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(1/8, 1/4… etc) and shifted to decimal prices. Since you can get finer gradations of prices in decimals,
it was hypothesized that this should lead to lower bid-ask spreads. Studies since the shift indicate
that there has been a decline in spreads on the smaller, less liquid stocks but no discernible impact
on the more liquid 11 See Barclay, M., 1997, Bid-Ask Spreads and the Avoidance of Odd-Eighth
Quotes on Nasdaq: An Examination of Exchange Listings. Journal of Financial Economics, 45, 35-60.
12 If 1/8 and 1/4 quotes are equally likely to show up, roughly half of all quotes should end with an
eighth (1/8, 3/8, 5/8 or 7/8) and half should end with a quarter (1/4, 1/2, 3/4). 13 K. Chung, B. Van
Ness, and R. Van Ness, 2001, “Can the Treatment of Limit Orders Reconcile the Differences in
Trading Costs between NYSE and Nasdaq Issues?”. The Journal of Financial and Quantitative Analysis,
vol. 36, no. 2, 267-286.. While they find that the treatment of limit orders does lower the bid-ask
spread on the NYSE, they conclude that collusion among dealers still leads to higher spreads on the
NASDAQ. 9 listings. The Price Impact Most investors assume that trading costs become smaller as
portfolios become larger. While this is true for brokerage commissions, it is not always the case for
the other components of trading costs. There is one component where larger investors bear more
substantial costs than do smaller investors and that is in the impact that trading has on prices. If the
basic idea behind successful investing is to buy low and sell high, pushing the price up as you buy and
then down as you sell reduces the profits from investing. Why is there a price impact? There are two
reasons for the price impact, when investors trade. The first is that markets are not completely
liquid. A large trade can create an imbalance between buy and sell orders, and the only way in which
this imbalance can be resolved is with a price change. This price change that arises from lack of
liquidity, will generally be temporary and will be reversed as liquidity returns to the market. The
second reason for the price impact is informational. A large trade attracts the attention of other
investors in that asset market because if might be motivated by new information that the trader
possesses. Notwithstanding claims to the contrary, investors usually assume, with good reason, that
an investor buying a large block is buying in advance of good news and that an investor selling a
large block has come into possession of some negative news about the company. This price effect
will generally not be temporary, especially when we look at a large number of stocks where such
large trades are made. While investors are likely to be wrong a fair proportion of the time on the
informational value of large block trades, there is reason to believe that they will be right almost as
often. How large is the price impact? There is conflicting evidence on how much impact large trades
have on stock prices. On the one hand, studies of block trades on the exchange floor seem to
suggest that markets are liquid and that the price impact of trading is small and is reversed quickly.
These studies, however, have generally looked at heavily traded stocks at the 10 New York Stock
exchange. On the other hand, there are others who argue that the price impact is likely to be large,
especially for smaller and less liquid stocks. Studies of the price reaction to large block trades on the
floor of the exchange conclude that prices adjust within a few minutes to such trades. An early study
examined the speed of the price reaction by looking at the returns an investor could make by buying
stock right around the block trade and selling later14. They estimated the returns after transactions
as a function of how many minutes after the block trade you traded, and found that only trades
made within a minute of the block trade had a chance of making excess returns. (See Figure 14.2)
Put another way, prices adjusted to the liquidity effects of the block trade within five minutes of the
block. While this may be understated because of the fact that these were block trades on large
stocks on the NYSE, it is still fairly strong evidence of the capacity of markets to adjust quickly to
imbalances between demand and supply. Source: Dann, Mayers and Rabb (1977) 14 Dann, L.Y., D.
Mayers, and R. J. Rabb(1977),Trading Rules, Large Blocks and the Speed of Price Adjustment, The
Journal of Financial Economics, 4, 3-22. 11 This study suffers from a sampling bias - it looks at large
block trades in liquid stocks on the exchange floor. Studies that look at smaller, less liquid stocks find
that the price impact tends to be larger and the adjustment back to the correct price is slower than it
is for the more liquid stocks. 15 There are other interesting facts about block trades that have
emerged from other studies. First, while stock prices go up on block buys and go down on block sells,
they are far more likely to bounce back after sell trades. In other words, when prices go up after a
block buy, they are more likely to stay up.16 A study by Spierdijk, Nijman, and van Soest (2002) that
looked at both liquid and illiquid stocks on the NYSE also finds a tendency on the part of markets to
overshoot. When a block buy is made, the price seems to go up too much and it can take several
days for it to revert back to a normal level for illiquid stocks. 17 These studies, while they establish a
price impact, also suffer from another selection bias, insofar as they look only at actual executions.
The true cost of market impact arises from those trades that would have been done in the absence
of a market impact but were not because of the perception that it would be large. In one of few
studies of how large this cost could be, Thomas Loeb collected bid and ask prices from specialists
and market makers, at a point in time, for a variety of block sizes. Thus, the differences in the
spreads as the block size increases can be viewed as an expected price impact from these trades.
Table 14.1 summarizes his findings across stocks, classified by market capitalization: Table 14.1:
Round-Trip Transactions Costs as a Function of Market Capitalization and Block Size Dollar Value of
Block ($ thoustands) Sector 5 25 250 500 1000 2500 5000 10000