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 (SEC) 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 of a dollar. Since decimalization, all stock quotes appear in the decimal trading format.
- Decimalization is the process of quoting stock prices in terms of decimal places.
- Decimal trading has been used across all U.S. stock exchanges since 2001 to better facilitate orderly and efficient trading.
- Prior to decimalization, the minimum spread was 1/16 of a $1, or $0.0625. After decimalization, the minimum spread is $0.01 for stocks over $1, and $0.0001 for stocks under $1.
- Rule 612, known as the sub-penny rule, 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.
Understanding 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. A decimal quote is $5.06, versus $5 1/16 in fraction format.
Decimal quotes are composed of a bid price and an ask price. Bids and asks may come from retail traders and investors, market makers, or institutional traders.
The difference between the highest bid and the lowest ask is called the spread. Generally, decimalization causes tighter spreads. 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. After decimalization, the minimum price movement is $0.01 for stocks over $1. Therefore stocks can now trade with a $0.01 spread instead of a minimum $0.0625 (or 1/16) spread.
Tighter spreads are typically favorable to most retail traders who want to get into or out of trades without paying a large spread. For traders and market makers who are attempting to "capture the spread" by routinely bidding and offering to snag small profits, decimalization reduced spreads and thus the profit potential of this strategy. That said, some traders do still use this strategy today, but primarily in regards to automated or algorithmic trading.
In 2005, the Securities and Exchange Commission introduced Rule 612, also known as the Sub-Penny Rule. 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.
Stocks that have lots of daily volume are likely to have lower spreads than stocks that have low volume. High-priced stocks are more likely to have larger spreads than lower-priced stocks. Volatile stocks also tend to have bigger spreads than low volatility stocks. The spread in any given security is based on the volume (number of participants), volatility, and the price of the stock.
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 uses a decimal quoting system utilizing pips. For example, the EUR/USD may have a 1.1257 bid. Some forex brokers also offer fractional pip pricing, which is to the fifth decimal place. For example, the above quote could be further specified as 1.12573. There are 10 factional pips to a whole pip, representing 1/10 the value of a full pip. The value of a pip varies based on the currency pair being traded.
Decimal Price Quote vs. Fractional Quote
Assume a stock like General Electric Company (GE), which has an average daily volume of over 50 million shares, is trading with a bid price of $9.37 and an ask of $9.38. This $0.01 spread is possible because of decimalization. Since the stock is trading above $1, the spread cannot be smaller than $0.01, although it could be larger. A larger spread may occur during times of heightened volatility, if the volume were to significantly decline over time, or if the price were to significantly increase.
Consider the same scenario before decimalization. The price quote might have been $9 5/16 by $9 3/8 (or 6/16), which is equivalent to a $0.0625 spread instead of the $0.01 spread above.