Updated: January 16, 2020
Order routing is the process by which a buy or sell order in the stock market is placed. In the past there were limited options, and non-institutional traders had to place orders through a trading desk. The problem with routing orders through a trading desk was that it could cause delays in order execution, putting the trader at a disadvantage.
The emergence of Direct Access Trading (DAT) eliminated the middleman from the trade execution process, making the market directly accessible to traders. Today, there are a multitude of ways to execute orders to buy or sell stocks and other asset classes. Variations in the process will largely depend on the brokerage firm that holds the trader’s account, as well as the type of account being held. Here are some explanations of how order routing works in each of the different types of trading accounts:
Retail and Discount Brokerages - Simple Electronic Access Accounts
A great majority of day traders and investors use an account type referred to as Simple Electronic Access. In this type of account, the burden to match up buyers and sellers to complete transaction within the stock market is absorbed by the brokerage firm. In other words, the investor specifies to the broker, generally via internet access, the conditions of the buy or sell order he would like to place. These conditions include: the stock symbol, the intention to buy or sell, the number of shares to trade and instructions for executing the order.
Depth of Market - Direct Access Trading Accounts
Most Depth of Market (DOME) accesses, such as NASDAQ’s Level II® or NYSE’s Open Book®, are provided to the brokerages which then offer it to their clientele. At this point, the Direct Order Entry Brokerages hand the burden of hunting for buyers or sellers to the customer. The customer is given access to a multitude of ways to execute an order provided by the major stock exchanges through the electronic system of order routing.
Electronic Communication Network (ECN)
ECNs give the trader the ability to directly communicate and trade with other traders or investors without having to go through trade desks. While, in 1997, ECNs were only incorporated into DAT with the NASDAQ, today, ECNs are allowed to participate in all listed exchanges. DOME’s are accessible for futures and options trading. Only Forex lacks the benefit of Direct Access Trading.
Some ECN Facts:
- ECNs are a trader’s means to post bids and offers to exhibit to the entire market
- There are several ECNs in the market, some examples are: ARCA, NSDQ, EDGA, EDGX
- It is possible to take advantage of buying from or selling to all posted ECNs. However, the ability to use ECNs to post bids and offers is limited to only the ones the trader’s brokerage has subscriptions to use
- ECN’s are now owned by the Market Makers. This was done to assure the Market Maker’s anonymity and hide order size
Smart Routes or Macros Keys
Smart routes are algorithms that a specific type of DAT software uses to assist the trader in buying or selling stock without having to push so many buttons to hunt for liquidity. Smart routes are not a specific trading system – they are merely macro or hot keys that contain a set of instructions on how a specific trader wants to send out buy or sell orders based on certain conditions. These instructions can be customized by the trader or are simply pre-set by direct access brokers or the trading software developer. There are a multitude of ways smart routes are configured, all with the intention of making the search for liquidity easier for the trader.
Importance of Order Routing
In the trading of equities, the method used to route orders is an important one because of the potential for small price improvements and, in many cases, being able to place the right kind of order during "fast market" periods. Since the modern stock market is made up of several "sub-markets" (ECNs and market makers), a trader's aptitude in the use of proper order routing to find the liquidity he or she needs to get the order executed is quite essential, especially on the NASDAQ.
While small price improvements may seemingly have little significance to a particular trade, price inefficiencies in order executions can collectively add up to a significant amount over a long period of time. This is especially the case for traders who tend to be more active. For example, while a 5-cent differential in a trade may seem to be insignificant, this equates to $50 on a one thousand share order! Taken collectively on a set of trades over a long period of time, these $50 inefficiencies can add up to several thousand dollars, all due to inefficient order placement.
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