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With the SEC’s tick pilot program fully underway, it is time to learn about what it does and the potential effects this change in ticks could have for day traders in the industry.
Years ago, the United States was the only country in the world that was not decimalized. What does that mean? Well, it meant that stocks in the U.S. were trading only in increments of ⅛ or 1/16. That limited the number of price points that shares could be traded at. This article takes a look at the 5 cent tick pilot and what it means for day traders.
In 2001, the SEC changed over to a decimal system, which meant that stocks were now being traded in increments of 1 cent. 1.01, 1.02 etc. This lead to a massive increase in the number of price points a stock could be traded at.
The rationale was two-fold. First of all, the thinking was that since the United States was the only market in the world that traded in fractional increments, switching to decimals would make the market easier to understand globally, which would encourage foreign investment. Also, increasing the price points would bring more volume to the market, which would increase liquidity and increase trading activity.
The issue was that narrowing the spreads pushed the big market makers out of the business. Large investment banks, that would have been getting into sectors of the market on a regular basis, were not doing that, because the spreads were so small. Less spread meant less chance for a profit. Market makers became much less interested in providing a market for stocks that were thinly traded. So certain markets dried up.
There was much discussion among business groups and regulators about the effectiveness and unintended consequences of decimalization since 2001. The SEC decided to implement a 5-cent tick size pilot program in 2001 to test the viability of increasing the spreads.
Some think that increase the spreads for small-cap stocks will bring more trading to those stocks and encourage IPOs of smaller companies. Which means more opportunities for investment for more people. But the decrease in volatility from the tick pilot program on small cap stocks is not great news for day traders. Day traders make a living on volatility and stocks moving up and down very quickly.
The final ramifications of the tick pilot program have yet to be seen.
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