Tick size is a basic concept on a stock exchange. It represents the
minimum price difference between two levels in the order book; in
other words, between to possible prices for orders. For
example, consider a product with a tick size of 1 cent. This means that
orders can be made at 1-cent intervals, so at 0.01, 0.02, 0.03...
65.45, 65.46. This implies that the difference between two orders in
the order book can never be less than the tick size.
Because the tick size represents the difference between two orders, it
also represents the minimum bid-ask spread in a stock. If the best bid is
$60.57, the best offer is at best (i.e lowest/cheapest) $60.58, although it
could be (much) worse (i.e. higher). This makes the tick size important
for the liquidity of an asset: if an asset has a tick size that is a
significant fraction of the asset price, crossing the bid-ask spread
when trading is expensive. This makes trading more difficult. As an example,
consider a stock that is worth $0.50, with a tick size of $0.01. This means
the bid-ask spread is at least $0.01, so buying and then subsequently
selling will cost 4% of our investment.
There are two reasons why the tick size is not infinitely small. The
first reason is practical: with an infinitely small tick size, it would be
possible to slightly outbid and outoffer other bids and offers by an
insignificant amount. This would create a lot of pretty much pointless
changing of prices, taxing exchange infrastructure. The second reasons is
the fact that having a larger tick size means that it can be a profitable
strategy to quote the asset. This means that we put a bid and an
offer with perhaps only one tick size between them. If someone wants to
buy and someone else wants to sell, we will buy at one price and
sell at a slightly higher price. We have no net position, but we have made the
tick size times the volume in profit. If the tick size is larger, this
strategy is more profitable, and there will be more people doing it. This
means there will be more size on the bid and offer, increasing
liquidity. Hence, optimal tick size can be a balance between cheap
trading for small volumes, but enough size to be able to trade
a good volume for a reasonable price.
The tick size is determined by the exchange. Different
products may have different tick sizes; it is even possible for different
stocks or bonds to have different tick sizes. Furthermore,
the tick size might depend on the value; for lower-valued assets, the tick
size might be smaller. Exchanges can change the tick size if they want to;
lately (late 2008), there has been a strong trend for smaller tick sizes
(0.001 cent) on European stock exchanges, which works well with the much
lower values of stocks nowadays.
In conclusion, the tick size is the difference between two levels in
an order book. The tick size may be important, because it determines the
minimum bid-ask spread of the underlying. This may impact the liquidity
and the costs associated with trading, especially when the tick size is a
significant fraction of the price of the asset, say more than 1%