The Fat Cat Days Are Finished: It is time for the buyside toaccept penny trading, argues a guest writer in this special study for Traders Magazine

The tightening of quotes has been far greater in the dealer market with tick size reductions. Yet the most striking revelation of the graph is that both eighth and teenie tick sizes were huge barriers to price competition. Only with a penny tick increase can one see a continuous relationship between spread width and the cumulative percentage of spreads. For example, on Figure 1, note the cumulative distribution for spreads on the Nasdaq market in August 1996 with the eighth tick size increase from 41% to 89% to 95% as spreads increased from 1/8 to 2/8 to 3/8, respectively. By contrast, in August 2001, as spreads increase from one cent to two cents to three cents to four cents, the cumulative percentage rises from 51% to 68% to 78% to 84%, respectively. The incremental changes in the penny world are much smaller. This indicates that limit order submission preferences are more readily met in the penny tick incremental world than they were in the teenie or eighth environment. (Fifty one percent of spreads pressed down against one- penny intimates that even the penny tick size could be viewed as a problem.) In other words, a significant barrier to price competition has fallen. Perhaps it is because of volatility with smaller tick size, which tends to help the sellside and hurt the buyside. To study volatility, I formed portfolios of the top 20 stocks in each market. I created a minute-by-minute return index for each portfolio and figured their volatilities in each period. My view was that of a buyside manager who invested in two portfolios consisting of the top 20 NYSE and Nasdaq stocks. As Table 2 shows, volatility had increased somewhat for Nasdaq, but not appreciably for the NYSE. The differences in neither NYSE nor Nasdaq volatilities are not statistically significant.