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TRADER'S NOTEBOOK


Bid/Ask And Order Execution

05/23/08 03:16:31 PM PST
by John Devcic

You hear them all the time, but do you really understand what these terms mean? Just to make sure.

Bid/ask spreads and order executions are two terms that often are misunderstood by both novice and experienced traders. So what are bid/ask spreads? I'll tell you, and then explain exactly what happens after you enter your order. This is important because the way a broker goes about executing your trades has an impact on your trading results.

WHO SETS PRICES?
To understand what the bid/ask price is and why there is a difference, you must understand that these prices are set by buyers and sellers. These prices will change all the time because they are set and reset by market action. Simply put, the bid/ask spread is what the security is actually worth at any given time.

Let's start with the ask price first. This is the current lowest price that the seller is willing to sell the security. The bid is what the buyers will currently pay for the security. The difference of the spread between the bid and ask can be as little as a matter of pennies or quite large, depending upon a number of factors. The biggest factor will be liquidity. The more liquid or easy to get in and out of positions, the lower the bid/ask spread will be.

BID/ASK SPREADS
You can see bid/ask spreads in the foreign exchange market as well as the NASDAQ. In order to expedite trades, brokers need to take a cut of the action. The spread, or the difference between the bid and ask price, is kept by the broker or specialist handling the transaction. This is the part that can get confusing. The spread is kept by the broker/specialist, but this is not the same thing as what you will pay your broker to make the trade for you.

Here's an example. Google's bid/ask spread is $583.18 (bid) $583.64 (ask). The difference between the two is 46 cents. This is what will be kept by the broker/specialists trading the stock. If you place a buy for Google, let's assume you buy the stock. I am also going to assume that you will pay the bid price. Remember, you will always be buying at the bid and selling at the ask price.

While the stock will cost you $583.18, you will still need to pay your broker's fee. Let's assume your broker charges you $10 to make a trade. This trade for one share at bid price will cost you $593.18. In the forex market, they do not charge a commission to place a trade, so the difference is only the spread. Let's take a bid/ask price for the euro/US dollar: 1.5466 (bid) 1.5463 (ask). In this case, you will only pay the bid price and sell at the ask price without a commission.

ORDER EXECUTION
And then what happens? A lot of traders, both novice and experienced, have no idea what goes on after they place an order. When you contact your broker and make a trade, he or she has a variety of ways in which to fulfill that transaction. Here are some of the ways your broker can fill your order:

1. Internalization. This is when the broker stays in house and your order is filled from the current inventory of the stock that the brokerage firm owns. This will often be the fastest way to have your order filled. We discussed spreads earlier in this article, and this is a great example of how a broker will make a profit off of this trade.
2. Electronic communications network (ECN). If you placed a limit order, your order will most likely be filled using an ECN. An ECN will automatically match buy and sell orders.
3. To the floor. If your order was for a stock traded on the NYSE, your order can be routed directly to the floor of the exchange or to a regional exchange. When this happens, a floor broker will take over and fill your order. This can take time and your order may not be executed right away.
4. Market maker. If your order was for a stock that trades on the NASDAQ, your broker may send your order to a market maker in charge of the stock you want to buy or sell.

Keep in mind that filling your order if your order is a market order is far more important to a broker than getting the best price. That's not to say that brokers do not look for the best price; instead, you should look at it as what they feel is more important to the customer. Most of the time, the customer will pay a little more for a stock in order to enter or exit a trade instead of entering or exiting that same trade with the best price.

If price is more important to you, do consider using something other than a market order. The Securities and Exchange Commission (SEC) has put laws into place to help protect customers from getting overcharged. On November 15, 2000, the SEC created two new rules that specifically addressed disclosure of order execution and routing practices. The biggest improvement for consumers is the ease at which they can compare what each broker will charge for an order to be executed.

Finally, it is important to note that the SEC requires brokers to tell customers if their order has not been routed for best execution. Next time you get your order confirmation slip, look through it. Your broker may inform you that your last trade was not made for the best execution.

The biggest point to take away from order execution is how important the added price of the execution is to you. If you are a daytrader, you need to have the best possible price because any extra cost will eat into any profits or add to any losses. On the flip side, if you are a long-term investor and you are buying a position in a stock, the best possible price is usually secondary to getting the order filled and initiating a position. If you have placed a limit order, you are more concerned with getting the right price versus having the order executed.

IT MAKES A DIFFERENCE
Bid/ask spreads and order executions are important to understand when trading stocks. If you are a daytrader or a long-term investor, understanding how the spread works and how your broker executes your order can help you decide what kind of orders to place. You need to keep an eye on the confirmation slip you receive from your broker. No matter if that confirmation slip is via email or regular mail, you need to look it over.

Next time you see a large discrepancy between the bid/ask spreads, you will understand what that means and how that spread can influence your trading decisions.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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