It’s a strange name for one of the simplest rules of the stock market. The rule was established by the Securities Exchange Commission (SEC) in 1934 following the Great Depression.

It’s a strange name for one of the simplest rules of the stock market. The rule was established by the Securities Exchange Commission (SEC) in 1934 following the Great Depression. The uptick rule was recently eliminated in July of 2007. The purpose of the uptick rule was to prevent the very sharp decline of a stock due to extensive short selling.

What would typically happen is, a company’s stock price would begin to decline because of various reasons such as missed earnings, a change in upper management, a lawsuit, etc. Many investors would become nervous because of the news, and would “sell off” their stock holdings for that company, causing a decline in the share price. Short-sellers would see the sudden drop in price and short sell an extremely high number of shares in the hopes of making a quick profit. The result of the extreme short selling sends the stock price into a free fall. During a typical stock market cycle, once the stock price is driven lower than the intrinsic value of the company, value investor’s jump in and buy up shares just as fast as the short sellers sold short. This sends the stock price back up almost as fast as it came down. This typically doesn’t cause a problem. But in a very uncertain economy, like the one we are in now, this can wreak havoc on an already weak stock market. In a failing economy, investors are afraid to jump back into the stock even when the price drops lower than the value of the company. In an environment like that, it causes a bottomless pit for stock prices. Some experts believe that the elimination of the uptick rule has directly contributed to the recent collapse if the financial market. After all, the stock market started to plummet precisely when the uptick rule was eliminated.

The uptick rule works like this: If a stock price is in a decline, it can not be sold short until it closes higher than the previous closing price. Example: Stock XYZ is in a down trend and it closed yesterday at 8.75. Today it closes even farther down at 8.43. This stock can not be sold short the next day, because it closed lower than the previous day’s closing price. If the same stock closes at 8.44 or higher tomorrow, than it can be sold short the next day, because it will have closed at a higher price than the previous day.

Many financial professionals and investors are making noise trying to get the uptick rule reinstated. The rule wouldn’t prevent a failing company from going under, but it would stop short sellers from singlehandedly sending a stock’s price into a free fall.

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