The Uptick Rule & Fat Finger Idiocy

There’s been no shortage of ridiculous explanations behind last Fridays stock market plunge which took the Dow Jones Industrial Average down 1,000 points. Perhaps the most preposterous of them all is the so called “Fat Finger” theory which suggests that some “lone trader” accidentally shorted S&P E-Mini futures contracts to the tune of $1 billion. This theory would be easily laughed away if it weren’t plastered all over our main stream media.

Both the CME and ICE trading systems, have multiple market protection mechanisms which would make this impossible. Both reject orders placed outside of a reasonable price range and limit the number of contracts one can trade per given transaction. CME also has a “Stop Spike Functionality” which prevents against a cascade of stop orders from triggering a precipitous collapse. Lastly, every time a trade is entered a “Review Order” screen pops up that repeats your desired trade and basically asks – are you sure you want to do this? The “Fat Finger” theory doesn’t hold water. What does hold water, however, is the removal of a long standing SEC rule designed to protect against short sellers driving a stock into the ground – The Uptick Rule.

The Uptick Rule (SEC Rule 10a-1) went into effect in 1938, following a crash in the previous year. The rule is quite simple – Short sellers can only short a stock after an “up tick” (increase) in price. This mechanism, which remained in effect until July 2007 , prevented free fall stock prices for nearly 70 years. Months after the removal of the uptick rule, stock prices plummeted in a manner which was reminiscent of crashes experienced 70 years earlier.

The history of the Uptick rule is interesting. It was created by a market manipulator who amassed a fortune by short selling stocks into the ground during the crash of 1929. As the country reeled through the depression, this investors net worth climbed from $4 million in 1929 to $180 million by 1935 and he would go on to become the 1st Chairman of the SEC, working to fill the very market vulnerability that made him reach years earlier. His name, of course, was Joseph P Kennedy (Father of John F Kennedy).

Kennedy was ‘uniquely qualified’ to expose the inefficiencies of the stock market. The zero uptick which was formed under his SEC prevented the 50% to 90% crashes that were common during his era. The SEC, in their infinite wisdom, decided to try things out for a while without the rule. Well, it didn’t work. The question is when will our politicians speak out and takes steps to protect investors rather than the powerful hedge fund interest who like the way thing are “Just fine.”