display | more...

Tick size is a basic concept on a stock exchange. It represents the minimum price difference between two levels in the order book; in other words, between to possible prices for orders. For example, consider a product with a tick size of 1 cent. This means that orders can be made at 1-cent intervals, so at 0.01, 0.02, 0.03... 65.45, 65.46. This implies that the difference between two orders in the order book can never be less than the tick size.

Because the tick size represents the difference between two orders, it also represents the minimum bid-ask spread in a stock. If the best bid is $60.57, the best offer is at best (i.e lowest/cheapest) $60.58, although it could be (much) worse (i.e. higher). This makes the tick size important for the liquidity of an asset: if an asset has a tick size that is a significant fraction of the asset price, crossing the bid-ask spread when trading is expensive. This makes trading more difficult. As an example, consider a stock that is worth $0.50, with a tick size of $0.01. This means the bid-ask spread is at least $0.01, so buying and then subsequently selling will cost 4% of our investment.

There are two reasons why the tick size is not infinitely small. The first reason is practical: with an infinitely small tick size, it would be possible to slightly outbid and outoffer other bids and offers by an insignificant amount. This would create a lot of pretty much pointless changing of prices, taxing exchange infrastructure. The second reasons is the fact that having a larger tick size means that it can be a profitable strategy to quote the asset. This means that we put a bid and an offer with perhaps only one tick size between them. If someone wants to buy and someone else wants to sell, we will buy at one price and sell at a slightly higher price. We have no net position, but we have made the tick size times the volume in profit. If the tick size is larger, this strategy is more profitable, and there will be more people doing it. This means there will be more size on the bid and offer, increasing liquidity. Hence, optimal tick size can be a balance between cheap trading for small volumes, but enough size to be able to trade a good volume for a reasonable price.

The tick size is determined by the exchange. Different products may have different tick sizes; it is even possible for different stocks or bonds to have different tick sizes. Furthermore, the tick size might depend on the value; for lower-valued assets, the tick size might be smaller. Exchanges can change the tick size if they want to; lately (late 2008), there has been a strong trend for smaller tick sizes (0.001 cent) on European stock exchanges, which works well with the much lower values of stocks nowadays.

In conclusion, the tick size is the difference between two levels in an order book. The tick size may be important, because it determines the minimum bid-ask spread of the underlying. This may impact the liquidity and the costs associated with trading, especially when the tick size is a significant fraction of the price of the asset, say more than 1%

Log in or register to write something here or to contact authors.