Stock Market for Beginners

The elimination of the short-sell “up-tick” rule has made a sketchy market even scarier. The Securities Exchange Act of 1934 was created to provide governance of securities transactions on the secondary market and to regulate the exchanges and broker-dealers in order to protect the investing public. Within this law was a rule that required short-sellers to wait for an up-tick in a stock before they could short. An up-tick can be defined as a trade price that is higher than the immediate preceding trade price. This was created to prevent manipulation, avoid large and steep declines in stock prices, and help create an orderly and balanced marketplace.

On June 13th, 2007, the rule was repealed after some small sampling showed that there was not an increase in volatility when the rule was not in effect. But now that short sellers can hit bids to short, I cannot see how that does not cause more volatility. Before the repeal, only investors that were already long could hit bids. Now, these same investors must compete with short-sellers to get out of a stock which will automatically make stocks drop harder and faster than they normally would because the specialists that provide the markets cannot get out of the way fast enough. This will make the price become oversold to a point where value investors step in and cause the stock to whip back up. The whip back up will be exaggerated due to the fact that short-sellers now need to cover and buy at any price. The specialist and market makers have a new dynamic to contend with now after the rule change. Before, they could see short sellers in their book waiting for up-ticks to be executed. Now, short-sellers do not have to put offers out there that are higher than the trading stock price. Instead, they can just come in and hit the specialist and market makers bids, forcing specialist and market makers to move their markets faster. Also, specialists protect themselves by making wider and thinner markets to avoid over-commitment.

Remember, specialists make money by buying on the bid and selling on the offer. The more they do that, the more money they make. It is their job to find a fair value where both buyers and sellers match up and they can buy on the bid and sell on the offer all day long. They don’t make money when they are just on one side just buying or just selling. If they are just buying, they move the stock down until some other buyers appear and if they are just selling they move the stock price up until they find some sellers. Now, with short-sellers being able to hit bids, specialists are being overwhelmed and must move stocks down much faster and deeper causing increased volatility.

It is going to take some time for specialists, market makers and the trading public to become use to this new phenomenon. What that means for us is that volatility is here to stay and if you want to make money in this environment, you need to adapt.

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