How much can a penny matter? A recent study suggests that stock speculators should place trades based on when a stock price moves on or off of a round number.
In “Penny Wise, Dollar Foolish: Buy-Sell Imbalances On and Around Round Numbers,” three Finance professors analyzed 100 million trades and found that more stocks are bought at a price one penny below a round number. They also found that more buying and selling took place when a integer price was reached rather than when it was crossed.
According to professors Utpal Bhattacharya, Craig Holden (both of Indiana University), and Stacey Jacobsen (an assistant professor at SMU), this results in ”transfers of an aggregate $40 million per year” that could be conditional or unconditional.
There are three effects discovered by the study. One is the left digit effect: where the price drops from $7.00 to $6.99. This results in the security being viewed as a $6 stock rather than $7, even though the drop is only a penny. According to the study, traders “do not round $6.99 up to $7.00, because this is mentally costly.” A drop from $7 to $6.99 will cause more buys than a drop from $7.08 to $7.07.
The second round number effect is based on “thresholds for action.” Called the “threshold trigger effect,” this is based on the preference of investors for round numbers; dollar, half-dollar, quarters, nickels, dimes and pennies. From this, when the price drops from a round number, $7 to $6.99, trades are “triggered.” When these “thresholds” are breached, there is excess selling and buying in the market.
The third round number impact results from ”limit order clustering and undercutting.” Previous research found that limit orders are based on the threshold trigger effect, that is structured on dollars, half-dollars, etc… “Undercutting” is placing an order to buy or sell a penny above or a penny below.
From the study, it can be surmised that traders are more comfortable with round numbers and buy and sell that way. In addition, stock programs are based on round numbers, too. That is why houses are priced at $499,900 as an example: buyers will search for places at $500,000 and under. Savvy speculators can profit from this insight.