Trade execution is the completion of a buy or sell order for security. However, the execution of orders doesn’t happen when investors place them but when they get filled.
So, when investors submit the trades, they’re sent to brokers, who then select the best manner for them to be executed.
The best execution is a law that calls for brokers to put their client’s interests first – over incentives like soft dollars provided by trade routing entities for the best order execution.
Now, let’s dive deeper and discuss different types of trade execution. Without further ado, let’s learn how trade execution works in great detail.
What’s Trade Execution?
Trade execution represents filling a buy or sell order in the market.
The trade can be executed in different manners. And they all come with automated methods as well as a manual. The brokers must determine the best possible way to execute their client’s trade by law.
They’re asked by law to provide investors with the greatest options available. According to the Securities and Exchange Commission, brokers should report the quality of their trade execution on a stock by stock basis and inform customers who didn’t have their orders arranged for the best execution.
It’s also important to mention that the price of executing trades has significantly declined because of the growth of brokers. And they provide their customers with a commission rebate if they execute a specific amount of trades. This matters to short-term traders who need to keep their costs as low as possible.
If the order assigned is a market order or can be transformed into a market order quickly, then there’s a high chance of settling the order at the preferred price. However, if it’s a large order that’s broken down into smaller orders, executing it at the best possible price range can be much harder in some cases.
And in these cases, the execution risk is inserted into the system. The risk refers to the lag between the placement of orders and their settlements. The broker must notify the client of the execution risk.
Now, let’s learn more about the 4 different types of trade execution.
4 Different Types Of Trade Execution
As I already established, trade execution is when a buy or sell order on the market gets completed. For a trade to be completed or executed, investors utilizing brokerage accounts should first submit their orders, which then get forwarded to brokers.
On the behalf of investors, they then determine which market makes the best choice to send the orders to. Once the orders reach the market and get fulfilled, only then they can be considered executed. Both the timing and technique utilized for the whole process will affect the end price.
Trades aren’t executed instantaneously, which is why timing plays a very important role in the execution process. The trades must be sent to brokers before reaching the market, so stock prices can be different from what investors ordered by the time the trade is executed.
Market Maker
Instead of forwarding customers’ orders to the market, brokers can choose to forward them to a market maker instead. Now, market makers represent companies that purchase or sell stocks.
To attract as many brokers as possible to forward orders to them, market makers can pay them to direct the flow of orders to them. This type of payment is known as “payment for order flow”.
OTC (Over-The-Counter) Market Maker
Investors can trade stocks over the counter. And in this case, over-the-counter (OTC) market makers can pay brokers to direct them to forward orders to them.
ECH (Electronic Communications Network)
Investors buy and sell orders can be forwarded to an electronic communications network (ECH), where a computer system will pair buy and sell orders together. This can happen especially in situations where limit orders take place, which is when investors ask for a specific price to buy and sell a stock.
Internalization
The broker’s company can already own shares of stocks, so in some cases, the execution of the trade is completed in-house by filling the order utilizing the company’s inventory of stocks. Brokers can be able to earn money from this trade execution if there’s a difference between the bid-ask spread.
Are Brokers Obligated To Conduct The Best Execution?
Fortunately, brokers should complete a trade execution that’s best for their customers. In doing so, they would evaluate all the orders that they would receive from their customers and determine what market, ECN broker, or market maker will offer the best execution prices.
In some cases, there’s a chance for a trade execution to be completed with a better price than what was required in the order. It’s considered a chance for price improvement which is very important to brokers when picking the right method and timing for trade execution.
In some cases, there’s a chance for a trade execution to be completed with a better price than what was required in the order. It’s considered a chance for price improvement which is very important to brokers when picking the right method and timing for trade execution.
For instance, an investor enters a market order to purchase 100 shares. The current price of the stock is $50. A broker may forward the investor’s trade to a market maker that can provide a stock price higher than $50. If the broker forwards the order to a market maker that provides a stock price of $49, then the investor purchases the shares at a lower price.
Can All Trades Be Executed?
Not all trades can be executed.
For instance, a buy order can be large and can’t be filled at once. In that case, the larger order will be broken into smaller ones to make it easier to complete. Then, the trade will be executed at different times. And most importantly, at different prices.
Further, a limit buy order and limit sale order can’t be executed, too! If the stock price is always higher than the limit buy order price, a limit buy won’t be executed. If the stock price is always lower than the limit sell order price, a limit sell order won’t be executed either.
Summary
Remember that the best execution isn’t a replacement for a sound investment plan.
Fast markets include substantial risks and can affect the performance of orders at significantly different prices than initially expected.
However, with a long-term plan, those differences won’t stand in the way of successful investing.
