Does the “uptick rule” stabilize the stock market? Insights from adaptive rational equilibrium dynamics

Abstract

Abstract This paper investigates the effects of the “uptick rule” (a short selling regulation formally known as Exchange Act Rule 10a-1) by means of a simple stock market model, based on the ARED (adaptive rational equilibrium dynamics) modeling framework, where heterogeneous and adaptive beliefs on the future prices of a risky asset were first shown to be responsible for endogenous price fluctuations. The dynamics of stock prices generated by the model, with and without the uptick-rule restriction, are analyzed by pairing the classical fundamental prediction with beliefs based on both linear and nonlinear forecasting rules deriving from the technical analysis of the financial markets. The comparison shows a reduction of downward price movements of undervalued shares when the short selling restriction is imposed. This gives evidence that the uptick rule meets its intended objective. However, the effects of the short selling regulation fade when the intensity of choice to switch trading strategies is high. In addition, the analysis suggests possible side effects of the regulation on price dynamics, such as an excessive swelling of speculative bubbles.