Understanding Trade Execution: A Comprehensive Guide

Trade execution is when a buy or sell order gets fulfilled. In order for a trade to be executed, an investor who trades using a brokerageBrokerageA brokerage provides intermediary services in various areas, e.g., investing, obtaining a loan, or purchasing real estate. A broker is an intermediary who account would first submit a buy or sell order, which then gets sent to a broker. On behalf of the investor, the broker would then decide which market to send the order to. Once the order is in the market and it gets fulfilled, only then can it be considered executed.

The timing and method used for the trade execution will affect the price investors will end up paying for the stock. The timingTrade Order Timing - TradingTrade order timing refers to the shelf-life of a specific trade order. The most common types of trade order timing are market orders, GTC orders, is important to note because trades are not executed instantaneously. Since trades need to go to a broker before going to the market, stock prices may be different than what the investor ordered by the time the trade is fulfilled.

Different Methods of Trade Execution

1. Market Maker

Instead of sending an order to the market, a broker may opt to send it to a market makerMarket MakerMarket maker refers to a firm or an individual that engages in two-sided markets of a given security. It means that it provides bids and asks in tandem with instead. A market maker is a firm that buys or sells a stock. In order to attract brokers to send the orders to them, a market maker may pay the broker to direct the flow of orders to them. This payment is referred to as a “payment for order flow.”

2. Over-the-Counter (OTC) Market Maker

Investors may trade stocks over-the-counter. In this case, an over-the-counter market maker may pay a broker to direct them to send the order to them.

3. Electronic Communications Network (ECN)

Investors’ buy and sell orders can be routed to an ECN, where a computer system will match up buy and sell orders together. This may happen especially in a situation where there is a limit order, which is when the investor requests a specific price to buy and sell a stock.

4. Internalization

Sometimes, the broker’s firm may already own shares of the stock. In such a case, the trade execution is done in-house by filling the order using the firm’s inventory of stocks. The broker may be able to earn a profit from this execution if there is a difference between the bid-ask spread.

An Obligation to Conduct the Best Execution

Brokers are required to execute a transaction that is best for their client. In doing so, brokers would evaluate all the orders that they would receive from their clients and assess which market, market maker, or electronic communications network will provide the best prices for execution.

Sometimes, there is an opportunity for a trade execution to be carried out at a better price than what was quoted in the order. It is an opportunity for “price improvement,” which is an important consideration when brokers are deciding the timing and method for a trade execution.

For example, an investor enters a market order to buy 100 shares of stock. The stock’s current price is $50. A broker may send the investor’s order to a market maker that can offer a stock price better than $50. If the broker ends up sending the order to a market maker that offers a stock price of $49, then the investor buys the shares at the lower price.

Not All Trades Can Be Executed

Not all trade executions can be fulfilled. For example, a buy order may be very large and cannot be filled at the same time. It will be broken down into smaller orders so it will be easier to fulfill. In such a case, the trade will be executed at different times and at different prices.

Additionally, a limit buy order and a limit sell order may not always get executed as well. A limit buy order will not be executed if the stock price is always higher than the limit buy order price. A limit sell order will also not be executed if the stock price is always lower than the limit sell order price.

Additional Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™Program Page - CMSAEnroll in CFI's CMSA® program and become a certified Capital Markets &Securities Analyst. Advance your career with our certification programs and courses. certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Alternative Trading System (ATS)Alternative Trading System (ATS)An Alternative Trading System (ATS) is a North American term that refers to a trading venue that matches buyers and sellers for transactions.
• Order BookOrder BookAn order book is a list of orders that presents different offers from buyers and sellers for a specific security. It shows the prices and volumes
• Stop-Limit OrderStop-Limit OrderA stop-limit order is a tool that traders use to mitigate trade risks by specifying the highest or lowest price of stocks they are willing to
• Trading FloorTrading FloorA trading floor refers to a literal floor in a building where equity, fixed income, futures, options, commodities, or foreign exchange traders buy and sell securities.