On October 3, 2016 small cap traders will see some big changes coming to the bid and ask prices of certain stocks. The new SEC tick size pilot test will begin in October, and selected small cap stocks will begin trading in five-cent increments instead of one-cent increments for the next two years. If this is the first you’re hearing of the tick size pilot, here are five things you need to know.
1. MOST STOCKS WILL NOT BE IMPACTED.
The average investor will likely not see any changes to his or her portfolio or trading. The pilot test consists of 1,400 stocks divided into three test groups and one control group. The 200-stock control group will continue trading as normal. All of the stocks included in the pilot test have market caps below $3 billion and average trading volume of less than 1 million shares. In other words, these stocks are typically extremely thinly-traded.
2. THE SEC’S INTENTION IS TO BOOST LIQUIDITY.
The entire idea behind the program is for the SEC to determine if increasing the spreads for thinly-traded stocks will improve liquidity in the market. The SEC is hypothesizing that larger spreads will provide brokers with more incentive to make markets in these stocks.
3. STOCKS IN THE THREE DIFFERENT TEST GROUPS WILL BE IMPACTED DIFFERENTLY.
As mentioned above, the 200 stocks in the control group will not be impacted at all. However, the three different test groups will begin trading under the following conditions:
Group 1: These stocks will all trade in five-cent increments without exception.
Group 2: These stocks will also trade in five-cent increments, but certain “midpoint trading” exceptions will be allowed. Midpoint exceptions will allow for orders to be filled at a price halfway between the bid and ask prices.
Group 3: These stocks will be subject to all the conditions of group two but will also be subject to a “trade at” requirement. According to the SEC, the trade at requirement is intended to prevent “price matching by a person not displaying at a price of a trading center’s best ‘protected’ bid or offer, unless an enumerated exception applies.”
From a trader’s standpoint, the takeaway is that spreads for all three test groups will shift from one cent to five cents. To see if any of your stocks are included in the test groups, check the Tick Pilot group assignments.
4. THE PILOT TEST LAUNCH COULD GENERATE SOME MARKET TURBULENCE.
According to Bloomberg, Wall Street insiders are expecting the launch of the pilot test to generate some volatility in the small cap market. Exchanges have had years to prepare for the pilot program, but some market experts are expecting technical problems and glitches when the program launches. Bats Global Markets Inc even sent a letter to the SEC arguing that the pilot test creates “an unacceptable level of systemic risk” to its software. Others argue that liquidity in the 1,200 test stocks will actually plummet as market makers look to avoid the risk associated with the program.
5. THE SEC MAY HAVE TO DO MORE THAN INCREASE SPREAD SIZES.
According to Bright Trading equity market structure analyst, and Benzinga PreMarket Prep co-host, Dennis Dick, the biggest drain on small cap liquidity isn’t narrow spreads.
“They may need to look at internalization and the rise in dark trading volumes if they really want to improve market quality in the small cap space,” Dick said. He pointed out that a large amount of trading volume has migrated off the exchanges to Over-the-Counter market makers. This migration leaves typical liquidity providers for small cap names feeling like they are simply setting the price for the stocks, assuming all of the risk and then getting their profits systematically siphoned off.
The test pilot should go a long way in determining the true cause of low liquidity among small cap stocks. The exchanges and FINRA will release preliminary assessments of the program in April 2018.
Disclosure: the author holds no position in the stocks mentioned.
This article is provided for educational purposes only and is not considered to be a recommendation or endorsement of any trading strategy. The author content and perspective is solely attributed to the author.