With the introduction of cryptocurrencies, one can explore several trading markets, like the crypto market, forex market, stock market, share market, and so on. Although the item or entity to be traded, price movements, volatility, profit percentage, and risks differ with the markets, there are certain terminologies whose meaning remains unaltered.
Published on 03 March 2023
One such terminology is the trading tick size. It is defined as the least increment in the price of a certain trading instrument. No matter how much experience you have gained as a trader in any trading market, you must know everything about the stock size.
It will help you to determine the price movement of the trading instrument, avoid the risks, and gain more profits. This article will introduce you to the basic concepts of tick size, its importance in trading, the working of the terminology, and so on.
There are many ways in which a trader can define the tick size. According to the textbook, the tick size is defined as the difference between the minimum sell price and maximum buy price of any trading instrument or asset. It can be the shares you have in the market, any currency pair for the forex market, or a crypto token in the cryptocurrency and blockchain market.
According to the trader version, the definition changes slightly. Tick size is often described as the minimum gap by which the price of the trading object changes, provided the price change is less than $0.1 and won't be displayed on the exchange graph. As the tick size has a nominal value, it is often considered with other valuation terminologies to determine the price of the trading entity.
Until the 2000s, traders and exchange markets calculated tick size as a fraction of 1 US dollar. It can be 1/16th of 1 US dollar, equivalent to a $0.0625 price change between the maximum buy and minimum sell prices. Another two common fractional expressions used to determine the trading tick size in the US stock market till 2000 were 1/8th of 1 US dollar or $0.125 change in the price and 1/32nd of 1 US dollar or $0.03125 increment or decrement in the price movement of the trading asset.
However, the fractional system to determine the tick size proved quite inefficient. Plus, there was no consistency between the valuation. If one trader used the 1/8th valuation for the tick size, another would use the 1/16th or 1/32nd fractional value. Therefore, to introduce consistency and ensure the tick size valuation is followed across the global market, the Sub-Penny Rule was introduced in 2005.
According to this rule, if the stock valuation is more than $1, the tick size will be $0.01, while for a lesser stock price, the tick valuation will be $0.001. Out of these two valuations, most traders use $0.01 as the tick valuation to make calculations much easier and smoother. However, when considering the Futures Contracts, the tick size will increase by more than $0.01. As of now, the highest tick size determined was $0.25 or $12.50.
Consider a stock with a tick size of Rs. 0.10. And state that it last traded for Rs. 100. The best bid prices for the stock might therefore be Rs. 99.90, 99.80, Rs. 99.70, and so forth. Given that the bid price doesn't really fit the tick size of the stock, a bid price of, let's say, Rs. 99.84 will be inconsistent and illegitimate.
Likewise, the tick size would also affect the offer pricing. These amounts are 100.10, 100.20, 100.30, and so on. When moving by the tick size, the price arriving at the following point will be taken into account if there aren't any bids at a given level. For example, the next bid price of Rs. 99.80 will be the highest bid price if there aren't any offers at Rs. 99.90. The offer price also falls within this category.
There are many benefits of considering the tick size that one needs to understand. Often traders overlook the importance of the tick size and have to deal with the consequences of a wrong trading call.
Keeping this in mind, we have explained some major ways the tick size can help the traders and the overall trading market.
One of the major areas where the tick size has found extensive application is determining the spread in the forex market. In the trading market, two prices are involved- bid and ask. The bid price is the amount a trader needs to pay to buy the asset, while the ask price is the money a trader will receive on selling any asset.
In the forex market, the difference between these two prices is termed the spread, and the tick size often regulates it. This is why considering the tick size will help you understand the spread for any bid-ask price pair if you are trading with the forex market.
It becomes difficult for traders to decide the right position to open or close during a trade in any market. Owing to improper knowledge about price movements, lack of understanding of the spread, and out of FOMO, many traders open or close the wrong position and suffer huge losses.
This can be avoided easily with the help of tick size. As its value determines the differences between the maximum buy and minimum sell price, traders can easily decide if they want to open a short or long position. Similarly, while closing a certain trade, traders can take help from the tick size to determine the risks and profits from the trade and act accordingly.
This article has walked you through the major aspects of tick size used in the trade markets. Although using this term or finding the proper valuation differs according to the market choice, the tick size is of utmost importance.