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Research Magazine > ARCHIVE > Summer 01 > Article

"Tick" Talk
by Paul Karr

When the New York Stock Exchange opened on the morning of Jan. 29, 2001, something was different. Historically different.

Since its founding two centuries before, prices on the exchange’s so-called Big Board had always been quoted in fractions of a dollar. The smallest fraction allowed — the “tick” size, in stock parlance — originally was set at one-eighth of a dollar; for example, a price quoted as 5 1/8 would be worth $5.125. In a widely heralded change in 1997, the tick size was reduced to sixteenths, creating quotes such as 5 1/16, but the ticker-tape numbers still rather resembled measuring instructions in a cookbook.

All that changed in January 2001. As quotes began rolling off the tape, they resembled prices at a grocery store, ending in decimals instead of fractions: For the first time in Big Board history, a quote such as $5.01 was now possible. That meant tick sizes had shrunk again, from one-sixteenth to one-one hundredth of a dollar.

It appeared to be a simple change, but it sparked an uproar — and UGA finance professor Marc Lipson saw it coming.

In 1999, the NYSE selected Lipson to spend an entire academic year as the exchange’s visiting scholar, closely studying the new system from an office high above the trading floor. Examining details from nearly 400,000 stock trades, he and collaborator Charles Jones of Columbia University found an interesting — and unintended — effect of the change in ticks: While stock spreads (the difference between buyers’ and sellers’ anticipated prices) declined as expected, suggesting the new system might save traders money, the cost of trading for institutional traders had nearly doubled.

“That is one of the important contributions of this work,” Lipson said. “Most studies assume that a reduction in spreads automatically means a reduction in trading costs. That assumption seems reasonable, but markets are notoriously complicated.”

The cost increases came about because the new, smaller tick sizes enabled some traders to engage in a practice called line-jumping — or “penny-skipping,” as it’s quickly becoming known on Wall Street. The problem with penny-skipping is that individual traders can take advantage of so-called “limit orders” — standing orders, often used by large institutional investors, to buy or sell stock when prices hit a pre-set level.

“Let’s say there is a huge limit order to buy a stock at $20 per share,” Lipson explained. “If a trader steps in and buys the stock for $20.01 and prices begin to fall, the trader can turn around and sell to the limit order, losing just a penny per share. But if prices rise, the trader can make a fortune. This is a great deal for the trader, and the trader will do it every time.”

It’s not uncommon now to see stocks changing hands furiously at prices such as $23.99 or $24.01 per share even when there are huge standing limit orders, set to be triggered at $24 per share, remaining unfulfilled.

For large institutional investors, such as mutual funds and pension funds, all this line-jumping means fewer limit orders are being filled, and then only at the worst possible times. As a result, these institutions submit fewer limit orders and become more aggressive on the trading floor, and both of these actions raise their trading costs. This aggressiveness also can cause markets as a whole to fluctuate more wildly than usual during a given series of trades — something nobody wants to see.

With Lipson’s research in hand, NYSE regulators now are considering at least two remedies: widening the tick size to five cents (which would be close to the former one-sixteenth of a dollar tick size) or creating regulations that would require traders to bid a minimum of five cents higher or lower than a given stock price in order to buy or sell it. These measures would at least partly neutralize the practice of line-jumping.

Although he doesn’t take direct credit for the NYSE’s re-examination of its new tick size, Lipson acknowledges his research has brought to light the darker side of the Big Board’s move to decimals — something his most recent paper on the subject anticipated clearly with its droll title, “Pennies from Heaven?”

Who said economists are humorless?

For more information, e-mail mlipson@terry.uga.edu.

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