Blog - Investing Notes

November 5, 2007 - Implications of Short Selling with No Tick Test

The SEC originally adopted Rule 10a-1 (the tick test) for listed securities in 1938 to restrict short selling in a declining market. After a test commencing 5/2/05 involving about 1,000 "pilot stocks," the SEC removed the tick-test rule for all listed securities effective 7/3/07. Does this rescission change the equity valuation landscape for U.S. equity investors/traders? In an October 2007 paper entitled "The Tick-Test Rule, Investors’ Opinions Dispersion, and Stock Returns: The Daily Evidence", Min Zhao investigates how the removal of the tick test changes the effect of short selling on stock prices. Using SEC Regulation SHO daily short selling data, along with associated daily return and firm fundamentals data, for the period May 2005 through December 2005, the study concludes that:

• Removal of the tick test significantly elevates average daily short volume, ratio of short volume to total volume and number of short orders.
• Removal of the tick test on average mitigates or even eliminates overvaluation as previously indicated for stocks with a high level of analyst disagreement on earnings forecasts. In other words, pessimists are now less inhibited from acting on their views, and trading systems that depend on dispersion of analyst forecasts are now less effective.
• For large-capitalization firms, for which shares are generally easy to borrow, removal of the tick test results in short-term undervaluations for heavily shorted stocks. Such undervaluations suggest the possibility of predatory (manipulative) short selling.
• A high level of daily short selling indicates a short-term reversal. On average, a daily rebalanced portfolio that is long (short) stocks with the highest (lowest) shorting activities generates an annual rate of return over 150% before trading costs. This return diminishes rapidly for longer holding (rebalancing) intervals.
• Since options have offered a means to circumvent the tick test constraint, removal of the tick test has less impact on stocks for which options are available.

In summary, removal of the tick test for short selling apparently: (1) mitigates overvaluation of stocks; (2) leads to temporary undervaluation of easily borrowed stocks; and, (3) disrupts trading systems that rely on dispersion of analyst earnings forecasts.

For related research, see Blog Synthesis: Short Selling and Short Interest.