Sunday, August 9, 2009

Tick Size has NO effect ?

I am actually caught by surprise that the KLSE new tick size article received quite valid challenges. When I first hinted tick size is important for speculators, almost no one bothered so I was assuming there are no stock investors readers. Basically the argument is that tick size does NOT really affect stock investment.

For example if we buy 200 units stock at RM45. Brokerage is 0.1%, Clearing fee 0.03% and stamp duty RM 1 for every RM 1,000. The total you pay would be RM 9,020.70

Below chart shows how much you earn when the price move up and down in the old tick size system. If the price goes down to RM 44.50 (2 steps down), you would get back RM 8,879.43 or a lost of 1.57%. On the other hand, you earn 0.64% when the price goes up to RM 45.50 (2 steps up).

Below is another chart showing how much you earn in the new tick size system. As you may see, you lose and earn the same as in the old tick size system, ie. lose 1.57% @ RM 44.50 and earn 0.64% @ RM 45.50. All the new tick size system does is to add more points in between.

So tick gap size doesn't really affect investor's return. It is TRUE as long as you are looking at it as a value investor.

It was mentioned before that some people like smaller tick size while some others like it bigger. So there will also be cases where tick size is NOT important, like wise there are also scenarios where tick size becomes critical.

Above analysis is assuming we don't know anything about the stock so each step price up is the same as down. However, in real life we invest into stock for a reason, sometimes we even have a target price. For example, we buy the stock at RM 45.00 with the expectation to sell at RM 45.50. So when situation goes our way (UP), the tick size doesn't really matter as shown above.

However, sometimes it may go opposite with your plan. In old tick size, the next down step is RM 44.75, causing a lost of RM 91.34 in comparison to your initial planned 2 steps up profit of RM 57.47. In new tick size, it will go down in smaller steps ...

RM 44.98, causing a lost of RM 45.39 then
RM 44.96, lost RM 49.39
then lost of RM 53.38
and finally the 4th step down causing a lost of RM 57.38. Almost the same amount as the initially expected profit.
... then at 13th step down, a lost of RM 93.33, equivalent to old tick size 1 step down lost.

So if you cut lost in old tick size, you would have lost RM 91.34, that would be your total cost in this investment. The Win Lost ratio is 1 to 2.

In new tick size, you are given more choices. You could ignore the choices and cut lost after 13 steps down in which this smaller tick size will have no effect to you. You can also cut lost at the 4th step down if you want to set your win lost ratio at 1 to 1. Or in extreme case, you cut lost immediately when the price goes opposite and you think your initial assessment was wrong, your RM45.39 lost is almost half of RM 91.34 in old tick size.

In summary, the profit taking plan can remain the same in both bigger and smaller tick size systems. But cut lost strategy can be applied more dynamically in a smaller tick size system. Cutting lost can be viewed as cost. Hence in smaller tick size system, cost can be reduced ( by 50% in above example ). The actual cost saving factor would depend on your investment strategy, hence its not a DIRECT cost saving but a strategical one.

All these smaller steps have translated into more choices, and these choices allow you to apply investment strategy more dynamically. So far, most arguments are quantitative based. There are also qualitative or psychological effect. For example, in a smaller tick size environment, you are most likely get into the investment vehicle more often since you know you can get out of it easier and faster anyway when you were wrong. You may be less afraid and making more bold decisions, faster and more of them. You can learn faster with less tuition fee, which eventually improves one's decision making skill.

Full details of the data used ( best viewed with screen width > 800px )