Option Investor
Trader's Corner

Dirty Little Secrets

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Lots of traders have a dirty little secret. They don't truly understand how order execution works. It's not too difficult to set up an online order and click "send," but what happens to the order you've sent? What's "internalization" or "payment for order flow"?

The SEC wants to help. Believe it or not, a government site has a clear and simple explanation of order execution, complete with a graphic describing the various steps. The explanation and graphics can be found at http://www.sec.gov/investor/pubs/tradexec.htm

Because the site explains the basics of order execution, I won't go into a complete discussion here, but what about those terms I asked about in the opening paragraph?

Your broker sometimes internalizes your orders. This happens when the broker routes your order to a division of the broker's firm. That division then fills your order out of its own inventory. Your order never makes it past your own brokerage, and that brokerage has the opportunity to make money on the spread.

Some brokerages send your orders to a regional exchange or to what is known as a "third market maker," a firm that agrees to buy or sell a stock at the publicly quoted prices. These regional exchanges and third market makers want your brokerage's business, so they may pay your brokerage (not your individual broker) for routing your orders to them.

There's been some controversy about payment for order flow. Some traders don't like the idea of using brokerages that pay for order flow, feeling as if they're not getting the best prices despite the requirement that they get the publicly quoted price. Some researchers believe that, although there's some variability among those companies providing order flow, some firms provide superior execution to the execution that traders might receive on an exchange such as the NYSE. Obviously, some may not.

The brokerages obviously like the tactic. They like it for reasons other than the rebate they receive for each order although those are an important source of income for some brokerages. Routing their orders this way is equivalent to a small company hiring a firm to administer their payrolls, withholdings, employee insurance and other such matters. It allows small firms to compete with larger ones because they've been able to economize. They don't have to set up and maintain the infrastructure they would need to be able to execute a large number of orders each day. For this reason, if you ask your brokerage to route your order to a certain exchange, supposing that your brokerage allows such requests, your brokerage may ask you to pay a bit more in commissions.

It may be difficult for individual traders to sort out whether they benefit more from having a brokerage that doesn't accept payment for order flow or from one that does. Your broker does have the obligation to get you the best execution that it's able to receive, whether that's through an exchange, a market maker, an ECN or electronic communications network or through internalization.

However, even if your brokerage is doing all it can to obtain that best execution, doing so requires that the brokerage make some decisions. Is it best to send the order to a particular market maker where it might get a better price or, in the time it takes for the order to be transmitted, might that better price be gone?

Some brokerages are certainly better than others at getting you that best execution, either because of the brokerage's internalization and payment-for-order-flow practices or because of the decision-making process mentioned in the previous paragraph. You can check out some of this information. The SEC requires that all brokerages tell their customers the names of the market centers to which they send a significant number of their orders, asking that this material be gathered once a quarter. If you have questions, you can also request that your brokerage reveal where your individual orders were routed. They're required to provide this information for orders executed in the previous six months.

The market centers to which your orders might be routed are also required to make disclosures, and they're required to do it monthly and in detail. How do they handle market orders of various sizes? When customers send in limit orders, how are they doing with providing executions at prices that are better than the public quotes?

If you're not satisfied with your broker's record or the way your individual orders are being handled, you can contact prospective new brokers and ask them how order flow and internalization are handled in their firm. You can compare notes, but I wouldn't take their word alone. Take a look at the new account agreement for each brokerage you're considering.

The SEC has some other ideas for checking out brokerages, including a check of your brokerage through the www.nasd.com site, where you'll find information under "Investor Information," then "Investor Protection," and then "Check the Background of Your Investment Professional."

In addition to the other information, you'll find out if your broker has had any run-in's with the legal system. Let's hope that this discussion of some traders' dirty little secret, their lack of knowledge of how trades are executed, doesn't lead to a discovery that any of our subscribers' brokerages have dirty little secrets.

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