The majority of the time, investors and traders alike are unsure of what happens when they click the “enter” button on their online trading account. Incorrect: If you believe that your order is always fulfilled immediately after you click the button in your account, you are mistaken.
Perhaps you will be surprised by the number of different ways in which an order can be fulfilled—and the resulting time delays—in this day and age. The method and location in which your order is executed can have an impact on the cost of your transaction as well as the price you pay for the stock.
The Most Important Takeaways
- A buy or sell order is executed in the market on behalf of a client when an order is accepted and completed in the market by a broker.
- Order execution can be done manually or electronically, depending on the account holder’s preferences and the limits or conditions he or she has placed on the order.
- Brokers are required to follow best execution practices, which are regulated by the Securities and Exchange Commission (SEC) as well as individual exchanges.
Options Available to a Broker
A common misconception among investors is that having an online account allows them to connect directly to the securities markets, which is not true. This isn’t the case at all. The order for a trade is sent to a broker when an investor places a trade, whether it is done online or over the phone. The broker then considers the size and availability of the order in order to determine which path is the most optimal one for it to be carried out successfully.
There are several ways in which a broker can attempt to fill your order. According to what you will learn, your broker has a variety of reasons for routing orders to specific locations. In order to profit from the spread, they may be more inclined to internalize an order or to send an order to a regional exchange or willing third market maker in exchange for a fee for the volume of orders they generate.
The decision made by the broker can have an impact on your bottom line. However, as we will see below, some safeguards have been put in place to prevent any unscrupulous broker activity when trades are being executed.
The Floor is now open for business.
In the case of stocks trading on stock exchanges such as the New York Stock Exchange (NYSE), your broker can route your order to the floor of the stock exchange or to a regional stock exchange, depending on your preferences. Known as payment for order flow, regional exchanges will sometimes charge brokers a fee in exchange for the privilege of executing their orders on their exchange. The fact that your order is passing through human hands means that it may take some time for the floor broker to reach your order and complete it.
Third Market Maker is to be contacted.
Your brokerage can direct your order to what is known as a third market maker when it comes to stocks trading on a stock exchange such as the New York Stock Exchange (NYSE). If a third market maker is able to entice a broker to direct the order to them through an incentive, or if the broker is not a member firm of the exchange to which the order would otherwise be directed, the order is more likely to be filled by the third market maker.
Internalization occurs when a broker decides to fill your order from the inventory of stocks that the brokerage firm owns rather than from the market. This may allow for a more rapid execution. This type of execution is accompanied by an increase in the amount of money earned by your broker’s firm on the spread.
Electronic Communications Network (ECN)
Buy and sell orders are automatically matched by electronic trading networks (ECNs). These systems are particularly useful for limit orders because the ECN can match orders by price in a very short period of time.
Order to the Over-the-Counter Market
When trading on over-the-counter (OTC) markets, such as those operated by the OTC Markets Group, your broker can route your trade to the market maker in charge of the stock you wish to buy or sell on your behalf. This is usually done in a timely manner, and some brokers earn additional money by sending orders to specific market makers (payment for order flow). This means that your broker may not always be routing your order to the most advantageous market maker.
Order Execution Requirements and Restriction Conditions
Even though the vast majority of orders submitted to a broker are market orders, others may be subject to conditions that restrict or alter the manner in which and when they can be executed. Among the types of conditional orders available are limit orders, which specify a fixed price above (or below) which a purchase (or sale) cannot take place.
Other conditions include the time frame within which an order may be executed, such as immediate-or-cancel (IOC) for orders that must be filled within seconds of being placed or good-til-cancel (GTC), which remains available to be filled as a standing order until it is explicitly canceled, which can last for several weeks at a time. There are numerous other variations and types of conditions or restrictions that can be applied.
Under the law, brokers are required to provide each and every one of their investors with the best possible order execution. Whether this occurs or whether brokers are routing orders for other reasons, such as the additional revenue streams discussed above, is still up in the air, according to some analysts.
Consider the following scenario: you want to purchase 1,000 shares of TSJ Sports Conglomerate, which is currently selling at a price of $40 per share. You place a market order, and it is filled at a price of $40.10 dollars. This means that you had to pay an additional $100 for the order. Some brokers claim that they are always “fighting for an extra one-sixteenth,” but in reality, the opportunity for price improvement is merely that: an opportunity, not a guarantee of future results.
Additionally, when a broker attempts to obtain a better price (for a limit order), the speed and likelihood of execution both decrease significantly. Although the market itself, rather than the brokerage firm, may be to blame for an order not being executed at the quoted price, this is especially true in fast-moving markets.
Trading on the high-wire is something that brokers must do when attempting to execute trades in the best interests of their clients while also protecting themselves. However, as we will see, the Securities and Exchange Commission (SEC) has put in place safeguards to ensure that the client’s best interests are served.
The Securities and Exchange Commission Intervenes
The Securities and Exchange Commission (SEC) has taken steps to ensure that investors receive the best execution possible, with rules requiring brokers to report the quality of executions on a stock-by-stock basis, including how market orders are executed and how the execution price compares to the public quote’s effective margins.
Furthermore, when a broker executes an order from an investor using a limit order and provides the execution at a better price than the public quotes, the broker is required to report the specifics of the better prices. Following the implementation of these rules, it will be much easier to determine which brokers obtain the best prices and which brokers merely use them as a marketing tool.
Additionally, the Securities and Exchange Commission (SEC) requires broker/dealers to notify their customers if their orders are not routed for the best execution. On the trade confirmation slip that you receive after placing your order, this information is typically included. Unfortunately, this disclaimer is almost never taken into consideration.
Is the execution of orders critical?
Depending on the circumstances, including, in particular, the type of order you submit, the importance and impact of order execution can vary significantly. For example, if you place a limit order, the only risk you face is that the order will not be fulfilled. With market orders, speed and price execution become increasingly important factors to consider when placing your order.
Think about it this way: on a $2,000 order of stock, one-sixteenth of a percent is equal to $125. This may not seem like a significant sum to an investor with a long-term time horizon, but contrast this with the actions of an active trader, also known as a scalper, who attempts to profit from the small ups and downs in day-to-day or intraday stock price movements.
The same $125 spent on a $2,000 order eats away at a percentage point increase of a few percentage points. As a result, order execution is significantly more important to active traders who are scrambling for every percentage point they can get their hands on.
What’s the bottom line?
Keep in mind that even the best possible execution cannot compensate for a sound investment strategy. Fast markets carry significant risks, and the performance of orders at prices that differ significantly from expectations can result in orders performing significantly worse than expected. With a long-term perspective, however, these differences are merely a speed bump on the road to achieving financial success.