Understanding Order Execution

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Often investors and traders alike do not fully understand what happens when you click the “enter” button on your online trading account. If you think your order is always filled immediately after you click the button in your account, you are mistaken. In fact, you might be surprised at the variety of possible ways in which an order can be filled and the associated time delays. How and where your order is executed can affect the cost of your transaction and the price you pay for the stock.

A Broker’s Options
A common misconception among investors is that an online account connects the investor directly to the securities markets. This is not the case. When an investor places a trade, whether online or over the phone, the order goes to a broker. The broker then looks at the size and availability of the order to decide which path is the best way for it to be executed.

A broker can attempt to fill your order in a number of ways:

  • Order to the Floor  For stocks trading on exchanges such as the New York Stock Exchange (NYSE), the broker can direct your order to the floor of the stock exchange, or to a regional exchange. In some instances regional exchanges will pay a fee for the privilege to execute a broker’s order, known as payment for order flow. Because your order is going through human hands, it can take some time for thefloor broker to get to your order and fill it.
  • Order to Third Market Maker – For stocks trading on an exchange like the NYSE, your brokerage can direct your order to what is called a third market maker. A third market maker is likely to receive the order if: A) they entice the broker with an incentive to direct the order to them or B) the broker is not a member firm of the exchange in which the order would otherwise be directed.
  • Internalization – Internalization occurs when the broker decides to fill your order from the inventory of stocks your brokerage firm owns. This can make for quick execution. This type of execution is accompanied by your broker’s firm making additional money on the spread.
  • Electronic Communications Network (ECN) – ECNs automatically match buy and sell orders. These systems are used particularly for limit orders because the ECN can match by price very quickly.
  • Order to Market Maker – For over-the-counter markets such as the Nasdaq, your broker can direct your trade to the market maker in charge of the stock you wish to purchase or sell. This is usually timely, and some brokers make additional money by sending orders to certain market makers (payment for order flow). This means your broker may not always be sending your order to the best possible market maker.

As you can see your broker has different motives for directing orders to specific places. Obviously, they may be more inclined to internalize an order to profit on the spread or send an order to a regional exchange or willing third market maker and receive payment for order flow. The choice the broker makes can affect your bottom line. However, as we explore below we will see some of the safeguards in place to limit any unscrupulous broker activity when executing trades.

 

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