A rule change that has made it easier for short-sellers to execute trades may be partially responsible for wild swings in the stock market over the last several weeks.
While the market is also facing considerable headwind from uncertainty over the housing market and the economy, the removal of the restrictive uptick rule for short sellers, may be accelerating market declines, analysts say.
The market move was not caused by the rule change, but there is little doubt that it made the slide occur faster than it might otherwise, Gregory M. Drahuschak, vice president of Janney Montgomery Scott Inc, wrote in a note to clients this week. Increased volatility is here to stay as long as the new regulation remains.
Short sellers bet a stock is overvalued and that its price is likely to fall. They borrow shares, sell them and then wait for the stock to fall so they can repurchase the shares at a lower price, return them to the lender, and pocket the difference.
But until last month, short sellers were only allowed to sell at a price above the last price of a stock, or at the price of the stock's last trade if it was higher than the previous price.
The so-called uptick rule or tick test was implemented in the 1930s after the stock market crash to ensure short sellers were not alone in causing a stock price to fall.
But regulators at the U.S. Securities and Exchange Commission revoked the rule in July, suggesting it modestly hurt liquidity and did not appear necessary to prevent the manipulation of a stock price.
Because (short sellers) had to chase the last sale in order to be compliant with the uptick rule, it kind of distorted market conditions, said Ingrid Werner, a professor at Ohio State University's Fisher School of Business, who has tracked the effects of the uptick rule.
Before revoking the rule, the SEC began a pilot program in 2005 to suspend the tick test for a group of 1,000 stocks. Werner and two colleagues published a study examining the program and they found short selling did increase and that thepilot stocks did experience higher short-term volatility immediately after the suspension. But the study also found that returns from the stocks and daily volatility were unaffected.
But others worry traders did not take pilot program seriously and, now that the SEC has revoked the rule at a time of tremendous uncertainty, short sellers are closing in.
The hedge funds were very, very aware of this. They sit around and giggle when this stuff happens, said Mallory Hill, chief executive of mortgage lender Novelle Financial Services. Without the uptick rule, they can put anyone out of business.
Mortgage lenders, battered by the subprime lending crisis, are particularly worried that removing short sale restrictions has contributed to their sector's troubles.
Before it declared bankruptcy this week, short interest in American Home Mortgage Investment Corp increased almost 9 percent from mid-June to mid-July, despite the fact traders had had trouble since March locating enough of the stock to short.
Also, since the tick test was officially eliminated on July 6, downside trades have proliferated and volatility has become increasingly prevalent in the stock market.
The CBOE volatility index, known as the market's fear gauge, hit a four-year high on Thursday.
Also, in the past few days, the New York Stock Exchange's Cumulative Tick Index, which measures the number of stocks trading on an uptick minus the number of stocks trading on a downtick, has seen its highest level of downticks in at least a dozen years.
In fact, in the 25 trading days since the tick test was revoked, the average level of the tick index has been more than 75 percent below its long-term mean.
But short interest is also at a record high on both the NYSE and the Nasdaq and has been rising steadily since February.
For all we know there's a lot of short covering out there, said Dylan Wetherill, president of ShortSqueeze.com. Every time you short a stock you're adding another buyer in the mix at some point and that can have an impact on the upside.
It is also possible that, faced with uncertainty, analysts are simply falling back on the blame the vultures excuse.
I think it's quite unfair, Fisher's Werner said. The uptick rule itself was just a tiny grain of sand in the machinery of trading ... It's just a confluence of events.
In fact, the other worries may be playing a bigger role in driving the market. Nasdaq small cap stocks in the Nasdaq Capital Market Composite Index were never subject to the tick test and that index has fallen nearly 10 percent since the uptick rule was revoked.