Should Day Traders Who Buy Penny Stocks Fear The Tick Size Experiment?

On October 3, 2016 the tick size pilot program was introduced into the market. It’s the regulators attempt to add liquidity to small cap stocks. The program consists of a control group and three test groups, there are 400 stocks per test group. Should day traders who buy penny stocks worry?

The control group trades regular. On the other hand, the first test group will be quoted in five cent increments. For example, instead of seeing a stock being quoted 5.01 by 5.02, you’ll see it quoted in five cent increments like 5.00 by 5.05.

Now, the second group is also quoted in the same fashion as the first group. However, there are some exemptions. Moving on, the third group works in the same way as the second, but they have exemptions for big block trades. Not only that, but they are subject to the trade-at-rule, which means you have to trade what is displayed on the exchanges before trading and buy penny stocks on a dark pool.

So the idea by having stocks trade in five cent increments is that market makers will be incentivized to facilitate orders. However, there are fewer and fewer traditional market makers left. The majority of market making is done by HFT and prop firms. For example, we wouldn’t have as many flash crashes in individual stocks if we still had traditional market makers.

You want to hear something crazy?

The person who helped lead the charge for the tick size pilot program is a former reality tv star turned politician. That’s right, not someone with a finance background or an understanding of market structure. You might not remember this, but the stock market used to trade in fractions, we later moved on to our present market structure where stocks are quoted in penny increments. So this change is kind of like going backwards if you think about it as someone that may potentially buy penny stocks.

Another argument on why the tick size program makes sense is that it might lead to more coverage by banks. The idea is if banks get involved with market making, then their research departments will also start covering the stock. Better research on the stocks should lead to greater interest from investors. In their perfect world that’s how the dominos will fall.

Every trader looks at the bid-ask spreads and makes a decision on whether the stock is worth trading. For example, if the average volume is low, the bid-ask spread is wide, and the depth of book is thin, then a lot of traders will avoid trading a stock like that. Generally, penny wide spreads, high volume, and a ton of bids and offers stacked on the book, are what most traders that buy penny stocks are looking for.

Overall, this sounds like an awful idea. The goal of the program is to collect data and see if situations improve in these low cap names. With that said, the program is running for about 2 years, so it’s not permanent. We’ll see how it plays out, whether or not the theory works in the real market for traders that buy penny stocks.