Tick Size Decides How Finely a Price Can Be Quoted
The minimum increment between quotes sounds like an administrative detail. It determines spread economics, queue behaviour, and whether market makers bother at all.
The Parameter
Tick size is the minimum price increment at which a security can be quoted. If the tick is one cent, quotes can be 20.00 or 20.01 but nothing between.
It sets a floor under the bid ask spread. A spread cannot be narrower than one tick, so the tick determines the minimum cost of an immediate round trip.
Tick size is the clearest example of a rule that looks purely technical and determines who earns what in a market.
The Historical Reduction
United States equities were quoted in fractions until 2001, initially in eighths of a dollar, meaning a minimum spread of 12.5 cents. Decimalisation moved to one cent increments.
The effect was immediate. Spreads narrowed substantially, reducing costs for investors executing small orders.
The offsetting effect was that displayed size at each price level fell. When a market maker earns one cent rather than twelve and a half, quoting large size becomes far less attractive, so quotes became tighter and thinner.
| Smaller tick | Larger tick |
|---|---|
| Narrower spreads | Wider spreads |
| Less displayed size | More displayed size |
| Cheaper for small orders | Better for large orders |
| Easier to step ahead of queues | Queue position has value |
The Queue Problem
Orders at the same price are generally filled in time priority. Being early in the queue at a given price has value, since it means being filled first.
A small tick makes it cheap to jump ahead: rather than joining a queue, a participant improves the price by one tick and moves to the front. With a one cent tick on a twenty dollar stock, that costs almost nothing.
The consequence is that resting orders get stepped ahead of constantly, which discourages posting size and reduces the depth of the visible book.
With a larger tick, stepping ahead is expensive, so participants join queues instead, and queue position becomes worth something. That supports displayed depth.
The Pilot Programmes
Regulators have tested widening ticks for smaller companies, on the theory that thinly traded stocks need wider spreads to make market making economic and thereby attract liquidity provision and research coverage.
Results have been mixed. Spreads widened as intended, which raised costs for investors, and the hoped for increases in liquidity and coverage were not clearly demonstrated.
The honest conclusion is that tick size affects the distribution of costs between investors and liquidity providers more reliably than it affects the total amount of liquidity available.
The Sub Penny Question
Where quoting is restricted to one cent increments but execution can occur at finer increments away from public venues, participants can offer marginal improvement over the public quote without displaying it.
This attracts order flow away from displayed markets, since a fractionally better price wins the order. The public quote does the work of establishing the price and receives less of the flow, which is the core of the regulatory argument about whether displayed liquidity is being adequately rewarded.
Where It Matters Most
Tick size is nearly irrelevant for very liquid securities, where spreads are one tick regardless and depth is plentiful.
It matters most for less liquid securities and for high priced ones, where a fixed tick represents a very different proportional cost. A one cent tick on a five dollar stock is twenty basis points. On a five hundred dollar stock it is a fifth of one.
This is why some markets use tiered tick regimes scaled to price rather than a single increment.
The Bottom Line
Tick size sets the minimum spread and therefore the economics of quoting. Smaller ticks narrowed spreads and thinned displayed depth by making it cheap to step ahead of resting orders. Larger ticks support depth at the cost of wider spreads. The parameter distributes cost between investors and liquidity providers more predictably than it creates liquidity.