from wsj online:
February 14, 2000
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FIVE AND DIME: Decimals Offer New Way To Sell Stock
By GASTON F. CERON
NEW YORK -- Wall Street, where billions of dollars change hands every day, is bracing itself for the arrival of the penny.
Stock prices are about to get a facelift that promises to reverberate throughout the securities industry and investing world. Quoting stock prices in fractions, such as 10 1/4, is as much a staple of the lives of traders and stockbrokers as the ticker tape once was. But U.S. investors will soon have to get used to seeing stock and stock-option prices quoted in decimals, such as $10.25.
For investors who aren't versed in Wall Street's trading lingo, displaying prices in decimals will make it easier to follow the ups and downs of the stock market. It will also bring U.S. exchanges up to date with foreign markets where decimals have long been the rule. But what has trading types truly concerned - and excited - is a change to minimum stock price increments, or "ticks," that will be ushered in with decimalization.
As decimalization is phased in through the second half of this year, stock prices will begin to move in increments as small as a nickel, leaving behind the 1/16 of a dollar tick that is the current standard. The securities industry is also preparing for the strong possibility that heightened competition among trading venues will eventually drive down the tick to a penny. "My feeling is, it will happen sooner rather than later," says Michael LaBranche, chairman and chief executive of LaBranche & Co. (LAB), one of the largest specialist firms on the floor of the New York Stock Exchange.
The difference between using a tick set at 1/16, at five cents or at one cent may understandably be lost on someone who follows the stock market from a distance. But academics who have studied the effects of changes in tick sizes, as well as seasoned Wall Street veterans, contend that the size of the tick is actually quite important.
"The minimum price increment significantly affects the profitability of various trading strategies," said finance professor Lawrence Harris, of the University of Southern California's Marshall School of Business, in a recent paper on decimal trading. "A smaller increment will make some strategies more profitable and other strategies less profitable. Traders therefore differ as to whether they would prefer larger or small increments."
Negative Effect Seen On Limit Orders
One trading strategy that is likely to be affected by lowering the size of the tick is the usage of limit orders, which are orders to buy or sell stock at no worse than a set price. As a step toward decimalization, the NYSE and the Nasdaq Stock Market lowered the tick size to 1/16 from 1/8 in June of 1997. That change was eventually found to have hurt limit orders because it made it easier to jump in front of orders.
Think of it like this: under the 1/8-sized tick, if an investor placed a limit order to buy 100 shares of stock at 20, it would take a 20 1/8 bid to jump ahead. But once the size of the tick was cut to 1/16, it became cheaper - by half, in fact - to cut in line. In turn, this lowered the incentive to place limit orders, since, as finance professor Michael Goldstein said in a July 1998 interview with Dow Jones Newswires, "If every time you went to a supermarket, you were being cut in line, you may not want to go to that supermarket anymore."
Goldstein, who teaches at the University of Colorado at Boulder, now warns that limit orders may be hurt even more this time around because the tick reduction being discussed is steeper. Going from a 1/8 tick to a 1/16 tick amounted to a 50%-off sale on the cost of jumping ahead of a limit order. But switching from 1/16 of a dollar to one cent amounts to a far greater discount - an 84%-off sale, in fact. Even if the blow is cushioned by first cutting the tick by just 20% to a nickel, as the securities industry is now planning to do, a cut to a penny-sized tick from a nickel is still an 80% drop. "The last step is the big one," says Goldstein.
Limit orders have grown in profile in the last few years. Securities regulators often counsel small investors to use them instead of market orders, which are filled at the best available price without pre-established parameters. And the stock-trading systems known as electronic communications networks, or ECNs, have built much of their business on automatically matching limit orders. It remains to be seen how these forces would interact with a reduced tick size.
Large Orders May Be Hurt, Order Flow Payment Seen Curbed
Goldstein also notes that the cost of executing large orders may rise while the cost of executing small orders decreases, as was found to be the case when the tick was cut to 1/16. But he warns that investors won't necessarily be better off on the whole just because they make out better when placing small stock orders. Those benefits could be more than offset by any disadvantages felt by the market players who place large orders - large institutions, whose investment funds, after all, represent the aggregated assets of millions of smaller investors. A good chunk of investors' money is kept in mutual funds, says Goldstein. "And that means most of their money is being held by the institutions. And because the institutions are worse off, they'll be worse off."
Trading in pennies could also curb the controversial practice known as payment for order flow. Stock dealers have grown used to paying off brokerage houses - in particular, online brokers - for sending them order flow. Dealers do this because they can often profit handsomely from trading in these orders. But trading in pennies may narrow bid-ask spreads and eat into dealers' profits. This would decrease payments for order flow, as the practice would become less profitable, says Harris, the USC finance professor.
Specific trading strategies aside, it's not hard to see why decimalization gives Wall Street pause. Computer systems are expected to be strained by the extra data they will have to process once the tick moves to a penny. And consider that the array of fast-changing stock prices on today's trading screens already requires traders to be quick on their feet. The thought of every stock moving up and down, a penny at a time, at the blink of an eye, is enough to give many a Wall Streeter a headache.
The Securities and Exchange Commission is also concerned about the effect of trading in pennies. The commission will allow trading in nickels through 2000, but it has asked U.S. stock markets to study the expected effect of trading in pennies.
It's tough to predict exactly what will happen once decimalization and penny-sized ticks are introduced. But Kenneth Pasternak, chief executive of market-maker Knight/Trimark Group Inc. (NITE), says that a stock won't necessarily trade all the time at a penny increment just because it can. A very active stock such as Dell Computer Corp. (DELL) might trade at every single one-cent point on the way to $40 from $39, for example, but Pasternak thinks that less-active stocks have more than enough price increments with the tick set at 1/16 or a nickel.
-Gaston F. Ceron; Dow Jones Newswires; 201-938-5234;
gaston.ceron@dowjones.com |
