If short selling is part of your strategy, you must be familiar with short sale restrictions.
They can drastically affect your order executions and potential trading plans.
But even if you don’t short sell, learning about the strategy and the rules affecting short sellers could possibly give you an edge in your trading.
There may be potential to take advantage of these restrictions on the long side…
It’s all about preparation and having a well-rounded trading education.
What is a short sale circuit breaker? I’ll answer that in this post. Plus, I’ll tell you how the short sale restrictions can affect your trading, and I’ll give you an example.
Let’s roll…
What Is a Short Sale Restriction?
Before you learn what a short sale restriction is, you must understand short selling. It’s a strategy traders use to profit when a stock’s price drops.
The trader borrows shares from their broker and sells them into the market at a high price. Then as the stock goes down, the trader buys to cover. That returns the shares to the broker and the trader profits the difference between their high sell price and lower buy price.
Basically, it’s the opposite of taking a long position. Check out this post to learn more.
Shorting’s not a strategy I recommend for new traders. It’s risky, has high fees, and comes with the potential for infinite losses.
It also comes with short sale restrictions (SSR). They’re rules the U.S. Securities and Exchange Commission (SEC) imposes to restrict shorting on certain stocks.
The original short sale rule was a restriction in place from 1938 to 2007. It was created after the market crash in 1929. It was known as the ‘uptick rule’ because it restricted shorting stocks as they were falling. All short sale orders had to be filled on an uptick.
In 2007, the SEC got rid of the uptick rule and allowed short selling at any price. Until 2010…
That’s when the SEC adopted a new rule, which still applies today. And that’s what I’ll focus on in this post.
Let’s dig into the details…
What’s the Alternative Uptick Rule?
SEC rule 201 is known as the alternative uptick rule. It came into effect in 2010 to replace the original short sale rule. And it’s the rule that’s still in place today.
The rule applies to stocks listed on major exchanges and over-the-counter stocks (OTCs).
When traders talk about a stock subject to the short sale restriction or SSR, they’re talking about the alternative uptick rule.
Under the rule, a short sale circuit breaker is triggered when a stock falls too far below the previous day’s closing price. And just like under the previous short sale rule, once the circuit breaker is triggered, shorts can only short the stock on an uptick.
When I first started trading 20+ years ago, I made my first million in profits from short-selling penny stocks.* Now I’ve made over $7.1 million in profits trading this niche.*
But I don’t short sell anymore. It’s an overcrowded strategy, and that increases the risk of short squeezes.
New to penny stocks? Get my free guide to trading penny stocks here.
The Impact of Short Sale Restrictions
The purpose of the short sale restriction is to prevent volatile crashes in stocks that are already down. It’s meant to add stability to the market and individual stocks.
It also gives long traders a chance to exit their positions when a stock’s trend changes … Before it gets heavy pressure from short-sellers.
But short sale restrictions can also make shorting harder. Once the short sale circuit breaker is triggered, there are rules restricting how your order gets filled.
That could mean you get executed as the stock rips higher, or you might not get executed at all.
The 3 Rules of the Short Sale Restriction
Let’s look at the three ‘rules’ that outline how the SSR is triggered and what happens once it is…
Triggering Rule
The short sale restriction is triggered when a stock’s price drops 10% or more below the previous day’s closing price.
Your broker or platform will display a symbol to indicate when a stock’s subject to the SSR. (I’ll show you an example later.) But they all display it differently. So get familiar with your trading tools before you trade.
Uptick Rule
If you want to get a position in a stock that’s subject to the SSR, your order will only be filled on an uptick.
That means you must enter a limit order at the ask or higher. Under the SSR, short sale orders will only be executed at a price above the current best bid.
Duration
Once triggered, the short sale restriction lasts for the rest of the trading day and until the close of the following trading day. Unless the stock continues to fall. Then it will remain subject to the SSR.
What Triggers the Short Sale Restriction?
I’ve already mentioned what triggers the short sale restriction. But what could cause a stock to drop 10% in a day? There are plenty of reasons…
A price drop through a support level can trigger stop-loss orders and create a massive sell-off. It can also be a sign of a trend reversal and a signal to longs to exit their positions.
There could also be dilution, bad news, or it could just be overextended and due for a pullback.
Bad news and dilution are good news for short sellers. They can be a negative catalyst and cause longs to sell. That adds even more selling pressure to the stock.
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Example of a Short Sale Restriction
Just because a stock’s subject to the SSR, it doesn’t mean it’s an automatic shorting opportunity. As a short seller, ideally, you’ll want to get in a short position before a stock’s already down 10%. Here’s a good example of why…
Pieris Pharmaceuticals, Inc. (NASDAQ: PIRS) ran on news of a collaboration agreement with another company. As part of the agreement, PIRS will receive $20 million upfront and the potential for up to $1.4 billion in royalty and milestone payments.
It had a massive first green day on May 25 after the news. The next day it had a huge gap but then failed and had a big red day. The stock was subject to the SSR around 2:30 p.m. when the price hit $3.38, or 10% below the previous day’s close of $3.79.
If you waited for the stock to be down 10% before trying to short it, you would’ve gotten executed near the low of the day. That’s not a good risk/reward.
The next day PIRS squeezed shorts as dip buyers came in and earlier shorts bought to cover.
You can’t see from the chart that the stock is subject to the SSR. StocksToTrade displays a gold S in a circle beside the company’s ticker when it’s subject to the short sale restriction. The symbol also displays on the stock’s tab. It looks like this…
Other brokers or platforms could display it in the Level 2 box or another way. Again, know how to use your broker and platform before you trade.
How to Trade With Short Sale Restrictions
Ready to short a stock subject to the SSR? Not so fast … Hopefully, you just learned a key lesson from the example I just shared.
Just because a stock’s subject to the SSR, doesn’t mean you should short it. But it doesn’t mean you should buy it either.
The price could go down, or it could squeeze shorts and go higher.
The best way to trade a stock under the short sale restriction is to trade the pattern and strategy that works best for you.
If you like to short sell, the SSR can make entry executions harder. And if a stock’s already down 10% or more from the previous day’s close, consider how much lower you think it can go.
If you like to go long you could potentially dip buy a hot stock with news and take advantage of a short squeeze to the upside. As the price goes up, more and more short positions will be executed on the uptick.
Then when it continues to climb, shorts are forced to cut losses by buying to cover. That adds to the buying. And it’s what creates massive short squeezes.
Whether you’re a long or short-biased trader — know the reasons why a stock is down before you plan a trade.
Is it a hot stock running on a catalyst and it was just due for a pullback? Or was there bad news or dilution announced?
The short sale restriction shouldn’t be the only factor you consider when making a trading plan. I look at seven indicators before I take a trade. I go over all of them in my “Trader Checklist Part Deux” DVD.
Is the Short Sale Restriction Good For Stocks?
Many people blame the 2008 market crash on short sellers being able to short stocks at any price.
Could the SSR have prevented the crash? Probably not.
Stocks still crashed in 2020. Even with the rule in place.
It’s not perfect, but it is what it is.
If you want to short sell, you must accept that the SSR can affect your trades. Just like traders with small accounts must accept the pattern day trader rule (PDT). There’s nothing you can do about it.
Instead of complaining about rules out of your control, focus on creating better trading plans that improve your risk/reward. And don’t use the SSR as an indicator to take a short or long position.
Frequently Asked Questions About Short Sale Restrictions
Check out the answers to these short sale restriction FAQs…
What Are Short Sale Constraints?
Short sale constraints are rules or factors that make short-selling harder. Finding shares to borrow, high fees, and rules that restrict entries to an uptick can all make shorting harder. Some market critics think short-selling constraints can lead to stocks being overpriced.
What Is a Short Sale Circuit Breaker?
The short sale circuit breaker is what’s triggered when a stock goes 10% or more below the previous closing price. Once triggered, it prevents short sale orders from being filled on the bid.
Why Was the Uptick Rule Removed?
The uptick rule was removed in 2007 as more trading became electronic. The SEC’s rationale was that the rule reduced liquidity and wasn’t necessary to limit price manipulation. Some investors think the removal of the rule added to the market sell-off in 2008.
Short Sale Restriction: The Bottom Line
Short sale restrictions are rules put in place by the SEC. They’re meant to protect investors and stabilize volatile downturns in stocks.
If you’re a short seller, you might not like the SSR. But you must accept it.
There are plenty of rules that affect traders. Familiarize yourself with all of them. Know the rules of the game before you play.
Because trading isn’t easy. There’s a lot to learn…
Sadly, most people are too lazy to put in the work and study. And that’s why I think the majority of traders lose — they don’t prepare.
But having a teacher can greatly increase your learning curve. When I started, I didn’t have one and I had to learn the hard way. I took some big losses before I learned the right trading rules to protect my account.
Now, I teach students everything I’ve learned over my 20+ years of trading. I have 10+ millionaire students and all of them went through my Trading Challenge.*
It didn’t happen overnight. They studied their butts off to get where they are today. All of them watched all my DVDs, video lessons, and archived webinars. Some more than once. Mark Croock watched them all three times! And now he’s made over $2 million in trading profits.*
That’s the dedication level it takes to become a self-sufficient trader. If you think you’ve got what it takes, apply for my Trading Challenge today.
What do you think about short sale restrictions? Are they good or bad? Let me know in the comments … I love to hear from you!
Disclaimers
**Tim Sykes has a minority ownership stake in StockstoTrade.com.
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