Gimme a Box of Plus Ticks

Wow, it’s Plus Tick Debate-Palooza today. This from the Journal.

With the stock market posting its worst quarter in six years, an obscure change in how stocks are traded is the subject of a nasty debate on Wall Street, with one side blaming the switch for everything from increased volatility to the collapse of Bear Stearns and the other side dismissing those critics as fools and worse.

The subject of this rancor is the “uptick” rule. Until July, investors typically had to wait until a stock was rising before they could wager on its decline. Under this rule, adopted in response to the stock market’s crash in 1929 to inhibit bearish traders, there had to be an “uptick” in a stock’s price before traders could short the shares. In other words, investors could borrow shares and sell them, hoping for the price to fall, only after a trade that pushed up the stock’s price.

After years of academic research suggested that the rule was hindering trading without protecting prices, regulators eliminated the rule last summer, giving a green light to those eager to sell a stock short, even as it was falling.

And in this corner, we have……

“Traders are in hog heaven — they keep banging and banging a stock [down] — but investors find it hideous,” argues Mario Gabelli, chairman of Gamco Investors, who wants the rule re-instated. “The increased volatility causes investors to want higher returns, so there will be a higher cost of capital for companies, putting our markets at a competitive disadvantage.”

Adds Martin J. Whitman, founder and co-chief investment officer of Third Avenue Management: “In my 58 years in the market, it’s never been easier to conduct bear raids.” His funds sustained losses when shares of companies such as CIT Group and bond-insurance companies, such as MBIA and Ambac Financial Group, fell significantly, declines he blames on short-sellers.

And, just over a week ago, CNBC’s James Cramer encouraged his viewers to contact the Securities and Exchange Commission and Congress to complain about the change, saying that “tens of billions of dollars” have been lost because of the change, and that SEC officials “are total morons” about the issue.

Gabelli I am completely surprised would have that position. It doesn’t seem to address the argument though. It is a demonstrable fact that volatility has trended higher, the question is whether the plus tick rule had anything meaningful to do with it.

Anyway, in the other corner, we have….

“Anyone who thinks the removal of this rule is somehow causing havoc in the financial markets is hopelessly lost in the bark of one tree and may never be able to see the forest,” says James Bianco, who runs Bianco Research in Chicago. He notes that there were ways around the uptick rule, such as using options strategies and exchange-traded funds, or simply violating it and paying a small fine. “To suggest that the removal of this rule is causing the markets to go down is to loudly announce ‘I don’t understand the credit crisis, and I am incapable of ever understanding it.'”

Well, it’s a bit over the top. I mean I would strongly suggest the motivation of the defenders here is more scapegoating than lack of understanding of the credit crisis.

But to me, he hits on the whole issue here. If you believe someone is manipulating a stock down to cause a panic, it wasn’t some little trader, it was a big fish. He wasn’t at all constrained by the rule. He could get himself long stock via options or ETF arbitrage.

Anyway, a former Big Fish describes the game here and why the plus tick was outdated, long before it was elimiated.

During the period I traded professionally, I have seen and heard attempts to bear-raid stocks. I have seen and heard organized rings to take stocks down. But at all times, the brokers policed this stuff and I made it very clear to anyone who tried to involve me that I would go right to the SEC on this lest I would be called in myself for knowing about it, and I feared the SEC. I know this because I used to use married puts, where I would buy common and puts, and then bang down the common fast and hard, breaking the stock, before the SEC told brokers they couldn’t do that any more because it was too easy to crack stocks, and crack stocks I did (as my brokers would attest) before the government decided to frown on it. I believe I did more married puts than any other firm during that period that it was legal.

It was child’s play to take a stock down and everyone knew it. I was also able to “get a short off” at lightning speed while the bozos were all waiting for someone to give them an uptick. The common I bought protected me from violating the law until the government figured the game out and took away the safe harbor.

Now, because of a slippery slope that started with the ridiculous exemption of the ETFs, it became possible to bang down whole sectors. Of course, it was during a bull market, so who noticed? Then the government decided if it was OK for ETFs, then why not individual stocks? On a sleepy July day last year, with minimal comments, they scrapped a rule that was designed for just these circumstances, a vicious bear market where it made more sense to drive down stocks and profit quickly than to go long.

That’s of course Cramer, and in a way it’s a self-defeating argument. Big Fish will always find a way to sell stocks down. And married puts are not illegal per se, and far from the only way to manufacture a long stock position. How about reversals and conversions? Shorting ETF’s (you can cross it on a plus tick if you want to add a new rule) vs. buying the basket?

And it all gets back to the meta-points, such as the fact that shorting is not illegal or immoral, and shorts take real risk. If Cramer made a fortune doing this, he took big market risk to make that happen. It only works if you can then turn around and buy it back from someone you sucked into selling.

Not to mention this whole reverse dynamic goes on in rallies. And in fact it’s that very short, who is now squeezed, that may add some real juice to the upside.

Adding that to suggest the uptick rule just vanished in the middle of the night is completely false. It was yapped about and studied for years. And I have no axe to grind other than my opinion that it was an outdated rule that actually disadvantaged the little guy and helped the Big Fish, like Cramer in this example.

….Adding also that the far bigger constraint on shorting stock is ability to borrow shares, and banning short sales on minus ticks on ETF’s makes no sense in that you would have to do it on futures too. And you would also have to ban buying Inverse Funds on plus ticks and……….I better stop.

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