Optimal Number of Ticks in a Spread Minimizes Trading Costs.

This article analyzes the relationship between liquidity and stock spreads. Using a large sample of US stocks, the authors show that spreads are driven mostly by stocks' liquidity. They then build a model to derive the optimum spread that each stock can achieve based on its liquidity--but find that many stocks do not trade near their optimal spread, indicating a potential US trading inefficiency. They argue that such inefficiency is due mainly to the one-size-fits-all US market structure, with all stocks having a 100-share round lot and one cent tick increment. Consistent with their argument, they find that many companies use stock splits to achieve their optimal spread and improve tradability. However, splits add to operational costs for companies, and stock prices change over time, making splits an inferior solution to this trading inefficiency. They propose that appropriate policy would set ticks dynamically, so companies trade 1.1-3 ticks wide, regardless of stock price. [ABSTRACT FROM AUTHOR]