Stock Order Execution:
Is Ignorance Really Bliss?

An old adage tells us why laws and sausages are essentially alike:  because we'll be happier if we don't see either of them being made. 

It's tempting to feel the same way about how your stock orders are executed.  "Aah, why should I worry," you say to yourself. "It'll only annoy me."  Maybe.  But as with laws and sausages, the more you know about stock order execution, the better your decisions will be.  Whereas the less you know . . . 

If questioned, many individual investors would say that an online account means they're somehow hooked directly, almost physically, into stock exchanges.  After all, it happens so fast:  You click, you blink, you get the best available deal, it's over, right?   Actually, there are several ways a securities order can be placed and filled, and any number of related delays and occasional surprises.

"Buy long 500,000 XOM at 3/16 under market now!"

If you own a seat on the New York Stock Exchange and are trading a few hundred thousand shares of Exxon Mobil, don't worry:  Your order will be filled in full at the price you specify in considerably under two seconds. 

If, however, you're a NYSE-seatless civilian investor trading a couple of hundred shares of a an over-the-counter issue, your order may go instantly and precisely as you place it.  Or not.

Whether placed online or by phone, your order always goes to a broker.  The broker considers the type and size of your order to determine how it will be routed and filled; this can affect the cost of your transaction and even the price you end up paying for the stock.  For the record, there are a number of ways to fill an order:

For stocks trading on listed, established, predictably-traded exchanges like the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE), the broker will in most cases direct the order to the floor of the exchange.  Since this order is actually going through human hands, it can take some time for the floor trader to get your order and fill it.  (See "What About Those Markets," below.)

With over-the-counter markets such as the Nasdaq, your broker directs your trade to a "market maker," someone in charge of selling and buying the stock you're trying to buy or sell.  Not all market makers charge the same commission, so some (not all) brokers make more money on your trade by directing it to certain market makers.  (The OTC market is a dealer market where several market makers can compete for your order.)

Electronic Communications Network (ECN) automatically matches buy and sell orders very quickly, so ECNs are often used for limit orders (see below).

Internalization (or "trading upstairs") takes place when the broker fills your order from the inventory of stocks the brokerage firm owns.  Very fast execution and sometimes a better deal; but know that your broker's firm will make money not only on the commission but on the spread — the difference between the bid (what the buyer is willing to pay) and the ask (what the seller is willing to accept).

How would you like that, sir?

It's worth knowing about the four common order types, too, as they determine how and when, or whether, your order will be handled:

A market order lets you buy or sell your stock as quickly as possible at the best available price at the moment your order hits the market.  Execution is almost certain since you haven't specified a price. However, a market order can cause you to say "Yikes!" if you place, say, your "market buy" order at 50 on a fast-moving, volatile trading day and by the time it fills, the market price has gone to 51-3/16.

A limit order, on the other hand, is an order to buy or sell at a specified price or better.  Buy limit orders are executed at or below limit price; sell limit orders are executed at or above limit price.  Since you've specified a price, there's no guarantee your limit order will fill.

A stop order is an order to buy or sell at the market price once your stock has traded at or through the trigger (stop) price.  If the stock trades at or through that price, your order will be filled as a market order.  Again, no guarantee of execution.

A stop limit order lets you buy or sell at a specified price once your stock has traded at or through the trigger price.  No guarantee of execution; your order, if placed, will be placed as a limit order.

Orders can also be partially filled, and there are other factors that affect execution.  We'll cover those topics in future articles. 

What About Those Markets 

You'd be surprised to discover how many sophisticated, longtime investors don't know the intricacies of the exchanges and over-the-counter markets, and are too shy to ask:

Listed markets are auction-style markets where issues are traded in a central "marketplace," with professionals who match investors' buy and sell orders via an open auction system.  Prices are determined by  matching the best asking price with the best selling price.

Listed markets offer the stocks of some 6,000 companies in the U.S.  The best known of these, of course, is the New York Stock Exchange, whose companies must be registered with the Securities and Exchange Commission and meet specific qualifications as to shares outstanding, earnings, market value, tangible assets and share price; this is why the NYSE's companies tend to be large and well established.  The other listed markets are the regional exchanges (the Pacific and Philadelphia exchanges, for example). The regionals compete on some of the same stocks as the NYSE, as well as serving smaller orders.

The over-the-counter market, or OTC, is the principal trading market for securities not traded on one of the exchanges.  Traditionally OTCs have been dealer markets, which means that shares are bought from and sold to market makers, who are dealers in individual securities.  The OTC market has provided an important mart for stocks of countless growing companies.  There are three markets for OTC trading:  The Nasdaq, the Pink Sheets, and the OTC bulletin boards.

The Nasdaq, or National Association of Securities Dealers Automated Quotation system, established in 1971, is a computerized network that provides bid and ask prices on more than 5,000 securities.  Capitalization and volume requirements are smaller for the Nasdaq than for the listed exchanges.  The Nasdaq has two levels:  the Nasdaq National Market, for nearly 5,000 well-capitalized companies that must meet strict standards for listing and corporate governance; and the Nasdaq Small-Cap Market, for about 1,000 smaller, emerging companies, with listing requirements less stringent than for the National Market.  All Nasdaq quotes are entered into a nationwide automated computer system that links market makers and customers.  Execution speed varies based on the market where the order is placed, the number of shares available, market conditions, size of order and volume of trading in that stock.

Thousands of less-actively traded stocks that don't qualify for Nasdaq listing are carried on Pink Sheets, a company that publishes stock price "indications" rather than true bids and asks.  To trade a Pink Sheets stock, a broker must obtain a price quotation by phone from at least market makers, which can slow execution.

The NASD's electronic bulletin board, established in1990, carries quotes for several thousand stocks previously quoted only on Pink Sheets.  While you get quotes more quickly, your trades are still handled manually. For both bulletin board and Pink Sheet stocks, prices are not current and are indications only of where a stock might trade.  Generally these stocks are not actively traded and thus have comparatively large spreads between bids and asks.  Moreover, bulletin board companies are thinly capitalized, not followed by analysts, and may not be required to file financial reports with the SEC, all making it difficult for investors to judge the risks of trading them.