Keith Fitz-Gerald

A Day Late and $2 Trillion 'Short'

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Last week, the U.S. Securities and Exchange Commission (SEC) announced new measures designed to reign in so-called abusive "short-selling" of stocks by forcing "short-sellers" to actually deliver the shares of companies they're shorting. Now the SEC has taken an "emergency action" and temporarily halted short selling on 799 financial companies.

Talk about shutting the barn door after the horses have bolted …

Still, this issue is worth a closer look.

A Short Course on Short-Selling

Short selling, in case you're not familiar with it, is essentially a bet that a stock is going to drop in price. Traders borrow shares they don't own and sell them, reaping the proceeds from the sale. If the price drops, the trader then buys the shares back at the lower price, repays the loan of the shares, and pockets the difference.

As an oversimplified example, let's say that a stock is trading at $20, and a trader is certain it's going to drop. He borrows 1,000 shares, and sells them, generating $20,000 in proceeds (not factoring in commissions). The stock drops to $10. So the trader goes back into the market, buys 1,000 replacement shares, spending $10,000. The $10,000 difference is the trader's profit ($20,000 in proceeds from the short sale minus the $10,000 spent to replace the shares equals the profit of $10,000).

For the last 70 years, a trader had to wait until the stock moved higher before he could short it. More formally known as Rule 10a-1, the uptick rule actually came into existence in 1938, after an inquiry into the concentrated short selling that took place during the collapse of 1937, an event that is beyond living memory for all but a few traders.

Under Rule 10a-1, a listed security could only be sold short at a price above the price of the immediately preceding trade. In other words, it had to "uptick," which is trader slang for a stock moving higher before it could be shorted or taken lower.

There were, of course, a few exceptions, but the gist of the matter was that the rule helped maintain orderly markets by restricting unlimited wholesale selling.

This all changed last year.