What Is Decimal Trading?
A system known as decimal trading uses a decimal format to quote a security’s price. By April 9, 2001, all U.S. stock exchanges were required by the Securities and Exchange Commission (SEC) to switch from fractional to decimal quotes. Market price quotations in the United States were previously based on a fractional quoting system with 1/16-dollar increments. All stock quotations now use the decimal trading format as a result of decimalization.
Understanding Decimal Trading
Since 2001, decimal trading has been used on all U.S. stock exchanges to help allow more efficient and orderly trade. Decimalization is the process of converting pricing quotations from fractions to decimals. Investors, market makers, and all other sorts of market players may more quickly and readily grasp prices when they are expressed in decimal quotations. The price in decimal form is $5.06, whereas the fractional price is $5.16.
A bid price and an ask price make up decimal quotations. Retail traders, individual investors, market makers, and institutional traders can all place bids and requests.
Bid-Ask Process
The spread is the difference between the highest offer and the lowest offer. Decimalization typically results in tighter spreads. For instance, the smallest price change that could be reflected in a price quote before decimalization was one-sixteenth (1/16) of a dollar, or $0.0625. For equities worth more than $1, the minimum price movement after decimalization is $0.01. As a result, stocks can now be traded with a $0.01 spread as opposed to a $0.0625 (or 1/16) minimum spread.
Most retail traders prefer tighter spreads because they want to enter or exit trades without incurring a significant spread fee. Decimalization decreased spreads, lowering the potential profit from this method for traders and market makers who regularly bid and offer to “catch the spread.” Nevertheless, some traders still employ this tactic today, mostly in automated or algorithmic trading.
Rule 612, sometimes referred to as the Sub-Penny Rule, was adopted by the Securities and Exchange Commission in 2005. Stocks quoted in increments of $0.0001 for stocks under $1.00 and $0.01 for those over $1.00 are required by Rule 612 to have a minimum price increment.
Spreads are expected to be less expensive for companies with high daily volume compared to equities with low volume. In comparison to cheaper equities, expensive stocks are more likely to have wider spreads. Additionally, spreads on volatile equities are often wider than on low volatility ones. Any specific security’s spread depends on the volume (number of participants), volatility, and stock price.
Pips and Forex Quotes
Pips are equal to one basis point, or 1/100, or $0.0001. Pips might gradually alter for securities with values below $1.
The foreign exchange market also employs a pips-based decimal quotation mechanism. For instance, the bid for the EUR/USD may be 1.1257. Fractional pip pricing, which is to the fifth decimal place, is also offered by several forex brokers. The quotation from above, for instance, may be further defined as 1.12573. A fractional pip is worth one-tenth of a full pip and has a value of 10. Based on the currency pair being exchanged, a pip’s value fluctuates.
Decimal Price Quote vs. Fractional Quote
Consider a company like General Electric Company (GE), which trades more than 50 million shares on a daily basis, and which has a bid price of $9.37 and an ask price of $9.38. Decimalization makes it conceivable for there to be a $0.01 spread. The spread cannot be less than $0.01 because the stock is trading above $1, yet it may be more. When volatility is at its highest, if volume were to steadily fall or if price were to noticeably rise, there may be a wider spread.
Think about how things were before decimalization. Instead of the $0.01 spread mentioned above, the price quote would have been $9 5/16 by $9 3/8 (or 6/16), which is comparable to a $0.0625 spread.
