Best Execution: 4 Order Types and Instructions
Abstract
The text emphasizes the concept of best execution, a fiduciary duty for stockbrokers to prioritize favorable conditions for client orders. Recent SEC proposals aim to enhance this framework, requiring detailed policies, disclosure of order practices, and periodic assessments. FINRA also mandates its members to follow best execution practices and disclose order flow payments. Key broker best practices include thorough reviews of execution quality and obtaining client consent before routing orders. Investors are reminded that best execution is dynamic and doesn't ensure the lowest price. Financial advisors must understand various order types, like market, limit, stop, and stop-limit orders, to effectively navigate markets for their clients.
Time to read: 5 to 7 minutes.
Level: Fundamental.
Category: Education Note.
Best Execution in the Stock Market: How Brokers Fulfill Their Duty to Customers
The obligation of stockbrokers to seek the most favorable conditions for client orders, considering factors such as price, speed, quality, and execution cost, defines the concept of best execution. It is a fiduciary duty that necessitates brokers to act in the best interest of their clients and disclose any conflicts of interest that may impact order routing decisions.
The Securities and Exchange Commission (SEC) recently proposed a comprehensive best execution framework for brokers, aiming to enhance existing requirements and address challenges in the current market structure. The proposed rules mandate brokers to establish detailed policies and procedures for achieving best execution, disclose more information about their order routing and execution practices, and conduct periodic assessments of execution quality and potential conflicts of interest. The proposed standards also impose greater obligations on brokers facing specific conflicts, such as order flow payment, internalization, or affiliation with a trading center.
Additionally, the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization for brokers, has rules and guidance on best execution and order flow payment applicable to its members. FINRA requires its members to have written policies and procedures for best execution, conduct periodic reviews of execution quality, and report order routing and execution data to FINRA and the public. Members must also disclose to clients any payment for order flow agreements or other incentives that may influence order routing decisions. FINRA conducts examinations and enforcement actions to ensure members comply with their best execution and order flow payment obligations.
Key best practices for brokers to achieve best execution and comply with relevant regulations include:
Establishing and maintaining written policies and procedures addressing the evaluation, monitoring, and review of client order execution quality.
Conducting regular and thorough reviews of execution quality, comparing it with other execution venues and brokers.
Seeking competitive quotes from multiple sources and considering the full range and quality of services offered by different brokers.
Disclosing material aspects of order routing and execution practices, including any payment for order flow agreements or incentives that may affect order routing decisions.
Obtaining prior consent from clients before routing orders to an affiliated broker or a broker providing payment for order flow.
Maintaining accurate and comprehensive records of order routing and execution activities and providing them to regulators upon request.
Investors should understand that best execution does not guarantee the lowest possible price or the best possible outcome for their orders. It is a dynamic and evolving process dependent on the specific circumstances of each order and market conditions at the time of execution. Investors have the right to inquire about their broker's order routing and execution practices and receive clear and honest information. Reviewing trade confirmations and account statements is crucial to verifying the accuracy and completeness of order execution details.
As a financial advisor, executing orders in the markets on behalf of clients requires a nuanced understanding of different order types, their advantages and disadvantages, and the pitfalls of overtrading that can harm clients and reputations.
Type of Stock Orders: What They Are, How They Work, and When to Use Them
The following general descriptions represent some of the common order types and trading instructions that investors may use to buy and sell stocks. Please note, order types and trading instructions available to you may differ between brokerage firms. Some brokerage firms may not offer some of the order types and trading instructions described below. Also, some brokerage firms may offer additional order types and trading instructions not described below. You should contact your brokerage firm to determine which types of orders and trading instructions it has available for buying and selling stocks as well the firm’s specific policies regarding the use of these orders and trading instructions.
Types of orders commonly used for market transactions, depending on client objectives, risk tolerance, and preferences, include:
Market Order: A market order is a directive to buy or sell a stock at the best available price, usually executed promptly. However, the execution price is not guaranteed, and investors should note that the last-traded price may differ from the market order execution price. In dynamic markets, the execution price of a market order may deviate from the last-traded price or real-time quote. Furthermore, in fast-moving markets, different segments of a large market order may execute at varying prices
Limit Order: A limit order is a directive to buy or sell a stock at a specified price or a better one. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. The execution of a limit order is not assured and can only occur if the stock's market price reaches the specified limit. Although limit orders do not guarantee execution, they serve to prevent an investor from paying more than a predetermined price for a stock.
Stop Order:A stop order, also known as a stop-loss order, is a directive to buy or sell a stock when its price reaches a specified level, called the stop price. Upon reaching the stop price, the stop order transforms into a market order. A buy stop order is placed above the current market price, typically to limit a loss or protect a profit on a short-sold stock. Conversely, a sell stop order is entered below the current market price to limit a loss or protect a profit on a held stock.
Investors should carefully choose the stop price, considering short-term market fluctuations. The stop price is not a guaranteed execution price; it triggers the stop order to become a market order, and the actual execution price may significantly differ in rapidly changing markets. To mitigate this risk, investors can opt for a stop-limit order, although the limit price might prevent execution.
Different trading venues and firms may use varied criteria to determine if a stop price has been reached, relying on last-sale prices or quotation prices. Investors are advised to confirm the applicable standard with their brokerage firms before utilizing stop orders.
Stop-Limit Order: A stop-limit order is a hybrid directive for buying or selling a stock, combining aspects of both stop and limit orders. Upon reaching the stop price, it transforms into a limit order, set to execute at a specified price or better. This order type allows investors to exert control over the execution price. Before utilizing a stop-limit order, investors should consider the following:
Similar to all limit orders, a stop-limit order may not execute if the stock's price deviates from the specified limit, especially in a fast-moving market.
The stop price and limit price need not be identical. For instance, a sell stop-limit order with a stop price of $3.00 may have a limit price of $2.50, executing only at $2.50 or a better price when the market reaches $3.00.
Prudent selection of stop and limit prices is essential due to short-term market fluctuations that can activate a stop-limit order.
Different trading venues and firms may employ distinct criteria for determining whether the stop price of a stop-limit order has been reached, using either last-sale prices or quotation prices. Investors should clarify the applicable standard with their brokerage firms before employing stop-limit orders.
Trailing-Stop Order: A trailing stop order is a variation of a stop or stop-limit order where the stop price is not a fixed value but is instead a defined percentage or dollar amount above or below the current market price ("trailing stop price"). As the security's price moves favorably, the trailing stop price adjusts or "trails" the market price by the specified amount. If the price moves unfavorably, the trailing stop price remains fixed, triggering the order if reached. Considerations for investors using trailing stop orders include:
Thoughtful selection of the trailing stop price is crucial, given that short-term market fluctuations can activate the order.
Different trading venues may have distinct criteria for determining if the trailing stop price has been reached, using last-sale prices or quotation prices. Investors should verify this information with their brokerage firms before employing trailing stop orders.
Trading instructions and timing restrictions
These basic order types apply to most markets and securities. However, additional trading instructions and timing restrictions may exist, such as:
Day Orders: These orders to buy or sell stocks are valid only during the trading day, expiring if not executed by the end of regular trading hours. They do not automatically carry over into after-hours trading or the next trading day.
Good-Til-Canceled (GTC) Orders: GTC orders remain active until completed or canceled. Brokerage firms may impose time limits on how long investors can leave GTC orders open, varying between brokers.
Immediate-Or-Cancel (IOC) Orders: An IOC order requires immediate execution; any unfilled portion is promptly canceled.
Fill-Or-Kill (FOK) Orders: FOK orders mandate immediate and complete execution; if any part cannot be fulfilled instantly, the entire order is canceled.
All-Or-None (AON) Orders: AON orders must be executed entirely or not at all. Unlike FOK orders, AON orders remain active until fully executed or canceled, even if not immediately fulfilled.
On Open Orders: These market or limit orders must execute when the market opens. Any unfulfilled balance is canceled after the opening trade.
On Close Orders: Market or limit orders must execute at the closing price, with any remaining balance canceled after the closing trade.
In conclusion, understanding and adhering to best execution principles, along with knowledge of various order types, possibilities and restrictions, empower financial advisors to navigate markets effectively while serving the best interests of their clients.
References:
Harris, Larry. Trading and Exchanges: Market Microstructure for Practitioners. Oxford University Press, 2003.
Angel, James J., Lawrence E. Harris, and Chester S. Spatt. Equity Trading in the 21st Century. Quarterly Journal of Finance 1, no. 1 (2011): 1-53
Recommended Readings:
Lehalle, Charles-Albert, and Sophie Laruelle. Market Microstructure in Practice. 2nd ed. Singapore: World Scientific, 2018.
Dale, Trader. Order Flow: Trading Setups. 1st ed. New York: CreateSpace Independent Publishing Platform, 2021.
