It may have gone unnoticed by many of us, but on July 6th the “uptick rule” for shorting was abolished by the SEC. This rule was born out of the 1929 stock market crash; it was created to “protect the investing public”-it requires that every short sale can only be executed on a higher price than a previous trade. The rule was created to prevent short-sellers from adding to the downward momentum of a sharp decline (causing crashes). The rule has been in effect for about 75 years. Now, the rule is gone. But the real issue is, how does it/will it effect us as traders? That is really what we want to know. One study that can help us deduce this is the SEC’s own study. Before dropping the rule, the SEC was doing a private study where they had dropped the uptick rule on multiple stocks (big caps, small caps, etc), and studied what happened. Would it be dangerous to the markets? (I have a hard time believing that you can determine this over a short period of time; the real danger is in market crashes). Nonetheless, they found out some interesting things that may help us.

Short selling accounts for much more volume than anyone originally realized. It may be that 25% of the NYSE volume is attributable to short sellers. This tells me that short-covering is probably causing more rallies than people had thought (more traders are caught short). And, possibly with the repeal of the rule-more people may begin shorting. This could cause more volatility with more violent vertical moves down, followed by bigger “pops” up. With regards to swing traders; there may be an advantage in placing limits a bit lower and exits a bit higher to take advantage of this.

Small caps stocks had significantly more shorting activity than large cap stocks when the uptick rule was eliminated. I think many of us may have suspected this. The small cap stocks are where people trade-it also tends to be an arena where there are many more new traders, hyperactive traders, and people trying to “knock it out of the park.” This just supports my idea that the most inefficiencies are in this part of the market. Additionally, these stocks may experience significantly more volatility if people can keep shorting all the way down in these stocks; likewise-we should see some significant bounces up when there are short covering rallies in these small cap, low volume stocks. Perhaps, when one of these stocks sells off hard enough (15+% over a day or two) -and there is a gap up-that might be a buy signal because of all of the short covering that will probably fuel the rally that day. I’ll have to look into it.

Although, not based on their research, the repeal of this rule could affect indicators that people have been using for their systems. For instance, ever since this rule was abolished the TICK has averaged about 0, whereas before that the TICK was averaging about 200. This is still too early to tell, but it makes sense that there is probably an increase in short volume since the rule was taken away. So, if you are trading based on the TICK score (or another related indicator)-your rules may need to be adjusted.

Additionally, this may lead to more effective and testable short systems and executable shorting ideas. One of the biggest (and strongest) arguments against shorting strategies in the markets is that it is very difficult to be able to predict how the uptick rule will effect your results. Backtested results may be completely different than what you would get in actual trading because the backtesting could not take into account the uptick rule. This made these strategies very unreliable. But, now, no problem. Which by itself, could lead to the creation of more short systems, thus causing more short volume. (see above) Wow...

Overall, this could usher in a whole new wave of volatility into the market in a way that we haven’t seen before. It could lead to new opportunities (for those who look), and new pitfalls (for those who don’t). But, most likely it will not affect the markets in a way that we think. After all, many proponents of this rule suspected that shorts were a big cause for the 1929 crash, so what do we blame the 1987 crash on? Certainly, the uptick rule did not do what the SEC felt it was suppose to do (or perhaps it mitigated something that could have been a lot worse). Just like everything else in the market-it’s all new, but really just the same again. So go find those new edges that were just created. I know I’ll be looking for them.

Happy Trading, Steve

ps--If you were wondering in the study who they found contributed to the majority of shorting...the individuals or the institutions (the smart money). It was the institutions--they accounted for 75% of short activity...WOW!