzing the performance of all the stocks included in the pilot program to see how they traded versus stocks that weren't included during the effective period.  And by the way, BSC was included in the pilot.

Comments

[Mike W.]

The pilot study of 1000 stocks was an extremely poor designed study producing misleading conclusions for the following reasons (people with background in statistics know the study was garbage).

1. Very small sample size that produced not statistically significant results (sample error)
2. The same short selling hedge funds that have been lobbying the SEC to eliminate this rule knew ahead of the time which stocks not to short for the period of this study (they manipulated the study by manipulating these stocks [easy to manipulate small caps stocks])
3. The study was not well publicized. Many traders continued shorting these 1000 stocks as up-tick stocks. They did not know that they can short them on a down tick and waited for an up-tick before shorting (it distorted the study)

[EQ]

I love volatility! I support anything that makes the market more volatile. Let's blow up a few hedge funds every month or so to add even more volatility. If we could get 500 point swings in the Dow everyday, I'd retire and trade for a living. In fact, given the sh*thole Wall Street has created in the underlying economy, I may be forced to do that.

Volatility likely has more to do with other factors. Maybe like hedge funds spreading rumors, historical correlations killing black box trading, etc.

[dave]

1. Sample error? Quite possibly, but certain not due to "very small sample size."
2. Ah, must be the workings of the Sith Lord.
3. Hilarious; they are powerful enough to manipulate markets, but too stupid/lazy to keep themselves informed? Yeah, that is how traders stay in business.

[stretcho44]

During the pilot phase, the trades were very closely monitored by the SEC, paid consultants and several university groups.

WHY would anyone wanting the rule overturned take advantage of it during this time?

The reports submitted to the SEC did show some increased shorting of small company stocks because any change was too hard to hide. There is not much chance seeing any effect in larger companies.

The Russell 3000 chart pattern was not unexpected. July 11, 2007 when the rule was lifted is the peak. Since then, the shorting of the Russell 2000 and 3000 index ETF has grown to the point where the short interest on the Russell 2000 ETF (IWM) is 150% of created shares and is #1 on the short interest list.

Shorting is a valuable part of the process but should not be on equal footing with ownership. With small cap companies, shorting now has an advantage over owning shares. If you own stock in a small company, you now have to take the risk that the shares will dramatically drop in value simply because someone decides to work the stock prices for profit.

[Chris]

The elimination of the uptick was to address low trading volumes? So much for that theory. Trading volume up until the last month has been LOWER since the rule was removed. Cramer has been on Wall St. for over 30 years and when he says removing the rule was idiotic, I agree 100%.
There simply was no legitimate reason to change the rule. If it ain't broke don't try to fix it, moron!
Just another in a series of misteps that have injected chaos into the market. Kind of like doing away with Glass-Steagall. Yeah, that was absolutely brilliant. It resulted in trillions of dollars in capital being destroyed. When you forget the lessons of the Great Depression out of extreme "hubris" you need to learn the hard way. That's just what the Lehman, Merrill, Bear Stearns crowd has learned. Idiots.

[Karen]

I am a Canadian financial planner and I agree completely with the comments above that the 'longs' -- which is the typical investor here, due to restrictions as to who is allowed to buy into alternative strategies (i.e. only 'sophisticated investors' with minimum investments and minimum net worth)-- are severely handicapped in their abiity to prosper in the markets. We deal mostly with people who are in retirement or near retirement. I'm not sure I can recommend that they stay in the market after this one!