Whether you invest in stocks, mutual funds or exchange traded funds (ETFs), you’ve probably heard of the uptick rule by now. But do you know what it is and why it exists?

It is Rule 10a-1, and states that an investor can not short a security until it has traded higher at least once.

Many have argued that the uptick rule is useless and was created in response to panic on Wall Street during a major economic depression, although we will never know if this is actually true. John Devcic Investopedia clarifies that it is true that the uptick rule only comes into play when there is heavy interest in the shorting of a stock.

Here are a few more points about this rule:

  • In 2007, The Securities and Exchange Commission (SEC) had eliminated this rule to test and see if there was any validity to it. The SEC’s Office of Economic Analysis concluded that it did not appear necessary to prevent market manipulation.
  • Ultimately, the credit crash of 2007-2008 caused many to re-instate the rule.
  • Short-selling should not be viewed in a negative light. Short selling can put a top on irrational values, so the uptick rule slows irrational selling. Both are market instruments that work to maintain a proper flow to trading.
  • The uptick rule only come to mind during a bear market, or a time of market panic. Exchanges have their own uptick rules on top of The SEC’s uptick rule.
  • The major effects of the uptick rule cannot be put into a nutshell; the rule prevents any trader, big or small, from easily falling to an already lower price. Adding new short positions when a stock is on margin also makes the trader think twice before deciding on a new short position.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.