In these troubled financial times, new regulation has been getting more and more attention, so now is a good time to talk about the “Uptick rule.” In order to understand what it is and why it is necessary, we’ll start with a brief introduction to short selling, followed by a cautionary tale about the dangers of short selling. Once that’s out of the way, we’ll briefly look at Bank of America, which might well be a great example of predatory short selling.

Short selling is the practice of betting against a stock’s performance by having someone lend you stocks under the agreement that you will return those stocks at some point in the future. Instead of keeping the stocks, you sell them immediately, and hold on to the cash. On the day of the repayment, you don’t give the money back – instead, you give the stocks back, and you do that by purchasing them at the current price of the stocks. If the lender gave you 100 shares and you sold them at $10/share, and now the stock is valued at $8, then you can purchase 100 shares for $800 and give those shares back to the lender. Congrats – you just made $200.

The uptick rule is a self-regulating mechanism that guarantees you can’t buy shares for less than a certain amount, by requiring shares to be purchased while they are gaining. If the stock is tanking, then that would be great news if you were short selling, but the uptick rule keep raises the minimum that you can buy the stocks for. Short selling creates an incentive to cause a company to fail, so the uptick rule is intended to keep this in check.

Of course, short selling goes both ways. Unregulated hedge funds can move massive amounts of money around, and some have made really calamitous decisions (e.g. the Porsche / Volkswagen case):

On [October 26 2008], Porsche announced it controlled more than 74% of VW shares.

VW’s home state of Lower Saxony owns another 20%.

The panic buying was caused by traders who had short-sold VW shares desperately trying to buy them back so they could close their positions.

Before Porsche’s announcement, many traders had been betting on VW’s shares falling.

They had borrowed VW shares and sold them in the market, planning to buy them back when the shares had fallen, return them to the lender and pocket the difference.

But what actually happened was that the shares rose as a result of Porsche’s effective takeover and the traders found themselves forced to buy the shares at any price.

As a result of the Volkswagen fiasco, one hedge fund manager committed suicide:

In killing himself German billionaire Adolf Merckle has become the latest casualty of the global financial crisis, his family saying on Tuesday he was broken by the struggle to salvage their business empire.

Merckle, who was the world’s 94th-richest person in 2008 according to Forbes magazine, spent his life building a business conglomerate with about 100,000 employees.

The empire was poised to come crashing down after his family made wrong-way bets on skyrocketing Volkswagen shares.

Yikes. In this case, Volkswagen was temporarily the most valuable company in the world, so it didn’t serve to damage the company in the short term. Of course, there is a flipside, and we’ll get after defining the uptick rule.

RTFA: http://en.wikipedia.org/wiki/Uptick_rule

The uptick rule is a securities trading rule used to regulate short selling in financial markets. The rule mandates, subject to certain exceptions, that, when sold, a listed security must either be sold short at a price above the price at which the immediately preceding sale was effected or at the last sale price if it is higher than the last different price. In 1938, the SEC adopted the uptick rule, more formally known as rule 10a-1, after conducting an inquiry into the effects of concentrated short selling during the market break of 1937. [1] The original rule was implemented by Joseph P. Kennedy, Sr., the first SEC commissioner.[2]

The NASD and Nasdaq adopted their own short sale price tests based on the last bid rather than on the last reported sale.[3]

The uptick rule makes great sense when you see a chart like Bank of America’s (BAC). In this case, it starts out great, but it almost seems like there’s no bottom to it.

Now, imagine that you have special knowledge (i.e. that BAC was just forced to purchase a company that had billions of toxic assets on its balance sheet). You might expect bad things on the basis of that knowledge causing you to aggressively sell BAC short. Someone loans you BAC stock at $40/share, and now it sells for $6.50/share. Congrats! You just made stinkybucks.

A panic might well be music to the short seller’s ears. What does a panic look like? In addition to the precipitous drop in share price, you want to look at the trading volume. The following graph is trading volume, and the panic is evident in how much that volume has increased:

This might be called a “feeding frenzy” for short sellers, because anyone who loaned out shares several months ago is going to get those shares back for pennies on the dollar. The idea of the uptick rule is to require the stock to recover slightly before repaying the short sale. If there’s panic, the stock stands to keep falling, and the short sellers actually have an incentive to prolong the panic. With the uptick rule, that incentive is mediated.

It’s possible that unchecked short selling is all part of a healthy economy, but it’s also possible that healthy companies could be destroyed by this process. The uptick rule might well interfere with the free market, but it may well be an appropriate check against predatory short selling.