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What is Decimal Trading?

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As the name suggests, decimal trading is a way to express the price of a security in a decimal format. It was on the 9th of April, 2001 that, according to the U.S. Securities and Exchange Commission (SEC), all stock markets in the United States converted from fractional quotes to decimal quotes. Before this date, the stock market in the US quoted prices through a fractional quoting system in increments of 1/16 of a dollar.

Understanding the Basics of Decimal Trading 

To make the process of trading more efficient and maintain order, decimal trading was introduced across all U.S. stock exchanges in 2001. The process of using decimals in place of fractions when it comes to price quotes is known as decimalization. When there are decimal points involved, the prices become easily and immediately understandable for traders, investors, and all other entities involved in the market. 

Where decimal quotes for trades are concerned, they usually compose a bid price and an ask price. Both these aspects are usually quoted by retail traders and investors, market makers, or institutional traders.

The Evolution from Fractional to Decimal Trading 

A Decimalization Steering Committee was formed in July 1998 by the Securities Industry Association and the equities and options markets to help develop a decimalization implementation plan. It was then on January 28, 2000, that the Securities and Exchange Commission or SEC ordered certain exchanges to develop and submit a plan to implement the decimal system in the market and submit it to them. This was to be done no later than July 3, 2000. The exchanges involved in this move included:

  • American Stock Exchange LLC  or AMEX

  • Boston Stock Exchange, Inc.  or BSE

  • Chicago Board Options Exchange, Inc. or CBOE

  • Chicago Stock Exchange, Inc. or CHX

  • Cincinnati Stock Exchange, Inc. or CSE

  • National Association of Securities Dealers, Inc. or NASD

  • New York Stock Exchange or NYSE

  • Pacific Exchange, Inc. or PCX

  • Philadelphia Stock Exchange, Inc. or PHLX

How Decimal Trading Works 

With, decimalization come tighter spreads, which is the difference between the highest and lowest bid. Here’s an example to better explain this:

Before decimalization, the 1/16 of $1, which equalled $0.0625, was the minimum price movement in a price quote. After decimalization, this changed to $0.01 for stocks over $1. This is why, now stocks can trade with a $0.01 spread and not the 1/16 spread.

When the spreads are tighter, they are favourable for retail traders wanting to get into or out of trades and not pay a large spread. When it comes to traders wanting to "capture the spread" through routine bids or offers to capture small profits, decimalization reduced spreads and the profit potential too. The SEC in 2005, introduced Rule 612 or the Sub-Penny Rule which requires a minimum of over $1.00 to be $0.01 where the minimum price increments for stocks are concerned. Stocks under $1.00, however, can be quoted in increments of $0.0001.2

Challenges and Criticisms of Decimal Trading

Some of the challenges and criticisms of the decimal trading system include:

  1. Reduced profitability: 

    • Before decimalization, bid-ask spreads let traders earn a small profit with each transaction because of the fraction system. 

    • With decimalization though, the spreads became narrower, making it harder for traders to make profits without carrying out a higher volume of trades

  2. Higher volatility: 

    • Decimalization also seems to have led to an increase in market volatility. 

    • With smaller spreads come the quick up-and-down movement of prices

    • With large swings in stock price, this could end up being quite stressful for traders.

  3. Less liquid small-cap stocks: 

    • Decimalization has proven to be a good measure for large-cap stocks as they trade frequently and in high volumes 

    • However, where small-cap stocks are concerned, the move has negatively impacted their liquidity

    • With narrow spreads that accompany decimalization, trading small-cap stocks have become less profitable

  4. Higher transaction costs: 

    • Even though decimalization was introduced to reduce trading costs for investors, it has had the opposite effect.

    • This stems from the increase in volatility and complexity that accompanies the introduction of decimalization.

    • With an increase in bid-ask spreads, transaction costs have also increased for traders.

Conclusion 

Decimal trading was introduced on the 9th of April, 2001 by the U.S. Securities and Exchange Commission or SEC and involves expressing the price of a security in a decimal format in the market. As is with any new provision, there were and still are both criticisms and praises for this move. 

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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Frequently Asked Questions

What is decimal trading in the stock market?

Answer Field

Decimal trading was introduced on the 9th of April, 2001 by the U.S. Securities and Exchange Commission or SEC and involves expressing the price of a security in a decimal format in the market.

How does decimal trading work?

Answer Field

In decimal trading, the price of a security is quoted in a decimal format. This is opposed to the older fraction-based trading system. In decimal trading, the tick size is the lowest amount a security can move in an exchange.

When did decimal trading start?

Answer Field

Decimal trading was introduced across all U.S. stock exchanges in 2001

What are the advantages of decimal trading?

Answer Field

Decimal trading enables more efficient and orderly trades

Are there any disadvantages to decimal trading?

Answer Field

Some of the main disadvantages of decimal trading include reduced profitability, increase in volatility and transaction costs and small-cap stocks becoming less liquid.

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