What Every Investor Should Know
When you place an order to buy or sell stock, you might not think about where or how your broker will execute the trade. But where and how your order is executed can impact the overall costs of the transaction, including the price you pay for the stock. Here's what you should know about trade execution:
Trade Execution Isnt Instantaneous
Many investors who trade through online brokerage accounts assume they have a direct connection to the securities markets. But they don't. When you push that enter key, your order is sent over the Internet to your broker—who in turn decides which market to send it to for execution. A similar process occurs when you call your broker to place a trade.
While trade execution is usually seamless and quick, it does take time. And prices can change quickly, especially in fast-moving markets. Because price quotes are only for a specific number of shares, investors may not always receive the price they saw on their screen or the price their broker quoted over the phone. By the time your order reaches the market, the price of the stock could be slightly or very different.
No SEC regulations require a trade to be executed within a set period of time. But if firms advertise their speed of execution, they must not exaggerate or fail to tell investors about the possibility of significant delays.
Your Broker Has Options for Executing Your TradeJust as you have a choice of brokers, your broker generally has a choice of markets to execute your trade:
The graphic below shows your broker's options for executing your trade:
Your Broker Has a Duty of Best Execution
Many firms use automated systems to handle the orders they receive from their customers. In deciding how to execute orders, your broker has a duty to seek the best execution that is reasonably available for its customers' orders. That means your broker must evaluate the orders it receives from all customers in the aggregate and periodically assess which competing markets, market makers, or ECNs offer the most favorable terms of execution.
The opportunity for "price improvement" which is the opportunity, but not the guarantee, for an order to be executed at a better price than what is currently quoted publicly is an important factor a broker should consider in executing its customers' orders. Other factors include the speed and the likelihood of execution.
Here's an example of how price improvement can work: Let's say you enter a market order to sell 500 shares of a stock. The current quote is $20. Your broker may be able to send your order to a market or a market maker where your order would have the possibility of getting a price better than $20. If your order is executed at $20.05, you would receive $10,025.00 for the sale of your stock $25.00 more than if your broker had only been able to get the current quote for you.
Of course, the additional time it takes some markets to execute orders may result in your getting a worse price than the current quote especially in a fast-moving market. So, your broker is required to consider whether there is a trade-off between providing its customers' orders with the possibility but not the guarantee of better prices and the extra time it may take to do so.
You Have Options for Directing Trades
If for any reason you want to direct your trade to a particular exchange, market maker, or ECN, you may be able to call your broker and ask him or her to do this. But some brokers may charge for that service. Some brokers offer active traders the ability to direct orders in Nasdaq stocks to the market maker or ECN of their choice.
SEC rules aimed at improving public disclosure of order execution and routing practices require all market centers that trade national market system securities to make monthly, electronic disclosures of basic information concerning their quality of executions on a stock-by-stock basis, including how market orders of various sizes are executed relative to the public quotes. These reports must also disclose information about effective spreads – the spreads actually paid by investors whose orders are routed to a particular market center. In addition, market centers must disclose the extent to which they provide executions at prices better than the public quotes to investors using limit orders.
These rules also require brokers that route orders on behalf of customers to disclose, on a quarterly basis, the identity of the market centers to which they route a significant percentage of their orders. In addition, brokers must respond to the requests of customers interested in learning where their individual orders were routed for execution during the previous six months.
With this information readily available, you can learn where and how your firm executes its customers' orders and what steps it takes to assure best execution. Ask your broker about the firm's policies on payment for order flow, internalization, or other routing practices or look for that information in your new account agreement. You can also write to your broker to find out the nature and source of any payment for order flow it may have received for a particular order.
If you're comparing firms, ask each how often it gets price improvement on customers' orders. And then consider that information in deciding with which firm you will do business.