Options Decimalization

Abstract

Trading liquidity in a financial market is affected by tick size: Smaller ticks allow finer resolution of valuation, but they also reduce the incentive to post large limit orders because it becomes easier to step ahead of a limit order by shading the price quote by a small amount. Most empirical evidence on liquidity comes from equity markets, but in this article, the authors review the results of a series of Penny Pilot studies at the Montreal Exchange. Option tick size was reduced from $0.05 to $0.01 for groups of stocks in five separate waves, which allows a natural identification of the effect of the tick change while controlling for other factors that occurred at the same time. The authors find that, in contrast to findings for equities, measures of option bid–ask spreads narrowed and market depth mostly increased. Return volatility and autocorrelation also showed an improvement in market efficiency. The largest effects were found for low-priced out-of-the-money contracts, for which the spread is a large fraction of the option’s price.