Recent allegations of shenanigans at Knight Trading (NITE) may have left investors wondering if their own trades are being handled properly.
Among other transgressions, Knight is under investigation by the
Securities and Exchange Commission
for allegedly front-running in the late 1990s, when its traders may have put Knight trades ahead of their clients'. Knight allegedly profited at its clients' expense -- sometimes even driving share prices higher in the process.
Since the time of those alleged misdeeds, though, the SEC has stepped in. Almost exactly a year ago, an SEC rule went into effect designed to cut down on the obfuscation and let investors know more about how their trades travel.
In the wake of various semiscandals surrounding the way online brokers executed trades in the late 1990s, the SEC established rules to improve public disclosure of order execution and routing practices. More specifically, institutions that make a market in exchange-traded stocks must make monthly stock-by-stock disclosures of how trades were executed.
The rules also require brokers who route customer orders to disclose quarterly the identity of the market centers where they route a significant percentage of their orders. And if customers want to know where their individual orders were routed for execution in the past six months, brokers must divulge that information.
But all of this begs the question -- what happens to your order after you place it with a broker or enter a trade online?
You already know that trading takes time, even when done via the Internet. Price quotes are for only a specific number of shares, and prices can change quickly -- which means that investors may not receive the quoted price (be it quoted by a broker or
Yahoo! Finance). The SEC doesn't impose a specific time restriction on trade execution.
Firms are required to execute a market order fully and promptly at the best available price. In other words, if you tell your broker to buy 1,000 shares of
AOL Time Warner
, the execution is guaranteed, but the price is not. If a stock is "popping" for some reason -- like a news event or earnings release -- the quote you receive when placing the order may be different from the price at which you actually purchase the shares.
Let's say Merrill Lynch is filling an order for a customer of Charles Schwab. The Schwab investor sees that
is trading at $16.75 and places a market order to buy 1,000 shares. But by the time Schwab's trading desk tries to execute the order, it sees that Merrill is offering shares of Tyco for $17, the best offer at the time. However, once that order is filled, the next best offer falls to $16.75. All of this can happen very quickly and legitimately, but the upshot is that the investor spent $250 more on the order than expected -- and the reason isn't immediately obvious to the investor.
Market orders are fine for investors (not active traders) in very liquid (high-volume) stocks -- which covers most U.S. equities and large foreign stocks that are traded as American depositary receipts (ADRs). Purchasing stocks that don't trade frequently -- like some foreign or small companies -- could prove tricky using market orders. In some cases, the "ask" price (the price at which the seller is willing to sell) of a low-volume stock can be a lot higher than the current market price. That spread means an investor could end up paying quite a bit more per share than anticipated.
Alternatively, limit orders are those that get executed only if the specified selling or purchase price can be met. In other words, the price is guaranteed, but the execution is not. Limit orders typically cost slightly more than market orders, but might be a good idea if you know to the penny exactly what you're willing to pay for a stock (or the price you won't sell below), which may be the case with low-volume or highly volatile stocks.
There are a slew of other order instructions, including fill-or-kill (if it can't be filled immediately, kill the order); day (if the order cannot be completed by the end of the day, it's killed); or good-till-canceled (the order is good until it's canceled by the investor or executed by the broker). But most investors don't need more than the market or limit orders to purchase the stock they want at a reasonable price.
Your Broker's Options
Brokers can handle an order a number of ways.
For stocks that trade on exchanges such as the
, a broker can make an
"order to the floor"
of the stock exchange. These orders are done by hand, so it may take longer to get the floor trader to handle an order.
and so-called over-the-counter (OTC) exchanges (so named because there's no actual exchange floor) a broker can make an
"order to the market maker."
Market makers -- generally a brokerage, bank or other financial institution -- make a market for a stock by maintaining a permanent firm bid and ask price for the shares. They are always prepared to pay a particular price to buy and sell securities for its own account (principal trades) or for customer accounts (agency trades).
Brokers also can fill an order from the inventory of stocks their firm owns. This process, called
, assures speed, but can cost more if the brokerage makes additional money on the spread -- the difference between the purchase price and the sale price.
Electronic communications networks, better known as ECNs, such as Island ECN and
, automatically match buy and sell orders. ECNs are particularly useful in matching limit orders very quickly.
Investors often can request that a trade be directed to a particular exchange, market maker or ECN, although the broker likely will charge a fee for granting that request.
Your Broker's Obligations
Brokers are obliged to give each investor the best execution possible at the time, which means brokers must continuously evaluate the orders they receive from both institutional and individual clients in the aggregate, and periodically assess which venues offer the most attractive terms of execution.
The intricacies of trading mechanisms shouldn't matter to most investors -- if you're not trading for sport, chances are none of this will make a difference in the long run. But if you are concerned, your broker should provide the details of how it executes trades.
Also consider asking about the opportunity for "price improvement," which is essentially the flip side of the example of the investor who paid an additional $250 for Tyco shares. Price improvement is the possibility of a trade's execution at a better price than what's quoted publicly.
The SEC advises investors to ask brokers about firm policies on payment for order flow, internalization and other routing practices. And remember that your broker is required to provide information on specific trades made within the past six months.
So if you're concerned, you have a right to ask questions -- and your broker has an obligation to answer them.