Tick size represents the smallest permissible price increment for an asset traded on an exchange. It mandates a minimum price difference between consecutive bid and offer prices. Essentially, prices can only change in multiples of the tick size.
For instance, if a stock's tick size is Rs. 0.05 and its last traded price is Rs. 100, the subsequent five best bid prices would be Rs. 99.95, Rs. 99.90, Rs. 99.85, Rs. 99.80, and Rs. 99.75. A bid price of Rs. 99.87, in this case, would be invalid as it doesn't adhere to the Rs. 0.05 tick size requirement.
Origin of tick size
The concept of tick size has its roots in the historical practices of stock trading on the floor of the New York Stock Exchange (NYSE). In those early days, prior to the widespread adoption of electronic trading, stock transactions occurred in person, with traders physically present on the trading floor. During this era, stock prices were characterised by movements in fractions of a dollar, specifically 1/8th or 1/16th.
To elaborate, a movement of 1/8th represented a fluctuation of $0.125 per share, while a 1/16th movement denoted a change of $0.0625 per share. Traders at the time strategically sought gains by exploiting these incremental changes in stock prices. The understanding of the minimum price increment, or tick size, was crucial for traders engaged in the practice of scalping – a strategy involving the capture of small price differentials.
The shift from floor-based trading to electronic trading marked a significant evolution in the concept of tick size. In the current landscape, tick size is defined as the minimum amount by which the price of a security can move. With the advent of electronic platforms, the precision and efficiency of trading have increased, necessitating a standardised measurement for price movements.
Importance of tick size
Understanding tick size is important for investors in the financial market. It is a prerequisite for investing money in the markets and for tracking market trends and movements. An understanding of tick size and stock price movements directly determines the likelihood of entering and exiting the market at the right time to make profits.
For example, a Rs. 0.10 fluctuation in the price of a stock moving in the negative direction (decrement) will have a very different implication compared to a fluctuation of Rs. 10. A higher price difference, or tick size, increases volatility and thus requires strategic planning to avoid losses. By understanding tick size and movement, investors can better predict an asset's price changes, offering a better chance to make profits.
What is tick trading?
Tick trading, also known as tick-based trading, is a strategy that capitalises on the incremental movements defined by the tick size. Traders employing this approach focus on the smallest price fluctuations allowed by the tick size to make rapid and frequent trades. The strategy is particularly prevalent in markets with established tick size regulations, such as the Indian stock market overseen by the Securities and Exchange Board of India (SEBI).
How does a tick trading work?
After learning what tick trading is, let us take a look at how it works. Different financial instruments have varying tick sizes, which dictate the value of minimum price movements in an asset. Tick sizes can differ across asset classes and exchanges. For example, on the National Stock Exchange in India, the tick size for various stocks varies between Rs. 0.05 and Rs. 1. Let us further understand it with an example. Let us take a company ‘ABC’ with shares listed on the NSE at Rs. 10 per share. We assume that the tick size for this company is Rs. 0.05. Accordingly, the smallest change in the share value would be Rs. 10.05 if there is positive price movement and Rs. 9.95 if there is negative price movement.
What is the difference between tick size and tick value?
Let us understand the major differences between tick size and tick value:
Feature | Tick size | Tick value |
Meaning | The smallest permitted price change | The monetary worth of a single tick movement |
Set by | Set by a regulatory body or the exchange | Calculated using the contract size and the tick size |
Significance | Shows the precision of price movements | Indicates the financial impact of price movements |
Example | Tick size - 0.1 | A tick size of 0.1, along with a contract size of 500 shares, results in a tick value of Rs. 50 |
Effect on price | Directly related to the price increase | Indirect relation to price increase |
Trading impact | Trading flexibility may be impacted by a higher tick size | High tick values have an impact on trading strategies |
Flexible | Fixed for a given asset or market | Variable as it is based on tick size and contract size |
Regulation | Falls under regulatory supervision | Decided by market conventions and rules |
Relevance | Significant in all asset classes | More significant for options and futures markets |
Market impact | Affects price discovery and liquidity | Affects transaction expenses and profit potential |
Key components of tick trading
Let us better understand tick trading by looking at its essential components:
1. Tick size as a unit of measurement
In tick trading, the tick size serves as the fundamental unit of measurement. Traders analyse the price movements in these increments, aiming to profit from the minor fluctuations in asset prices.
2. Precision and speed
Tick traders operate with precision and speed, executing numerous trades within a short timeframe. The goal is to capture small, rapid movements in the market that may go unnoticed by investors employing longer-term strategies.
3. Scalping opportunities
Scalping is a common technique within tick trading. Traders seek to exploit the bid-ask spread and the tick size, making quick profits by buying at the bid price and selling at the ask price, or vice versa.
4. Algorithmic and high-frequency trading
With the rise of electronic trading platforms, tick trading often involves algorithmic strategies and high-frequency trading (HFT). Automated systems can swiftly execute a large number of orders based on predefined algorithms, taking advantage of small price differentials.
Challenges and considerations
Tick trading inherently comes with several challenges. Let us take a closer look at some of them:
1. Market liquidity
Tick trading relies heavily on market liquidity. In less liquid markets, executing numerous rapid trades may be challenging, and the bid-ask spread may widen, reducing potential profits.
2. Transaction costs
While individual trades may yield small profits, the cumulative impact of transaction costs can significantly affect overall profitability. Traders must carefully manage costs to ensure the viability of the tick trading strategy.
3. Technological infrastructure
Successful tick trading requires a robust technological infrastructure. Traders need access to advanced trading platforms and high-speed internet connections to execute orders swiftly and efficiently.
4. Risk management
Due to the rapid nature of tick trading, effective risk management is crucial. Traders must set stop-loss orders and establish clear risk-reward ratios to mitigate potential losses.
Tick size in futures trading
The minimum possible value change in the price of a futures contract is referred to as the tick size. For example, let us assume the futures market tick size to be 0.5. Then, this would be the smallest increment or decrement in the price of a given futures contract.
In the futures market, tick sizes influence margin requirements. A small tick size facilitates better risk management because positions can be adjusted along with small movements in the price. Conversely, a large tick size may necessitate holding higher margins owing to the potential for significantly higher fluctuations in price.
When trading in commodities, tick size has a direct bearing on price fluctuations, specifications of a contract, and the degree of risk management.
Tick size in forex trading
The smallest movement in currency pairs is known as the tick size in forex trading. Similar to other sections of the market, tick size in forex affects the costs of executing trades, placement of a stop-loss, and targeted profit by influencing the overall trading strategy. When designing an investment plan for the forex market, the tick size must be taken into consideration to determine a risk-reward ratio according to your risk appetite.
In the forex market, a small tick size can increase the chances of price volatility, offering the opportunity to earn higher profits at a higher risk.
Tick size in options trading
The tick size in options trading represents the minimum change in an option’s price. It is a direct determinant of the price of options trading.
The tick size has an impact on the price efficiency, bid-ask spread, and the option to make trades at desirable price values. It is also a significant factor to consider when designing customised strategies for options trading.
Tick size also impacts the liquidity in the options market as it affects the counterpart availability, trading ease, and depth in the market. A small tick size improves liquidity in the options market and brings in more participants.
Dependency of tick trading on tick size
Tick size and tick trading are closely related. Let us understand the correlation between the two:
1. Precision in decision-making
Tick traders rely on the precision offered by the tick size to make split-second decisions. With each tick representing a specific value, traders can strategically enter and exit positions based on these incremental changes.
2. Setting profit targets and stop-loss orders
The tick size serves as a crucial factor in setting profit targets and stop-loss orders.Traders calibrate these levels in alignment with the tick size, ensuring that potential gains and losses are in harmony with the incremental movements allowed in the market. This dependency on tick size facilitates a structured and disciplined approach to risk management.
3. Quantifying returns and risks
Tick traders quantify their returns and risks in relation to the tick size. This quantitative approach enables a clear understanding of the potential profitability of each trade. By aligning their strategies with the tick size, traders can optimise their risk-reward ratios and maintain a calculated approach in the fast-paced environment of tick trading.
4. Adaptability to market conditions
Tick trading strategies are adaptable to various market conditions due to their dependency on tick size. In highly volatile markets, the tick size allows traders to navigate through swift price movements with precision, while in calmer periods, it provides a structured framework for capturing smaller, predictable fluctuations.
Why does tick size matter?
Here are key reasons why tick size matters:
Effective risk management: Tick size plays a crucial role in risk management, helping traders set stop-loss orders and determine optimal position sizes.
Impact on liquidity: Tick size influences market liquidity, with smaller tick sizes often correlating with higher liquidity levels.
Volatility assessment tool: Traders use tick size as a metric to assess market volatility, adapting strategies to different market conditions.
Transaction costs and profits: Tick size directly affects transaction costs, impacting the balance between potential profits and expenses associated with frequent trading.
Regulatory compliance: Adherence to prescribed tick sizes is essential for regulatory compliance, ensuring fair and orderly markets.
Characteristics of tick size
Understanding the characteristics of tick size is paramount for traders seeking to optimise their strategies in the dynamic world of financial markets. Several key features define the nature of tick size and its impact on trading:
1. Fixed incremental movements
Tick size represents the smallest price movement allowed in the market. It creates a framework of fixed incremental movements, providing a standardised measure for price changes. This characteristic allows traders to quantify market fluctuations with precision.
2. Varied across instruments
Tick size is not universal; it varies across different financial instruments. Equities, futures, and forex may have distinct tick sizes, reflecting the unique characteristics and trading dynamics of each market. Traders must familiarise themselves with the tick size specifications of the specific instruments they trade.
3. Regulatory determination
Tick size is often determined and regulated by financial authorities such as the Securities and Exchange Board of India (SEBI). Regulatory bodies establish tick sizes to maintain market orderliness, prevent manipulation, and ensure fair trading practices. Compliance with these regulations is essential for market integrity.
4. Impact on market liquidity
Tick size influences market liquidity. In markets with smaller tick sizes, there are more price levels for traders to interact with, potentially enhancing liquidity. However, excessively small tick sizes can lead to fragmented markets and reduced liquidity.
5. Tick size changes
Regulatory bodies may occasionally adjust tick sizes to adapt to evolving market conditions. Traders need to stay informed about any changes in tick size, as these adjustments can impact trading strategies and execution.
6. Psychological impact
Tick size can have a psychological impact on market participants. For instance, a stock moving by a tick may trigger certain trading behaviours or decisions. Understanding the psychological aspects of tick size movements is crucial for anticipating market reactions.
Conclusion
In essence, the significance of tick size in trading lies in its multifaceted role as a guiding metric for precision, risk management, liquidity assessment, volatility considerations, transaction cost analysis, and regulatory compliance. Traders who grasp the intricacies of tick size are better equipped to navigate the complexities of financial markets and strategically execute their trading plans, particularly in the context of the Indian stock market governed by regulatory standards set by entities like SEBI.
