How Bid-Ask Spreads Influenced My Trading Profits Negatively
Last Updated on July 7, 2022
Commissions and slippage might ruin your trading strategies. The market offered a nice opportunity to show how bigger bid-ask spreads eat into your profits.
This article covers the newly implemented 5 cents spread in certain stocks and how that has influenced my trading profits negatively.
Why bid-ask spreads increased
On October 3 in 2016 SEC implemented the Tick Size Pilot Program.
Put short, there will be a minimum of 5 cents spread in specified stocks. The entire idea behind the program is for the SEC to determine if increasing the spreads for thinly-traded stocks will improve liquidity in the market. The SEC is hypothesizing that larger spreads will provide brokers with more incentive to make markets in these stocks.
A lot of “experts” argue that narrow spreads are bad for the markets. Here is a random explanation for that:
In my opinion, decimalization is a negative because it narrowed the spreads. On the surface you would think it would be better for the markets, but narrower spreads mean less profit for market makers. Less profit leads to less capital and less capital leads to less liquidity” (Forbes). A market maker’s job is to sit at the ready for a trader who wants to come to buy or sell shares. That means the market maker must have shares on both the bid and the ask. If a trader decides to suddenly sell 10K shares, it’s the job of the market maker to absorb that sale. In order to generate profits, market makers profit from the spread. Prior to decimalization, a market maker could buy shares at 10 1/8 and offer to sell at 10 1/4, which is a 6.25-cent profit in the spread. With decimalization, their profits diminished greatly. While this may seem better for investors, market makers have become less inclined to provide a market for stocks that are thinly traded. That means a small-cap investor who wants to sell 10K shares may not always have a market maker there to absorb the sale. As a result, prices could suddenly drop, leading the investor to receive far less from his or her sale than if market makers were there creating the spread. These quick drops and spikes in prices have resulted in more volatility, which further increases risk for investors of small-cap stocks.
This is a typical phrase I have been hearing about why bigger spreads are good.
But bigger bid-ask spreads are detrimental to trading profits
I have detailed statistics going back many years for a lot of the stocks affected by the pilot program. So I decided to look at my own data and how a bigger bid-ask spreads have affected my P/L. I enter trades purely mechanical and exit 90% mechanically. I have not changed anything as regards my trading due to the pilot program. Most of these stocks are small-cap and low-volume stocks. All my stocks in the pilot group are from 200k daily on average to about 750k.
In total, I have 65 stocks that I regularly trade which now have a minimum of 5 cents spread. I have divided my results into two time series: the 7 months before the implementation, and the 7 months after the implementation. In total it is hundreds of trades. Here are the results:
- From 1st of March 2016 until the 3rd of October my average accumulated profits (per ticker) in affected stocks were 135% of my average for all stocks (per ticker) in my trading universe.
- From the 3rd of October 2016 until the 1st of May 2017 my average accumulated profits (per ticker) in affected stocks have fallen to just 50% of the average of all stocks (per ticker).
Is this just the freak nature of randomness? It is anybody’s guess, but I don’t think so.
My simple conclusion is that I’m giving away money to market makers that previously ended up in my account.
I am not gonna go into any politics on this blog, but it is quite obvious that the industry is making it favorable for the members and the bigger institutions.
I got intrigued, how can you trade these low volume stocks? Probably you send limit orders adding liquidity to the market, but do you break your orders into small ones or the full size of your orders are kept very small? In the case of a 200k daily volume stock you will be probably trading a large % of all daily trasactions in this stock. Do you have a minimum avg daily volume for a stock that you look for before trading it or do you change your trade size according to the stock volume? Could you open up these numbers?
I only trade 100-200 size in these stocks. However, I’m being outcompeted by computers so I’m going for 100% automation in futures (and stocks) now.
Can’t you automate your trading in these stocks to compete? It shouldn’t be difficult to hire a programmer or partner with one.
Perhaps, but I suspect I will always be at a disadvantage. They have much more resources than me, not to mention regulation on their side.
The good thing is that this made me look at other strategies.