The effect of tick size on price clustering and trading volume

Abstract

This paper has studied the impact of tick size on price clustering and trading volume for stocks that trade on the Stock Exchange of Singapore, on which the trading tick varies over several price ranges. Substantial clustering is found within each price range. Price clustering is found to increase with stock price level and decrease with trading volume. No significant relationship between clustering and price volatility is detected. Controlling for other variables, price clustering is found to increase as the tick size decreases. This negative relationship is pervasive across stock price levels. Our limited evidence suggests that a reduction in tick size is more likely to increase trading volume if the stock is actively traded. These results are consistent with the price resolution hypothesis, which predicts that a smaller tick size will increase negotiation costs. This causes investors to seek to reduce their negotiation costs by trading only at round numbers, which results in additional price clustering. Studies that ignore the effect of increased negotiation costs on price clustering and trading volume are likely to overstate the benefits to traders of a smaller trading tick. © 1998 Blackwell Publishers Ltd.