What is a Lot size?

In trading, the term "lot size" holds significant importance. It refers to the standardised quantity in which assets are traded, setting the minimum transaction amounts. This concept ensures consistency and orderliness in trading. Also, lot size impacts various aspects, such as investor accessibility, market liquidity, and bid-ask spreads.

Let us understand lot size meaning in detail, see how companies fix lot size during an IPO, and learn how it impacts market liquidity.

What do you mean by lot size in trading?

In the context of financial markets, “lot size” is a popular term used in:

• Initial Public Offerings (IPOs)
  and
• Derivatives trading

Let us understand its various meanings in detail.

What is a lot size of an IPO?

In an IPO, a company offers its shares to the public for the first time. These shares are offered in specific quantities known as “lots”. These lots represent the minimum number of shares that must be purchased by investors participating in an IPO. They cannot buy fewer shares than the specified lot size.

For example:

• Say ABC Ltd. is planning to raise funds from the public.
• The company has received SEBI approval to launch an IPO.
• It has set 100 equity shares as the lot size.
• This means investors participating in the IPO must purchase at least 100 shares or 1 lot.

Also read: Equity share capital

Who determines the lot size for an IPO?

The lot size for an initial public offering (IPO) is determined through a collaborative process, which involves:

• The issuing company
• The lead managers (investment banks or financial institutions managing the IPO)
• The stock exchanges where the IPO will be listed

Let us understand this process in detail.

Step I: The issuing company determines an ideal lot size

• The company seeking to go public makes the initial decision regarding the lot size for its IPO.
• Usually, the following factors are considered:
  • Total number of shares being offered
  • The company's valuation
  • The target investor base
  • Market conditions

Step II: Consultation with lead managers

• Once the company decides on a tentative lot size, it consults with the lead managers of the IPO.
• They provide inputs based on:
  • Their market analysis
  • Investor feedback
  • Applicable laws and regulations

Step III: Approval by stock exchanges

Once the company and lead managers finalise the lot size, they submit the IPO prospectus to the stock exchanges where the company intends to list its shares.

• The stock exchanges review the IPO documents, including the proposed lot size.
• Upon approval, the lot size becomes finalised.
• It is disclosed in the IPO prospectus and other offering documents.

Also read: What are share certificates

What is lot size in derivatives trading?

When it comes to derivatives markets, such as futures and options, “lot size” refers to the standardised quantity in which contracts are traded.

Why does lot size matter?

Some of the major benefits of lot sizes is that:

• They provide standardisation
  and
• They ensure trading in the financial markets goes on in an orderly fashion

By specifying fixed lot sizes, exchanges make it easier for traders to understand the terms of the contracts and execute transactions. Furthermore, lot sizes also play a role in risk management. They help traders in:

• Managing the size of their positions
  and
• Controlling their exposure to the market

How do lot sizes impact market liquidity?

Lot sizes have a significant impact on market liquidity. They influence the ease and efficiency with which assets can be bought and sold. Let us understand how.

Lot sizes impact investor accessibility

Read the table below to see how smaller and larger lot sizes influence the entry of investors in the market:

Lot sizes affect the depth of the order book

• Lot sizes affect the depth of the order book.
• This depth represents the cumulative quantity of buy and sell orders at various price levels.
• Smaller lot sizes often lead to a deeper order book.
• That’s because more investors can participate and place a greater number of buy and sell orders at different price levels.
• A deeper order book improves liquidity.
• It increases the number of potential counterparties available for each trade.

Lot sizes affect bid-ask spreads

• Smaller lot sizes usually reduce bid-ask spreads.
• For those who are unaware, the bid-ask spread is the difference between:
  • The highest price a buyer is willing to pay (bid)
    and
  • The lowest price a seller is willing to accept (ask)
• When the lot sizes are smaller, there is more competition among market participants.
• This narrows bid-ask spreads and improves overall market efficiency.

Conclusion

In the financial markets, “lot size” is a broad term. Its meaning varies based on the nature of the trade executed. In the context of an IPO, lot size represents the number of shares that investors must purchase in an IPO. On the other hand, in derivatives like futures and options, lot size shows the minimum trading quantity.

It is pertinent to note that lot sizes bring order to trading by standardising transaction sizes. This standardisation makes it easier for traders to understand contracts and manage risks.

Also, lot sizes influence market liquidity. Smaller lots encourage broader investor participation and narrow bid-ask spreads. In contrast, larger lot sizes eliminate smaller investors and reduce overall market participation as well as liquidity.

Do you wish to expand your share market knowledge? Know about different types of shares and shareholding patterns.