Execution: A Guide to Types and Examples

What Is an Execution?

Execution is the process of completing a buy or sell order for securities in the financial markets. When executed, trades are filled, which signifies actual ownership of the asset. Understanding how the process works and why it's so important in the financial markets can help you tailor your investment strategies so you can make better investment decisions. Keep reading to learn about different order types, how they're executed, and broker obligations to ensure the best execution for their clients.

How Execution Works in Financial Markets

Brokers are required by law to give investors the best execution possible. The Securities and Exchange Commission (SEC) requires brokers to report the quality of their executions on a stock by stock basis as well as to notify customers who did not have their orders routed for best execution. The cost of executing trades has been significantly reduced due to the growth of online brokers. Many brokers offer their customers a commission rebate if they execute a certain amount of trades or dollar value per month. This is particularly important for short-term traders where execution costs need to be kept as low as possible.

If the order placed is a market order or an order which can be converted into a market order relatively quickly, then the chances that it will be settled at the desired price are high. But there might be instances, especially in the case of a large order that is broken down into several small orders, when it might be difficult to execute at the best possible price range. In such cases, an execution risk is introduced into the system. The risk refers to the lag between the placement of an order and its settlement.

Methods for Executing Stock Orders

• Order to the Floor: This can be time-consuming because a human trader processes the transaction. The floor broker needs to receive the order and fill it.
• Order to Market Maker: On exchanges such as the Nasdaq, market makers are responsible for providing liquidity. The investor's broker may direct the trade to one of these market makers for execution.
• Electronic Communications Network (ECN): An efficient method, whereby computer systems electronically match up buy and sell orders.
• Internalization: If the broker holds an inventory of the stock in question, it may decide to execute the order in-house. Brokers refer to this as an internal crossing.

Broker Responsibilities for Best Order Execution

By law, brokers are obligated to give each of their investors the best possible order execution. There is, however, the debate over whether this happens, or if brokers are routing the orders for other reasons, like the additional revenue streams we outlined above.

Let's say, for example, you want to buy 1,000 shares of the TSJ Sports Conglomerate, which is selling at the current price of $40. You place the market order, and it gets filled at $40.10. That means the order costs you an additional $100. Some brokers state that they always "fight for an extra one-sixteenth," but in reality, the opportunity for price improvement is simply an opportunity and not a guarantee. Also, when the broker tries for a better price (for a limit order), the speed and the likelihood of execution diminishes. However, the market itself, and not the broker, may be the culprit of an order not being executed at the quoted price, especially in fast-moving markets.

It is somewhat of a high-wire act that brokers walk in trying to execute trades in the best interest of their clients as well as their own. But as we will learn, the SEC has put measures in place to tilt the scale toward the client's best interests.

The SEC has taken steps to ensure that investors get the best execution, with rules forcing brokers to report the quality of executions on a stock-by-stock basis, including how market orders are executed and what the execution price is compared to the public quote's effective spreads. In addition, when a broker, while executing an order from an investor using a limit order, provides the execution at a better price than the public quotes, that broker must report the details of these better prices. With these rules in place, it is much easier to determine which brokers get the best prices and which ones use them only as a marketing pitch.

Additionally, the SEC requires broker/dealers to notify their customers if their orders are not routed for best execution. Typically, this disclosure is on the trade confirmation slip you receive after placing your order. Unfortunately, this disclaimer almost always goes unnoticed.

The Role of Dark Pools in Trade Execution

Dark pools are private exchanges or forums that are designed to help institutional investors execute their large orders by not disclosing their quantity. Because dark pools are primarily used by institutions, it is often easier to find liquidity to execute a block trade at a better price than if it was executed on a public exchange, such as the Nasdaq or New York Stock Exchange. If an institutional trader places a sizable order on a public exchange, it is visible in the order book and other investors may discover that there is a large buy or sell order getting executed which could push the price of the stock lower.

Most dark pools also offer execution at the mid-point of the bid and ask price which helps brokers achieve the best possible execution for their customers. For example, if a stock’s bid price was $100 and the asking price was $101, a market order could get executed at $100.50 if there was a seller at that price in the dark pool. Main Street is generally skeptical of dark pools due to their lack of transparency and lack of access to retail investors.

Real-World Example of Stock Order Execution

Suppose Olga enters an order to sell 500 shares of stock ABC for $25. Her broker is under obligation to find the best possible execution price for the stock. He investigates the stock's prices across markets and finds that he can get a price of $25.50 for the stock internally versus the $25.25 price at which it is trading in the markets. The broker executes the order internally and nets a profit of $125 for Olga.