Does a stock split change the way stock trades? It's a common belief that splitting doesn't change the fundamentals of a stock, and as such, shouldn't affect valuation. Research proves that this is far from the truth. Here's how. 

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Splitting fundamentally changes how stocks trade, which can make it cheaper for investors and improve their returns, and as a consequence of increased investor returns, stock valuations should outperform.

 

Splits help stocks trade higher, with a range of academic research showing that split stocks tend to outperform the market. Overall, the result of splitting large cap stocks is for them to outperform the market by an average of 5% over the following 12 months. The mere announcement of a split also has the result of average stocks outperforming the market by 2.5%, indicating that gains were expected by the market even before the improvement of tradability, thus acting as a material boost to both issues and investors.

 

Why would a split make trading cheaper? Most trading costs are driven by three factors - spreads, liquidity, and volatility. 

 

Spreads are the percentage difference between bids and offers. Liquidity is the typical value traded, also limiting how much stock can be bought in a day. 

Volatility reflects the risks of losses for market makers providing liquidity - low volatility also helps keeping spreads tight.

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Research spanning over a longer period of time also shows that for decades, impact costs have been falling, partly due to liquidity increasing and spreads falling all across the market. Smaller stocks, which usually have wider spreads, less liquidity, and more volatility, are estimated to be costlier to trade.

 

Achieving lower trading costs is done by a combination of lower volatility, better spreads, and better liquidity. The result of costs going down is that returns should go up and there should be an increase in valuations.

As orders are working during the day, intraday volatility is more important for traders. Lower intraday volatility attracts an increased number of liquidity providers, thus reducing impact costs. A common question is, why does stock trade affect tradability? An understanding of trading rules and market structure is required for the answer.

All stocks in the U.S. trade under a very similar set of rules, which can result in different trading. Stocks with a low price have ticks that make spreads too wide, thus increasing trading costs and queue lengths. By definition, they also have wide spreads.

Stocks with a high price have a large round lot and too many ticks. Jumping queues is made easier by all those ticks, while the large round lot makes it costly to post cheap offers and bids. Their spreads are wide because trading is difficult. In between lies a price level in which the ticket more closely represents the tradeoff for liquidity and immediacy. Those stocks trade with the lowest spread costs.

Portfolio manager models determining after-cost alpha will also incorporate artificially wide spreads. In turn, that may reduce the size of position new investors decide to buy, or deter them altogether.The minimum price increment that orders can use is a tick. In the U.S., all stocks have a one-cent tick. As an example, you can bid $10.01 or $10.02 but not in between. However, this can become a problem.

This means that spreads can be "expensive" for investors to cross when it comes to low priced stocks, thus causing more investors to form in longer queues or create queue priority solutions such as using mid-point orders or paying for inverted venues, thus adding to trading complexity and liquidity fragmentation.

Even the most liquid U.S. companies in the market have a spread closer to 0.01%. Those increments lower the cost of jumping in front of buyers already in line, thus penalizing the original buyer, who may miss fills, without significantly improving prices for reported spreads or those wanting to sell.

High priced stocks also have a round lot problem. Nearly all U.S. stocks have the "round lot" concept, meaning 100 shares, which was designed to ensure that a meaningful trade value was reflected by benchmark spread prices, as well as reducing paperwork on settlement. Because of this, odd lots and round lots aren't treated the same.

The prices the public see are round lots, setting the official spread that institutional investors use to compute trading costs, and are “protected,” meaning that traders cannot skip over them to trade elsewhere.

Contrastingly, odd lots are neither protected nor visible on the consolidated data feed. There are two ways that this can increase costs for large buyers.

Buyers who trade off-exchange could do so at worse prices than available odd lot orders on exchange.Some institutional buyers using algorithms might intentionally miss odd lot liquidity. Research on lower priced stocks occasionally suggests that odd lot orders reveal too much information of large trades. Many algorithms can legally limit trading to fills of 100 shares or more to counteract that.

Generally, stocks trading with spreads around 1-2 ticks wide have relatively low levels of odd lots inside the official quote. Nonetheless, as prices rise, the number of ticks between the bid and offer and the probability that the true best bid and offer is an odd lot do as well. This shows the negative link between higher stock prices and a worsening odd lot problem.

Regulators have also started to act after hearing from investors about how difficult it's become to trade high priced stocks. The SIP committee suggested adding odd lots to the tape, which would fix the round lot problem but create a best-ex problem if one share sets the benchmark price.

The SEC proposed the change of round lot sizes, which only partly fixes the round lot problem, but also removes key investor protections in trying to avoid the best-ex problem, and allows trade through.

European regulators have changed tick sizes and eliminated round lots. That fixes all these problems, but appears a complicated solution.

If all stocks traded with roughly the same prices, it would simplify the process for traders. For over 70 years until 2007, when stock splits were normal, stock prices were consistently placed around $40 a share. Prior to 2007 it was unusual for the S&P500 to have more than a few stocks over $100. Today roughly a quarter of the index has stocks over that value.

Data shows that the lack of stock splits is a fairly new phenomenon set off around 2007 and coinciding with the finalization of Reg NMS. While they were adapting to decimalization, the novel trading rules helped make markets interconnected and electronic, thus allowing spreads to collapse to a one-cent level.

Many share prices have long surpassed levels in which a one-cent tick remains a limitation. Instead, trading is increasingly happening away from exchange prices. Ultimately, this can widen spreads further and harm market efficiency and price discovery.

Another common question is what is the perfect stock price? By translating the spreads for your stocks liquidity into one or two ticks, you can easily calculate the perfect stock price. As an example, a stock trading around $10 million in notional value daily should target a 10bps spread. That translates to a stock price of $10 or $20 when talking about a one-cent tick.

An interesting comparison is brought to mind by AAPL and AMZN, the U.S's two most liquid stocks. Both trade roughly $10 billion on a daily basis, but AAPL spreads stay very near the “optimal” line and odd lots are much lower. That seems to confirm that AAPL helps keep all investors equals and has an easier to trade stock by keeping stock price just over $100.

 

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