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Understanding Trade Execution

What happens when you place your order to buy or sell stock? Is the trade immediately executed? Where does that happen, how, and what is your broker's role in the process. These are questions that every investor should know the answers to.

To start with, it is a common misperception that online accounts connect investors directly to the securities markets. In fact, right after you push that enter key your order goes to a broker.  It is then your broker who decides which market to send your order to for execution.

Broker's Options for Executing a Trade

Brokers can choose one of the following ways to execute your trade:

  • Direct the order to an exchange or a third market maker.

    Stocks that are listed on exchanges such as the New York Stock Exchange (NYSE) can be directed by your broker to that particular exchange, to another exchange, or to a firm known as a "third market maker"(a third market maker is a firm that is ready to purchase or sell stocks listed on an exchange at publicly quoted prices).

  • Send the order to a market maker.

    For stocks that are traded in over-the-counter (OTC) markets (for example the Nasdaq) brokers may send the order to the market maker in charge of the particular stocks.

  • Direct the order to an electronic communications network (ECN).

    Electronic communications networks (ECN) automatically match buy and sell orders at specified prices. Therefore, "limit orders", which are orders to buy or sell stocks at a particular price, are often directed to them since ECNs can match by price very quickly.

  • Fill your order from the brokerage firm's own inventory of stocks.

    This is called "internalization" and is accompanied by your broker's firm making money on the spread.

If you know where your want to direct your trade to (a particular exchange, market maker, or ECN), you may ask your broker to comply with your request. Have in mind though that some brokers may charge for that service. There are also brokers that offer active traders the option to direct orders in Nasdaq stocks to an ECN or market maker of their choice.

Duty of Best Trade Execution

Your broker is obliged to seek the best possible execution for your orders. In other words, the broker should evaluate the orders from all customers and assess which competing exchanges, market makers, or ECNs offer the best terms of execution.

The factors that need to be considered by a broker when executing customers' orders are:

  • the opportunity for "price improvement" (in other words the opportunity, but not the guarantee, for an order execution at a better price than the price that is currently quoted publicly),
  • the speed (some markets need additional time to execute orders which may lead to your getting a worse price than the current quote - this is particularly true in a fast-moving market),
  • the likelihood of execution.

Why is Quality Trade Execution Important?

Usually trade execution is seamless and quick. However, it does take time. And time is precious when you are placing a market order. Prices can change really quickly, especially in conditions of a fast-moving market. By the time your order actually reaches the market, the stock price may already be slightly, or very, different.

The speed of trade execution is also especially important for active traders who aim at profiting from the small ups and downs in stock prices. A few percentage points in the price movement can make a big difference to them.

Have the importance of fast trade execution in mind and yet, know that if you are an investor with a long-term horizon, such small price differences can have insignificant effect on fulfilling your investment goals.

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