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What is Decimal Trading & How it Works?

stock market
20 Jun 20246 mins readBy MOFSL

Introduction

When a security's price is quoted in decimal notation, it's called decimal trading. A brief history of the organisation: on April 9, 2001, the U.S. Securities and Exchange Commission (SEC) mandated that all U.S. stock markets switch from fractional to decimal quotes. The United States had a fractional system for market price quotes before 2001. They were in increments of 1/16 of a dollar. Since the adoption of decimalisation, all stock quotations are displayed in decimal trading format. This shift aimed to modernise the exchange, enhance price clarity, and align U.S. practices with international standards. This article will examine the impact, benefits, challenges, and proposed solutions for Indian stock markets regarding decimal trading.

Understanding How Fractional Shares Work

Fractional shares allow investors to purchase a portion of a share rather than a whole unit. This makes investing in high-priced stocks accessible to those with limited funds. Here's how it works:

  • Investors need to have an account with a brokerage that offers fractional share trading.

  • Companies do not issue fractional shares directly. Instead, brokers purchase and hold total shares in their name.
  • When investors decide to buy a fractional share, they specify the dollar amount they wish to invest.
  • The brokerage calculates the fraction of the share based on the investment amount and the current share price.

Benefits of Fractional Shares

  • Fractional shares make high-priced stocks accessible to small investors.

  • Investors can diversify their portfolios more effectively, even with limited funds.

  • Capital is utilised more efficiently, and investors can employ strategies like dollar-cost averaging.

  • Companies can attract a broader range of investors, including those with limited funds.

  • Increased trading activity and liquidity can result from more investors holding fractional shares.

  • More investors and better liquidity can raise a company's market value and appeal.

Impact on Market Mechanics and Liquidity

The change to a penny increment fundamentally altered market dynamics. It increased the number of possible prices and could affect liquidity and trading.

Reduction in Spread and Depth

The switch to decimal pricing significantly reduced both quoted and effective spreads. Quoted spreads are the difference between the bid and ask prices. They decreased by an average of 35% in decimalised stocks and 9% in control stocks. Spreads show the true cost of trading. They fell by an average of 11% for decimal stocks. However, this came at the cost of less depth. Depth is the volume of shares available at the best bid and offer prices. Decimalisation led to an average decline in depth by about 62% for decimalised stocks. This shows fewer shares were available at the best prices and could reduce liquidity.​​​​​​​

Increased Trade Frequency

The move to decimals increased trade frequency. This was especially true for smaller trades. Trading volumes for trades of less than 1,000 shares went up. But, larger trades over 1,000 went down in frequency and volume. This shift suggests the market became easier for small investors. But, it might have become harder for big institutional trades. They would struggle to execute without moving prices.

Quote Adjustments and Autoquotes

Decimalisation also led to more quote adjustments. They are known as "quote flickering," and the rise of autoquotes. These rapid changes in quotes reflect a more dynamic and competitive market environment. About 29% of quote changes were at a penny. Nearly 80% were at five cents or less. This shows finer price adjustments.

Liquidity and Market Efficiency

The reduced spread and increased trade frequency suggested better prices. But, the deep decline raised concerns. It made people worry about the market's ability to handle large orders without big price impacts.

Introduction of Fractional Shares in India

India is also working to make the stock market more inclusive. This concept addresses the challenges retail investors face in purchasing high-priced stocks.

Accessibility and Diversification

Fractional shares allow small investors to buy parts of expensive stocks. This increases market inclusivity. This lets investors diversify their portfolios better. They can do so even with a little capital.

Cost-Efficiency and Risk Management

Investing in fractional shares can lead to better capital utilisation and risk distribution. It allows for strategies like rupee cost averaging. Investors can invest fixed amounts regularly. This smoothens out the market volatility impacts.

Challenges and Solutions

In India, the current law prohibits brokers from holding shares in their name. This prevents them from distributing fractional shares. 

One proposed solution is to let companies issue fractional shares directly. This would need legislative changes to allow. SEBI and the Ministry of Corporate Affairs collaborate. They will change the relevant parts of the Companies Act.

Conclusion

The NYSE's decimalisation mostly affected trade speed and liquidity. India is moving towards fractional shares. The goal is to make stock ownership easier and more inclusive for small investors. SEBI is working to change the Companies Act. The change will allow companies to issue fractional shares directly. This could increase the number of investors and market liquidity.

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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