Is tick size Important

Changing the E-mini SP500 tick size

Does size matter?

The following question is posed in a trader's survey: Would you like to see the tick increment in the ES changed from 0.25 to 0.1?

A discussion inspired an expansion on the The odds in random day trading part of the Is Day Trading Gambling? article.

Introduction

The S&P 500 futures contract is (I believe) the most traded index future in the world. There are many ways to get a piece of this action but the two most popular ways are through the CME exchange traded contracts known as the SP and ES.

Here are the full contract specifications.

For the purposes of this article you just need to know the following differences: The SP trades in increments of 0.1 points and the ES in increments of 0.25 points. Otherwise they are pretty much identical and settle at the same time and same price each quarter.

Which tick size is better?

Because of the bid/ask relationship in the market, any trade that you make is immediately at a 2 tick disadvantage as soon as you enter the trade. It's a bit like your new car losing $2,000 as you drive it out the showroom. As soon as you enter a trade you are at a 2 tick disadvantage. (Note that the market only has to move 1 tick for you to break even if you assume no commissions and the bid/ask being 1 tick wide. However, you need to take into account that your stop will be hit 1 tick earlier than the target.)

So a strategy that used a 10 tick profit target and 10 tick stop will have the stop triggered if the market moves 9 ticks against it and will close in profit if the market moves 11 ticks in its favor. See The odds in random day trading for a full explanation of this.

Let's implement this 10 tick (1 S&P 500 point) strategy for the SP and ES in the scenario when we buy the market. Both strategies assume that we buy at the market with a 1 point target and a 1 point stop.

Given the SP trading at 1230.0-30.1 we need it to move 1.1 points to hit the target and drop 0.9 points to be stopped out.

The equivalent ES trade would probably have the ES trading at 1230.00-30.25. This would have the ES moving 1.25 points (to 1231.25 bid) to hit the target or drop 0.75 to be stopped out.

This is a very simple illustration and I've left out a lot of other factors for the precise reason that I only want to demonstrate the effect of tick size on the advantage/disadvantage that you will experience in the market. It should be fairly clear that a move of 1.25 versus a move of 1.1 is less likely: i.e. achieving your profit target in the SP is more likely. Likewise being stopped out in the SP is less likely and so being stopped out in the ES is more likely.

Think of the ES as a market with a spread that is forced to 2.5 times the size of the spread in the SP market. So it is forced to simulate a less liquid market.

Which do day traders prefer?

Statistics from the CME show that the value of contracts traded in the ES on a daily basis is higher than that for the SP, however, overnight interest in the SP is higher than the ES. This leads us to the assumption that more day traders use the ES over the SP.

Do day traders prefer the ES because of the tick size? I very much doubt that. Increasing tick size, from what I have researched, is only useful in thinly traded markets in order to keep the spread between bid and ask small. The S&P 500 futures market is anything but thinly traded.

The most likely reason that day traders favor the ES is because it's an ELECTRONIC direct-access level-playing-field market (ignoring exorbitant fees CME commands for ES etc), whereas SP is PIT open outcry . (Bold type text added from mtzianos' comment on Elite Trader.)

Smaller traders will also favor the ES because of the smaller contract value (5 times smaller) than the SP. This allows small traders the ability to scale in and out of trades and implement trading strategies that would not otherwise be available to them if they were trading the SP contract.

Worked Example of the BID/ASK disadvantage

I've been doing some thinking since I wrote this article and thought that I would put in a theoretical worked example to explain from another angle the effect of the bid/ask on executing a strategy.

Here are a before and after DOM (Depth Of Market) screen laid out as a table:

Image that this is the scenario with the number of contracts bid/asked at each level being 400. You buy 1 contract at market (i.e. price of 1318.75) and aim to make 1 point with a 1 point stop.

The number of contracts asked at 1318.75 drops by 1 (because you bought 1) and the number of contracts asked at 1319.75 increases by 1 (because that's your target).

Now look at the number of contracts that have to be bought in order for you to achieve your target. Somebody has to buy all the asked prices up to your target and clear out the 400 contracts ahead of you in the queue. That's 2000 contracts.

Now look at your stop. As soon as 1 contract trades at your stop then your stop is triggered (of course you can override this and let more trade there before you trigger it). You only need 1,201 contracts to be sold in order for your stop to be triggered.

So when you execute this strategy, you are doing so with an edge which says that (say 60%) the market is more likely to cruise through 2000 contracts on the buy side than it is to eliminate 1,201 contracts on the sell side. Is your edge really that good?