Sub Penny Trading
- Posted by Jeff Carter
- on June 6th, 2012
There is some talk these days about narrowing spreads in the stock market. Currently, it’s traded in pennies. It used to be traded in eighths. To people that don’t understand that, here is what it means.
The bid is where people are willing to purchase the stock. The ask is where they are willing to sell it.
In a stock like $IBM, the current bid is $192.41 and the ask is $192.43, with the last trade being $192.42.
That’s what it looks like traded in pennies. The spread is one penny.
If we were trading in eighths, the bid would be $192.38 (or 3/8ths) and the ask would be $192.50. The spread is 12 pennies.
Penny spreads offer tighter bid/ask spreads. The problem is that penny spreads, combined with really bad regulation, have resulted in more volatile markets and less volume at each bid/ask price. In the old pre-machine days, floor traders were able to exploit the wider spread to earn a lot of income. Today they are cut out of the process.
However, I am not sure the process we have today is very good for price discovery and transparency, which is what the whole market is designed to do anyway.
The price you see isn’t necessarily the actual price the market trades at. There are so many side markets. Banks will operate dark pools, and send order flow to them. They trade at a lower price than and arb it off into other dark pools or the market for instant profits. Hedge funds and banks will pay for order flow (reducing your commission) and trade against it for instant profit. HFT traders will move that one penny spread around, sniffing for big orders to trade against.
The SEC looks the other way.
Everyone in the market suspects that there are structural problems with market design today. We just can’t agree on what to do about it. The latest idea is sub penny trading. Instead of IBM stock having a penny wide spread, it will go to sub pennies.
Sub pennies aren’t going to make the market more transparent. They aren’t going to decrease the volatility. Sub pennies are just going to put a premium on speed.
Instead, we ought to encourage thicker volume on bid/ask spreads, but have spreads tight enough so there isn’t a lot of juice in them. In addition, we need to reform the market structures so that they are horizontal, with full access to all participants and transparency. That means ending dual trading, ending dark pools, ending payment for order flow, internalization and front running. It also means reforming reporting requirements for block trades and price reporting.
I would propose a .05 spread. It’s easily understandable. It allows for arb opportunities between dual listed stocks and options. It will encourage thicker volumes on the bid and offer. Trading in five cent increments doesn’t penalize anyone who is making an investment for the long haul, nor does it penalize anyone when they decide to sell an investment.
When I was in the Eurodollars, we went from a big tick ($25) to half ticks($12.50), and then quarters ($6.25). All it did was increase trading costs. Narrower spreads magnified trader risk, and encouraged more market movement through the range. It increased volume but didn’t do anything for transparency. Independent traders like me hated it. We took the same amount of risk for half the price.
Sub penny trading would be sub optimal for the market.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
Jeffrey Carter is an angel investor and independent trader. He specializes in turning concepts into profits. He co-founded Hyde Park Angels one of the most active angel groups in the United States in April of 2007. He previously served on the Chicago Mercantile Exchange Board of Directors. He has done market commentary for (More...)
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