Short Sell Restriction

Short Sell Restriction

5 min read

What is a short sell restriction? It’s also known as a rule that came about in 2010. The short sale rule is one where short sales are executed when there is an uptick. Or in the instance where someone pays up to the price at where your order is.

What Causes a Short Sale Restriction?

It can be quite tricky to understand how the short sell restriction works if you don’t know what a short sell is in the first place. So first, I’ll be explaining the concept of shorting to you.

Traders engage in buy and sell transactions all the time. When you buy an asset, you do so hoping that its price will move up.

Also, when you sell an asset, you do so for the fear that the price will shift downwards. When you short a sale, you benefit if the price moves downwards. For example, suppose you get into a short contract for a stock valued at $100 currently.

You will benefit if the price of this stock falls below 100 dollars. Essentially you’re betting on the stock price to decline.

A short sell restriction has been introduced by the SEC to limit the amount of short selling happening in the financial market. This ruling was introduced to prevent short sellers from pushing the market price lower.

The Original Short Sell Restriction Rule

The short sale rule came into existence in 1938 where there was a significantly greater opportunity for stock price manipulation. There were reports that speculators were pooling together and short selling stocks to raise prices.

The SEC introduced a rule that you could only short sell where the short sale needed to be higher than the previously traded price.

This means that you could only sell on the uptick. Before this, the SEC didn’t have market mechanisms to prevent market manipulation of this sort.

The SEC also went ahead and rescinded this regulation in 2007 based on a test program of stocks in 2003. The rule was reinstated after the 2008 financial crisis.

There were suspicions of a bear raid market manipulation to bring down all the stock prices significantly.

Today the rule is known as the alternative uptick rule. It serves to curtail short selling when the stock has triggered a circuit breaker. This method helps prevent any aggressive short-selling and also prevents collusion between different investors and firms.

Current Short Sale Rules

There were a couple of updates/modifications to the short sell restriction and regulations following the global financial crisis. Currently, if you wish to engage in short sales, you need to follow these requirements.

  1. The short sale rule is triggered only when the stock price falls by 10% within a day from the previous market close.
  2. Once triggered, the rule remains active for the remainder of the day; the rule can also extend to the next day.
  3. The SSR rule applies to all the stocks listed on the American exchange, like the NYSE and Nasdaq.
  4. This rule is enforceable by brokers.

If a stock hits the SSR, you won’t be able to hit the bid on a short sale. Instead, you’ll have to wait for the stock price to go up to your ask price for the order to execute.

Is There a Ban on Short Selling?

As market uncertainty continued to increase in the rise of COVID-19 where market participants had to face uncertainty about quarantine measures, travel restrictions, etc. Financial regulators placed restrictions on short selling in March 2020.

These restrictions were intended to help keep the financial markets fair, orderly, and efficient. Instead, policymakers ended up banning short selling for several months in a row.

In addition, some exchanges didn’t ban short sales altogether. Rather, they worked on introducing new measures that would limit the activities that could harm the market performance.

Most European regulators were inclined towards broader bans. Whereas most Asian policymakers tweaked financial market rules to limit short selling.

Throughout history, many regulators have blamed short-sellers for market stress and introduced periodic bans.

For example, in 2008, the United States imposed a ban on short-selling for 1000 stocks. During the Eurozone debt crisis, several countries went ahead to ban short-selling for several weeks. In China, when the stock market showed significant volatility, the Chinese imposed a restriction on short-sellers.

Final Thoughts

A short sell restriction is aimed at protecting financial institutions. In most instances, short-sellers are experienced investors. And their actions are well informed. During a financial crisis, activities like short sales tend to be riskier because they can induce a panic run. In normal market conditions, short-sellers act as investigative journalists of financial markets by exposing failing business models, bad management, and excessive leverage.

However, studies examining the effect of short sales on the general market haven’t found short sale restrictions to be exactly helpful in curtailing the situation. Scholars argue that short-sale bans are actually doing more harm than good. A ban on short sales decreases market efficiency, impedes price discovery, and brings negative effects like price inflation. Placing restrictions on short sales, particularly in periods of volatility, intensifies the situation.

With the recent global pandemic, the United States has remained hesitant about banning short sales. However, while they didn’t ban short sales, they did go ahead and make short-selling more costly. Currently, short selling is under scrutiny because of the GameStop stock frenzy that occurred in early 2021.

Short sales restrictions often become a highly heated topic of discussion between market experts. However, the general rule of thumb is to engage in short sales only when you’re an experienced trader and someone willing to take a high level of risks.

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