What is Decimal Trading
Decimal trading is a system in which the price of a security is quoted in a decimal format. The U.S. Securities and Exchange Commission ordered all stock markets in the U.S. to convert from fractional quotes to decimal quotes by April 9, 2001. Prior to 2001, market price quotes in the United States were based on a fractional quoting system in increments of 1/16. Since decimalization, all quotes appear in the decimal trading format.
BREAKING DOWN Decimal Trading
Decimal trading has been used across all U.S. stock exchanges since 2001 to better facilitate orderly and efficient trading. The use of decimals rather than fractions in price quotes is known as decimalization. Decimal quotes make prices more easily and immediately understandable for investors, market makers and all other types of market participants.
The place value for decimalization can vary by securities. All types of exchanges use market makers to facilitate the trading of securities among participants. Market makers quote bid and ask prices based on the decimalization rules outlined for specific securities. Overall, decimalization impacts the spread a market maker will make from a trade and the price movements that occur for security trades.
Market makers seek to match buyers and sellers on an exchange. They seek to facilitate the orderly exchange of securities while also generating a profit from the bid-ask spread. While the introduction of decimalization in the market created more easily comprehensible quoting, it also presented some challenges.
Generally decimalization causes tighter spreads since it causes smaller price movements. For example, prior to decimalization, one-sixteenth (1/16) of $1 was the minimum price movement represented in a price quote, equal to $0.0625. With tighter spreads market makers lose some of their opportunity to receive higher profits.
Decimalization also initially allowed for some traders to use sub-penny quoting to their advantage. With sub-penny quoting, traders could move ahead of other participants simply by quoting prices in sub-penny decimals. In 2005, the Securities and Exchange Commission introduced Rule 612, also known as the Sub-Penny Rule, in response to this issue. Rule 612 requires the minimum price increments for stocks over $1.00 to be $0.01 while stocks under $1.00 can be quoted in increments of $0.0001. The two decimal point quoting structure works in favor of market makers creating greater profit opportunities from spreads.
Pips and Forex Quotes
Pips are the equivalent of 1/100, one basis point or $0.0001. Securities with prices less than $1 can see incremental changes in pips. The foreign exchange market also broadly uses a four decimal quoting system which leads to the application of pips.