Definition: A rule put in place by the Securities and Exchange Commission (SEC) in 1938 to prevent sophisticated and wealthy investors from starting a downward spiral in the price of a stock. It says that a stock cannot be sold short by investors who believe it will go down in price (or who are trying to force it to go down) unless the shares are sold to a buyer at a higher price than the last buyer and seller agreed upon. The rule was repealed on July 3, 2007.

Selling short means borrowing another stockholder’s shares and selling them to a person wanting to own them. The short seller has to eventually return the shares he borrowed. If he can buy the shares back weeks or months later when the share price has dropped, he can return the shares he borrowed and pocket the amount of the drop.

Example: The last price at which UPTC’s shares changed hands between a buyer and seller was $94. The share price began the day at $100 so it has already fallen $6 today. Many owners of the stock are nervously checking their computer screens at work and watching what’s happening.

A person wanting to see the downward price move accelerate might be willing to sell a few shares short at $93 or even $92 to further scare the owners and get some of them to sell their shares in a panic. That would drive the price down even further. Under the uptick rule, a person wanting to sell UPTC’s shares short would not be able to unless a buyer stepped up and was willing to pay more (even if it was just a penny) than $93 for the shares.

Investeach explain: Notice in our example how this prevents the short-seller from being able to sell shares short at lower and lower prices and stoke the panic among UPTC’s shareholders. Shares could only be sold short if a buyer was willing to pay *more* for them than the price of the last trade. What can cause the stock to continue to fall? The owners of the stock who want to sell their shares before further damage is done. They may be willing to take less for their shares than $94, meaning that the stock’s price drop would continue.

The SEC has never stated a good reason why it repealed the uptick rule. Just months after it did, the stock market began a series of frightening plunges that reflected the arrival of the housing and credit crisis. Many believe that if the uptick rule was in place the volatility and severity of the price drops would have been less.

Finally, as if to admit its mistake, the SEC on March 10, 2010 put in place a woefully insufficient replacement. It basically turns the old uptick rule back on if the price of a corporation’s shares drop 10% or more in the day. A 10% drop in one day is enormous. The short-sellers may have been significant contributors in getting the plunge started. By the time the drop has reached 10%, panicked owners rushing to sell may be all that’s needed to make the stock price fall further.

Riddle me this:

1. What investing technique does an investor use to profit from a fall in a stock price?
2. Looking at what the rule requires, what does the term ‘uptick’ refer to?
3. What can cause a stock’s price to fall even if investors are not allowed to sell shares short at lower and lower prices?
4. Why is the SEC’s new rule a poor substitute for the old one?