Stock Quotes: Making Change

For every investor who has struggled to figure out whether 5/16 is more or less than 3/8, it would seem as if the scheduled start of decimal stock pricing next month can’t come fast enough.

After years of debate, the New York Stock Exchange will finally begin trading stocks in simple dollars and cents, jettisoning the centuries-old system of pricing in dollars and fractions.

The move, which is expected to start with a pilot program of just seven stocks Aug. 28, is the first step toward decimalization of all U.S. stock and option prices by April 2001.

Proponents of decimalization--including members of Congress who have hounded the markets for years--say the move to a common-sense pricing system is long overdue. Indeed, decimal pricing is likely to be a boon to many individual investors.

Besides making share pricing easier to understand, using decimals is expected to reduce the often hidden costs that individuals incur when they buy and sell stocks.

Those unseen costs, essentially levied by Wall Street dealers as markups on stock prices, can be hefty. Regulators estimate that decimal pricing could shave investors’ trading costs by $3 million a day.

Yet pricing stocks in pennies is far from a complete panacea for investors. In fact, it could have some significant negative consequences for individuals--especially for active investors trading hot stocks and for those who buy and sell larger blocks of shares, critics say.

Pricing stocks in decimals could subject small investors to a harsh double whammy that makes it tougher for them to buy fast-rising stocks and easier for them to get stuck with losers in a falling market.

“The prescription is there for calamity,” said Dan Weaver, a finance professor at Baruch College of the City University of New York.

Investors will find out soon just how it all works: Pending final Securities and Exchange Commission approval, the NYSE pilot program will begin Aug. 28 with seven stocks, and will be extended to 50 stocks Sept. 25. The results of the pilot program will then be assessed before decimal pricing is expanded to include all NYSE-listed stocks.

The Nasdaq Stock Market, meanwhile, will begin

decimal pricing by March 12, and all markets must be quoting in pennies by April 9. (Nasdaq won a delay because of computer issues.)

The most obvious benefit of decimal pricing is the time savings: It eliminates the need to perform split-second conversions of fractions to decimals when trading.

Penny pricing also will make the U.S. competitive with major foreign markets, all of which already trade in decimals.

But far more important is the expected effect on what’s known as the bid-offered, or bid-asked, price spread on stocks.

When individuals trade stocks, they typically buy from, and sell to, Wall Street brokerages or specialized dealers. In each transaction, the brokerage or dealer “bids” to buy shares from investors at one price and “offers” to sell to them at a higher price.

The difference between the two prices--the spread--is pure profit for the brokerage and an often unseen cost for investors that adds up over time.

Under the current fractional quotation system, the smallest increment between stock prices usually is 1/16 of a dollar, or 6.25 cents. For example, a dealer might pay $20 a share to buy shares from one investor while simultaneously selling shares to someone else at $20.0625.

Because prices between $20 and $20.0625 simply aren’t recognized by major U.S. trading systems, investors largely can’t avoid paying a spread, or markup, of at least 6.25 cents.

That may not seem like much. But on a 500-share order, it adds up to $31.25. So an investor who thinks he’s paying only a $10 brokerage commission for a trade actually is forking over several times that amount, if the spread is included.

In a market where stocks are quoted to the penny, however, there could be a range of orders between $20 and $20.0625. Thus, dealers’ traditional spread would be whittled down.

“Definitely, spreads will narrow. There’s no doubt about it,” said Venkatesh Panchapagesan, an assistant finance professor at Washington University in St. Louis. “This is the good side of decimalization.”

When the Toronto Stock Exchange went to decimal pricing of stocks more than $5 in 1996, spreads fell about 20% “virtually overnight,” said Jeffrey Bacidore, a former Indiana University professor who is now research director at the NYSE.

“For individuals who trade small-size [orders], this is good news,” said Larry Harris, a USC finance professor who has closely studied decimalization.

‘Stepping Ahead’ of Small Investors

But decimalization also will give Wall Street dealers and other professional traders a new edge, at small investors’ expense, experts say.

In particular, decimal pricing will give professional traders a big leg up on individuals when jockeying for hot technology stocks and other fast-moving shares.

When buying demand is strong, small investors may simply be unable to acquire shares at close to the last trade price.

Imagine this scenario: You want to buy shares of XYZ Corp., an up-and-coming tech company. Seeing the stock trading at $20, you send your broker a “limit” order--a request to trade at a specified price or better--to buy at $20 or less.

But here’s the rub: Your order now is visible to Wall Street. Either the firm executing your order or other professional traders using sophisticated market-scanning computers can see buying demand build for XYZ and can deduce that the price is likely to head higher.

So a dealer or trader may easily “step ahead” of you by instantly sending in a buy order for XYZ at $20.01 a share. In effect, the pro has grabbed shares that you otherwise might have gotten.

Think of it as somebody in a sports car snatching the lone empty space in a crowded parking lot, even though you saw the spot first.

The stepping-ahead game has long existed on Wall Street. But critics say decimal pricing will make the practice commonplace: Because a pro has to outbid you by only a penny instead of by a minimum of 6.25 cents, the cost and risk of stepping ahead can be slashed.

“If it becomes easier to step in front of the individual investor, the dealers will,” said Hans Stoll, a Vanderbilt University business professor. “It is a significant cost to the individual investor.”

If the price of XYZ indeed is on the rise, you could be forced to raise your bid repeatedly to get the shares. That assumes, of course, that you have the time and knowledge to sit at your computer furiously bidding for the stock.

And if you do get the stock, the shares may be sold to you by the same dealer that stepped ahead of you.

But what if XYZ begins to fall in price? You may figure the professional will get stuck with a loss.

Think again.

If the price of XYZ drops and your limit order to buy at $20 is still in place, a dealer could turn around and dump the stock on you at, say, $19.98 a share.

If the price keeps falling, the dealer has minimized his losses. Probably unaware that these behind-the-scenes machinations have occurred, you may think you picked up a bargain--unless the stock continues to head lower.

That’s the worst-case scenario under decimalization, USC’s Harris said: “When you can’t trade, you wish you had because prices are rising,” he said. “And when you do trade, you wish you didn’t because prices are falling.”

More Benefits Than Costs for Investors?

But regulators and some Wall Street pros say the potential downside of decimal pricing is exaggerated.

Ed Nicoll, chief executive of Datek Online Holdings, whose brokerage began offering decimal pricing for Nasdaq stocks July 3, believes small investors will gain far more through reduced price spreads than they’ll forfeit through lost trading opportunities.

“If we believe in reducing transaction costs, it’s very important that we go to decimalization,” Nicoll said.

Thus far, Datek customers--who can trade directly with each other on Datek’s Island ECN electronic trading system, an upstart rival to the Nasdaq market--are using decimals on about 5% of orders, Nicoll said.

SEC Chairman Arthur Levitt conceded in congressional testimony last month that the agency can’t predict all the effects decimal pricing will have on markets. That’s why the SEC has adopted a go-slow approach with an NYSE pilot program, he said.

Indeed, the potential for dealers to step ahead of smaller investors more often isn’t the only risk involved with decimals, critics say.

Other concerns:

* A reduction in market “depth.” A key way for dealers to minimize the possibility of others stepping ahead of them is to cut the size of trades they’re willing to make at specific prices.

For example, in posting stock quotes on the electronic Nasdaq market, a dealer may commit to selling only 200 shares at $20 instead of the 1,000 shares it may have listed previously.

In fact, Baruch’s Weaver said, that’s exactly what happened when the Toronto Stock Exchange went to decimal pricing.

For individuals, the effect could be that even routine orders are filled at several different prices. That could pose bookkeeping headaches, especially come April 15.

“The more fills you have, the more calculations you have to do at tax time,” Weaver said.

* Greater confusion over how to price orders. Investors who use limit orders have always had to make a decision about the minimum price they’re willing to accept to buy or sell shares. But with fractional pricing, there are only three possible price “slots” between $20 and $20.25, for example. With decimal pricing, there are 24 slots.

Do you try to trade at $20.03--or $20.07?

“It makes trading more complicated for everybody,” Harris said.

* Greater market volatility. At the least, individual stock prices are likely to flutter more than ever--say, as trades occur at $20, then $20.02, then $19.99, etc.

One of the reasons Nasdaq has said it needs more time to introduce decimal pricing is the expectation that the number of different quotes in the market at any moment will skyrocket, putting stress on its computers.

* More service troubles at online brokerages. Reduced stock-price spreads could squeeze profits at some online brokerages, analysts say. Because competition means the firms aren’t in a position to raise commission prices, they might compensate by trimming expenses, which could hurt service.

That’s an unwelcome prospect for investors who already have grappled with Web-site outages and strained brokerage computer capacities.

Whatever the risks, though, decimalization is finally on its way.

Said Rep. Michael Oxley (R-Ohio), who has badgered U.S. markets for years about moving to decimals: “It will make stock prices as easy to understand as grocery prices.”

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Decimals in The Times

The Times’ stock tables and news stories have used simple decimals to report stock prices since early this year, and other newspapers have followed suit.

Although stocks still officially trade in fractions, The Times’ stories and tables round those fractions to the nearest penny.

The Times made the change after asking for readers’ response to the idea. That response was overwhelmingly in favor of using rounded decimal pricing rather than continuing to report prices in fractions.

Readers can find a fraction-to-decimal conversion table on The Times’ Web site, at http://my.nohib.com/fractions .

(Times Editors)

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Goodbye, Fractions; Hello, Decimals

Starting in late August, U.S. stock markets will begin the shift to quoting stocks in simple decimals, abandoning the age-old practice of quoting in fractions. Whereas stocks now are generally traded in minimums of 1/16 of a dollar (6.25 cents), decimal pricing could allow pricing in increments of a single penny.

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1/16

The origin of fractional stock trading was the Spanish dollar, or “piece of eight.” The silver coin became popular in the American colonies as anti-British sentiment rose. The coin was commonly broken into eight pieces to make change.

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0.01

U.S. markets will be following all other major world markets in finally moving to decimal pricing. Though the shift will have great benefits for individual investors--at the very least, simplifying pricing--it also poses risks. For example, professional traders will find it easier to “step ahead” of small investors’ stock orders. Also, even an order for a few hundred shares might be filled at many different penny-increment prices, creating an accounting headache.

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Source: Times research

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Times staff writer Walter Hamilton can be reached at [email protected].