The market rally that began today after Citibank announced that it was once again profitable saw further gains after Rep. Barney Frank said he expects the uptick rule to be restored within one months time.  The uptick rule, which was instated in 1938 to regulate short selling of stocks, was eliminated in July of 2007.  To understand the uptick rule and its potential effects consider the definition and the following uptick rule example.

The uptick rule simply states that a stock cannot be sold short unless the sale price is above the last sold price.  The previous sale price can be matched if it was higher than the preceding sale price.  As a reminder, selling short is the practice of selling stock that you don’t own in the hopes of buying it back (covering your short) at a lower price later.  So if you thought a stock was going down, you could sell it short and still make a profit.  When a stock is declining, short sellers can push prices even lower in much the same way a rush a buy orders can send a rising stock soaring.

With the uptick rule in place, the downward pressure from short selling is supposed to be moderated.  As sellers outnumber buyers, the price of a stock would tend to fall.  Adding short sellers to the mix increases the shares available for sale, driving successive sale prices lower and lower.  With the uptick rule in place, the short sellers could not sell unless they could get a higher price than the last sale price.  So if a stock last traded at $10.00 and the highest bid was $9.99 no short sale could occur.  Long sales would be allowed to proceed at $9.99 (and below) but the shorts couldn’t sell unless $10.01 was offered.  At the very least, the uptick rule only allows short sellers to partake in every other sale in a falling market, assuming that prices do a little bit of back and forth.  Here are some hypothetical example prices listed chronologically, along with whether or not a short seller could get in on such sale (short sale prices marked with a *).  10.00 9.99 10.00* 9.99 9.98 9.99* 10.00* 9.98 9.95 9.92 9.90 9.89 9.85 9.86* 9.85.

Short sellers want prices to fall and their sales help those prices to fall.  By only allowing short sellers to sell during price rises (when they’d rather not sell), the uptick rule helps to eliminate the recurring cycle of falling prices leading to more short sales leading to even lower prices and more short sales.  The effectiveness of the uptick rule is debateable and lack of strong evidence for it is largely the reason it was eliminated in 2007.  But proponents claim that the uptick rule’s dismissal added to the financial crisis and its reintroduction can help price stability and confidence to be ragained.