Understanding a futures contract’s tick size and tick value is essential in the trading of futures financial instruments. These financial instruments are a type of contract that lock in to prices in the present and are either sold or bought at that price in the future. Commodities and currency are often traded in the futures markets such as the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME)
Tick size is a metric used in futures exchanges and trading that accounts for the smallest unit measure by which the price of a financial instrument can move up or down. Not all financial instruments have the same tick sizes and even those that are similar i.e. Treasury securities, tick sizes vary.
To illustrate tick size further, according to the Chicago Mercantile Exchange (CME), the tick size for a 30 year U.S. Treasury Bond Future is 1/2 of 1/32 of a point. This means each basis point is comprised of individual ticks of .015625. If 100 basis points is one percent, then the tick size is 1/64th of a basis point which is between 1/100th and 2/100ths of a percent, or more accurately .00015625
Tick value represents cost or profit in proportion to the tick size. In other words, a move in tick size will have differing advantages and disadvantages depending on how much money one has invested. Since tick sizes can be so small, very large amounts of money or quantity are needed to influence price movement significantly enough to be worth while.
For example, suppose Mrs. Smith wants to take part in a foreign exchange option. She chooses a currency pair and an exchange rate with which to sell at at a future date. The currency pair is the U.S. Dollar against the Japanese Yen and the exchange rate is 81.3400, meaning one dollar can be purchased with .8134 Yen indicating the Yen is a stronger currency. Now suppose the value of the dollar rises against the Yen i.e. one dollar buys more Yen buy 1 uptick, which is 1/100th of a cent, how much does Mrs. Smith make or lose?
To answer this question we need to understand the futures tick size and value in addition to the amount invested and the strike price. If Mrs. Smith buys $100,000 Dollars with the right to sell at an exchange rate with the Yen at 81.34 within 60 days and the value of the dollar against the Yen increases by ten upticks to ¥81.44, then the value of the Yen has risen by 10,000 which after conversion to dollars at the new rate would be $8,144. In light of this not exercising the option and forgoing the option premium is a wiser choice.
Since futures markets are often highly leveraged to take advantage of relatively small tick movements the risk can be quite high. This is why understanding exactly what a futures tick size and value are is crucial because one small miscalculation could end up costing thousands of dollars if one is overly leveraged and/or a large tick movement occurs.
Sources:
1. http://bit.ly/cPXRPG (Chicago Mercantile Exchange)
2. http://yhoo.it/37rUpV (Yahoo Currency Exchange Convertor)
3. http://bit.ly/bwNEzH (Commodity Futures Trading Commission)