De-jargoned: Tick size

In a recent announcement, BSE Ltd said it has increased the tick size of stocks listed only on it and that are trading in a price range of 500-2,000 from 10 paise or 0.10 to 25 paise or 0.25.

Tick sizes are often talked about; read on to find out what it is and its relevance in market trading activity.

What is tick size?

Tick size refers to minimum allowed price movement of a security such as stocks and derivatives traded on exchanges. It is the lowest amount by which the value of a security can change. This can be for a buy or a sell order. For example, if the tick size for a stock is 0.05 and the market price is 105.60, then the closest price the next buy or sell order can be placed at is 105.65 or 105.55.

What is the relevance?

Tick sizes are generally determined by the stock exchange itself and varies depending on the type of underlying security. Tick sizes for stocks with different market price ranges can also vary. For instance, a higher value stock can have a higher tick size than lower value stocks.

Theoretically, tick sizes can influence the liquidity of a security and trading volumes. Where a security suffers from low liquidity and witnesses a wide range in the bid-ask spread, a low tick size is found to be less productive; a high tick size can improve trading and liquidity as chances of making profits from a wider change in prices increases for market makers and institutional investors. Experts argue that a low tick size for inactive securities also discourages traders from putting in limit orders. This happens because a low tick size means your limit order can be crowded out easily by others; orders can be put at price points very close to each other, thus, making your price ineffective. On the other hand, a slightly higher tick size might lead to fewer bids at a price which is very close to yours. So volumes also tend to suffer if tick sizes are too small. This particularly affects stocks with relatively smaller market capitalizations.

For actively traded stocks, the volume and liquidity are not an issue and hence, discussion around tick size is not cumbersome. Recent research has found that smaller-sized inactive stocks tend to suffer if tick sizes are too low. In this context, the US Securities and Exchange Commission recently released a plan to do a one year pilot programme to widen minimum tick sizes for small-cap stocks.

If tick sizes across exchanges vary widely, it will create room for price arbitrage on a stock which is listed on more than one exchange.

Long-term investors versus traders

For traders measure of profit is short-term and in small bursts. Every percentage point change in price is important. In this context, tick price being low or high matters. Currently, our exchanges have tick prices starting from 0.05 to 1 depending on the underlying security.

For long-term investors who look to hold stocks for years at a stretch, tick sizes are not relevant. Nevertheless, in the near term they can have an impact on the trading volume and liquidity of stocks.