Short Sell Rules

Short sellers make money if prices fall, but lose money when prices rise.

It is possible to make money in the market whether prices are rising or falling. Investors who buy stocks and other securities profit when prices rise. Contrarily, short sellers profit when prices decline. Some people regard short selling as immoral, as short sellers profit from the demise of share prices. In reality, short selling is beneficial for the markets as it creates price stability. When prices are falling, short sellers who buy back to collect profit can stop prices from falling further, aiding investors.

How Short Sales Work

Selling short can be a bit confusing to new investors. To profit from falling prices, short sellers sell stock they don't actually own. Short sellers borrow shares from their broker and sell them on the open market. If the price goes down, they can buy the shares back and return them to their broker at a lower price, thus profiting from the difference between the price they sold and the price they bought back.

Naked Short Sales

In the past, short selling has been used abusively, so the Securities and Exchange Commission, SEC, has invoked certain rules. One rule bans naked short sales. A naked short sale occurs when sellers sell shares that their broker doesn't actually own. In other words, it is essentially counterfeiting shares since they are selling shares electronically, which don't exist in reality. To loan shares to short sellers, a broker must first locate real shares to loan.

Up-tick Rule

In 2007, the SEC eliminated the up-tick rule, making it legal to sell short when share prices are falling. Prior to 2007, short sellers were required to sell only when the price of a stock was ticking higher. The original rule was designed to create price stability and stop short sellers from forcing the prices lower by selling more and more shares at lower and lower prices. Market stability does not appear to have been adversely affected since this rule was lifted.

Trading Curbs

In 2008, the markets lost more than 30 percent of their value in just a few short days. In 2010, the SEC initiated new short sale rules that curbed trading to avoid a similar price decline in the future. The new rules temporarily curb short sales in a stock once it has fallen 10 percent below its previous day's close. Once a stock has fallen 10 percent in a day, short sellers are now required to sell short at a price above the highest bid price for the duration of the day.

References

• "The Wall Street Journal"; In 3-2 Vote, SEC Limits Short Sales; Fawn Johnson; February 2010
• Fulcrum Inquiry: SEC Changes Short-Selling Rules
• Securities and Exchange Commission: Key Points About Regulation SHO