What it means
Most stock exchanges set a minimum price increment, called a tick size. In the United States, shares priced at $1 or more generally have to be quoted in whole cents.
This means that a bid or an offer cannot normally be displayed at, say, $20.0051. The reason for the rule is to stop traders from gaining priority over others by offering a tiny, meaningless improvement.
If sub-penny quotes were allowed, someone could step ahead of a long queue of orders by bidding a hundredth of a cent more. Regulators wanted to avoid a market in which queue jumping was rewarded and quotes flickered constantly.
Even so, sub-penny prices appear in executed trades. A trade can take place at the midpoint between the best bid and offer, which may be half a cent.
Retail brokers that route orders to wholesale market makers often receive price improvement, a better price than the one displayed, and that improvement can be a fraction of a cent per share. The practice has supporters and critics.
Supporters argue that small price improvements save money for investors, especially on large volumes. Critics argue that it moves trading away from public exchanges to private venues, reduces the amount of visible liquidity and makes it harder for the public quote to reflect the real market.
For finance teams and investors, the point to remember is the difference between quoting and trading. Quotes are generally in whole cents for most shares, while executions can be finer.
When reviewing execution quality reports, it is worth looking at how much of the price improvement comes from sub-penny fills. Rules on tick size are set by regulators and exchanges.
They are reviewed from time to time, so the current position should be checked before drawing conclusions.
In practice
Real-world examples.
Example
A retail investor buys 500 shares through an online broker. The displayed offer is $35.20, but the trade is filled at $35.1975. The broker's execution report records a small sub-penny price improvement, which adds up across millions of trades.
Example
A wholesale market maker receives a flow of retail orders and fills them at half-cent increments inside the public spread. It earns a profit on the difference between its price and the wider market. The firm argues that retail clients receive better prices than on a public exchange.
Example
A regulator reviewing market quality sees that a large share of trades in a stock take place at sub-penny prices away from public exchanges. It asks whether the rule on minimum increments is working as intended. The review considers changes to the tick size for some shares.
Formula
Calculation
Total price improvement = (displayed price - executed price) x number of shares, for a buy order
Suppose the best displayed offer for a stock is $20.01 and an investor sends a market order to buy 10,000 shares. A wholesale market maker fills the order at $20.0050, which is a sub-penny price. The improvement per share is $20.01 - $20.0050 = $0.005. Across 10,000 shares the total improvement is $0.005 x 10,000 = $50. The investor pays 10,000 x $20.0050 = $200,050 instead of $200,100.Case study
Seen in the real world.
Marlin Trading is an illustrative, fictional proprietary trading firm that noticed that one of its competitors always seemed to get ahead of its orders. Investigation showed that the competitor was using sub-penny executions in a private venue to fill orders just inside the public price.
The firm's head of trading calculated that, on a typical day of 2,000,000 shares, the competitor gained about a tenth of a cent per share by jumping the queue, worth $2,000 a day. Over a year of 250 trading days, that came to $500,000.
Marlin adjusted its own strategy to offer similar improvements in private venues and also raised the issue with its regulator. The illustrative lesson is that tiny fractions of a cent add up to real money when multiplied by large volumes.
Watch out
Common mistakes.
- Thinking that sub-penny prices are never allowed, when rules typically restrict quotes but permit some executions at finer prices.
- Assuming any price improvement is automatically fair, without checking how it compares with the best available price.
- Ignoring that tiny amounts per share become large when multiplied by millions of shares.
Questions
People also ask.
Why are quotes limited to whole cents?
The rule prevents traders from jumping ahead of others by offering a negligible improvement, which would discourage genuine liquidity.
How do sub-penny trades happen if quotes cannot be sub-penny?
Trades can be filled at the midpoint of the spread or at an improved price by a market maker, which can be a fraction of a cent.
Is sub-pennying good or bad for investors?
Individual investors often get slightly better prices, but critics argue that it moves trading away from public markets and can weaken price discovery.
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