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September 2, 2013

What's Hurting Small Caps

Price discovery for small-cap stocks has become nearly impossible given the broad decline in trading volume and rise in off-board trading

By Dennis Dick

High-frequency trading has arguably led to an increase in liquidity and tighter spreads in many of the top S&P components. Issues like Bank of America and Ford have an abundance of liquidity as algorithmic market makers compete with each other to capture liquidity rebates and scalp the spread. Unfortunately, there is a much different story in the small- and mid-cap space. In fact, once you venture into the smaller market capitalization world, many of these stocks seem to trade by appointment only.

Dennis Dick

Declining volumes, wide spreads and a lack of liquidity have made these issues a nightmare for any trader looking to execute an order of even moderate size. The declining volume and lack of liquidity in the small caps has the Securities and Exchange Commission concerned, as well. The regulator recently held a roundtable to discuss tick size, and is exploring the possibility of widening the tick size in certain issues to encourage liquidity providers.

The logic is that a wider tick size would offer market makers more potential profits and encourage them to quote more aggressively in these securities.

See Chart: TRF Market Share

The wider tick would also eliminate penny-jumping in these securities. On many small caps with wide spreads, there are automated penny-jumping algorithms that can discourage liquidity providers. Our traders complain about this constantly. If a trader places a limit order to buy the stock at $25.05, the auto-penny jumping program automatically bids $25.06. If they go $25.07, the penny-jumping program moves to $25.08. If they cancel their order, the penny-jumping algorithm cancels as well. It is difficult to play a market making role in these illiquid securities when there is an automated program stepping ahead of you by a penny.

Some of our traders have resorted to using hidden order types in illiquid securities to avoid the penny-jumping. This helps with the penny-jumping, but it is still difficult to get executed (because nobody knows your order is there).

Increasing the tick size, in theory, should eliminate the penny-jumping and provide more return to the market makers in the form of wider spreads.

But would it really bring more liquidity to the small-cap space?

For market makers, it is all a game of risk versus return. In a high-frequency trading world, where things happen very quickly, adverse selection risk has increased substantially for market makers, especially in thinly traded issues. A sudden fall in the S&P futures, a breaking news event or even a sudden order flow imbalance, and a market-making limit order risks getting picked off by a more informed algorithmic trader. The return has to justify the risks taken, and in the small-cap market, those risks can now be substantial.