Learn about tick size and lot size effects — Stock-Market notes

WHAT are we talking about?

WHY do these exist?

Without a tick, traders would undercut each other by fractions of a cent forever ("penny-jumping" to infinity) — the order book would become chaotic and quotes meaningless.
Without a lot, exchange systems would drown in dust-sized orders. Lots standardize contracts (crucial in derivatives) so every participant knows the notional per unit.

Tick size — deriving the effects from first principles

HOW does tick size set a floor on the spread?

The bid-ask spread is the gap between the best buy price (bid) and best sell price (ask). A market maker earns this spread as compensation for providing liquidity.

The spread must be a whole number of ticks: $\text{Spread} = n \cdot \tau$ where $n \ge 1$ , $\tau=$ tick.
Therefore the minimum possible spread is exactly one tick: $\text{Spread}_{\min} = \tau$

Why this step? Because bid and ask must both sit on the grid and ask > bid, the closest they can be is one rung apart.

Why this matters: Low-priced stocks are tick-constrained — their spread cannot narrow below a fat percentage. High-priced stocks feel the tick barely at all.

The tick-size trade-off (steel-manned both ways)

Smaller tick	Larger tick
Tighter spreads → cheaper to cross	Wider minimum spread → costlier to cross
Less depth at best price (queue splits over many rungs)	Deep queue at each price, stable book
Encourages HFT penny-jumping	Rewards patient limit orders

Figure — Learn about tick size and lot size effects

Lot size — deriving the effects

HOW does lot size force a minimum trade value?

$V_{\min} = L \cdot P$

where $L=$ lot size, $P=$ price. Why? The smallest order is one lot, worth one lot × price.

Rounding / odd-lot effect: if you want $\$ 50{,}000 $of the stock above, you can hold at most$ \lfloor 50000/3000 \rfloor = 16 $shares — but with$ L=100$ you can't even buy one lot. Lot size granularizes allocation and creates odd-lot residuals.

Worked examples

Common mistakes

Active recall

Recall Quick self-test (predict before revealing — Forecast-then-Verify)

Minimum spread in terms of tick? → $\tau$
Relative spread formula? → $\tau/P$
Minimum trade value from lot size? → $L\cdot P$
Two opposing effects of a smaller tick? → tighter spread ✅ but thinner depth / queue-jumping ❌
Why do splits boost liquidity? → they cut $V_{\min}=L\cdot P$ , widening participation.

Recall Feynman: explain to a 12-year-old

Imagine a shop that only sells eggs in boxes of 12 (that's the lot size) and only lets you pay in 10-cent coins (that's the tick size). You can't buy 5 eggs, and you can't pay exactly $1.03. If the coins were tiny (1-cent), you could pay a fairer price — but the cashier would have to count forever and there'd be chaos at the till. If the box were smaller (say 3 eggs), more kids could afford a box. Prices and quantities in the stock market live on a grid just like this, and the size of the squares changes who can play and how cheap it is.

Flashcards

Same $0.01 tick: which is cheaper to trade, a$ 5 or $250 stock? ::: The$ 250 stock — its relative spread (0.004%) is far smaller than the $5 stock's (0.20%).

What is tick size?

The smallest permissible price increment between two quotable prices.

What is lot size?

The smallest tradable quantity (or the multiple orders must be in).

Minimum possible bid-ask spread in terms of tick τ?

One tick, i.e. Spread_min = τ.

Formula for relative (proportional) spread?

s = τ / P (tick divided by price).

Why are low-priced stocks called "tick-constrained"?

Their τ/P is large, so the spread cannot narrow below a big percentage.

Minimum trade value implied by a lot size L at price P?

V_min = L · P.

Give one downside of making tick size smaller.

Thinner depth per price level and easier queue-jumping/penny-jumping of limit orders.

Why do stock splits tend to increase liquidity?

They lower price P, so V_min = L·P falls, letting more (smaller) investors participate.

Contract notional formula in derivatives?

Notional = L · P · m (lot × price × multiplier).

Connections

Bid-Ask Spread
Market Liquidity and Depth
Limit Order Book
Stock Splits
High-Frequency Trading
Order Types and Queue Priority
Derivatives Contract Specifications

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Dekho, stock market ek smooth line nahi hai — ye ek grid hai. Price sirf kuch fixed steps par ruk sakta hai, aur us step ki size ko tick size bolte hain. Agar tick $0.05 hai to price$ 100.00, $100.05,$ 100.10 ho sakta hai, par $100.03 kabhi nahi. Isi tarah quantity bhi bundles me aati hai — usko lot size kehte hain. Agar lot 100 shares ka hai to aap 100, 200 le sakte ho, par 150 nahi.

Ab intuition: spread kam se kam ek tick ke barabar hota hai (Spread_min = τ), kyunki bid aur ask dono grid par baithe hain aur closest do rungs bas ek step door ho sakte hain. Lekin jo trader ko actually feel hota hai wo hai relative spread = τ/P. Ek hi $0.01 tick,$ 5 wale stock par 0.20% cost banta hai, par $250 wale stock par sirf 0.004%. Isliye sasti stocks "tick-constrained" hoti hain — unka spread percentage me mota reh jaata hai.

Tick chhota karne ka matlab hamesha "acha" nahi hota — yahi common galti hai. Haan, spread tight ho jaata hai (taker ko sasta), par har price level par depth patli ho jaati hai aur log ek chhote step se poori queue ko jump kar lete hain. To ye ek trade-off hai: spread cost vs depth. Isliye exchanges tick "pilot" chalate hain.

Lot size ka main effect hai minimum ticket = L × P. $3000 wale stock me lot 100 ka matlab$ 300,000 chahiye ek lot ke liye — chhota investor bahar ho jaata hai. Isiliye company stock split karti hai: price gir jaata hai, V_min gir jaata hai, aur zyada log participate karte hain, liquidity badhti hai. Yaad rakho: TICK = price ka step, LOT = size ka bundle.

Test yourself — Market Microstructure

Connections