The uptick rule is designed to prevent short sellers from jumping nonstop on a declining stock and driving it to oblivion. It was implemented in 1938 in the aftermath of the the depression and the huge market declines. Every bear market needs a scapegoat and the public loves to blame the villainous short-sellers for everything that goes wrong.
Short sellers borrow stock from their broker and sell it at the current price, hoping to buy it back at a lower price and returning the borrowed shares to the broker. Anyone with a margin account signs an agreement to allow the broker to lend out the shares in the account. In truth, you never know your shares are gone because the short seller has to pay you any dividends that are paid while he has borrowed your shares.
The short seller keeps the difference between the price he sold the borrowed stock at and the price (hopefully lower) at which he bought back the shares. So, if I sold short 100 shares of XYZ at $80 per share and later buy the shares back at $60 per share, I pocket a profit of $20 per share, minus commissions and margin interest. Short sellers therefore make a profit as a stock declines, gaining the ire of persons who helplessly watched their shares decline in price.
The uptick rule requires that in order to execute a short sale, the prior sale must have occurred at a higher price (uptick) than the previous sale. Someone had to bid up the price of the stock before it can be shorted. The uptick rule is designed to slow down the progression of short sales. The uptick rule was eliminated in 1997, in the middle of a bull market when people did not worry about short sellers.
Our politicians do not understand short selling and should not be influenced by the emotional reaction against short sellers that is produced by a bear market. Short selling can actually slow down a stock’s decline. This is because, using the example above, if a short seller sold short stock XYX at $80, the short seller is looking to buy back the stock he shorted (borrowed and sold) when he has a profit or a loss. If s/he sold the stock short at $80 and the stock rises to $90, the short seller has a $10 loss because he must buy back (cover) the short shares at a higher price than he sold them at. Alternatively, anyone who has a short position that is profitable wants to retain the profit and buy back the shares as soon as the stock begins to rise.
Thus, a stock with a lot of shares sold short (short interest) has a large number of borrowed shares outstanding that the short sellers must eventually buy back to close their positions. This is why shares with a large short interest often times rebound quickly after a decline as the short sellers buy back their shares and take profits. (Don’t we want these rebounds?)
The dirty little secret here is that people (even so-called advocates of a free market ) want to rig the market in favor of rises as opposed to declines. In a free market, short sellers take the other side from people who are going long (buying) stocks. If we say that people should not be able to jump on a stock to drive it down, why not say the same about people who are stampeding into a stock to drive it up? If we need an uptick rule to protect us from frenzied short selling, then we need a downtick rule to protect us from frenzied buying. Only let people buy a stock if the prior sale was lower than the the previous sale. Do you see the silly road that we are traveling down!
If they really want to protect investors, enforce the laws against naked shorting. Some traders are being allowed to sell short stocks that they never borrowed–now that’s unfair manipulation.