Trade Execution: Why Quality Matters for your Performance
Trade execution quality is one of the most overlooked investing topics. Many investors and professionals are unaware that the type of execution matters regarding performance.
When your investment advisor buys a financial security your performance is affected by ‘how’ and ‘where’ your order is executed.
In this article you will understand one of the major influencers of performance - trade execution quality.
In fact, the article is more of an answer to a comment on our Facebook page.
English Translation: "I have invested for six months and my loss is -1.5% while the market and competitors with similar approaches are up"
What is Trade Execution?
Trade execution occurs when the buy or sell order is fulfilled.
When an investor intends to buy a financial security, he clicks the buy button in his online brokerage account, this order goes to his broker, dealer who sends this order to an exchange, or the market maker for ‘execution’.
The flowchart below demonstrates the execution process.
Trade Execution Process for Equity Order (Individual Investor)
The manner in which your orders are filled refers to the quality of execution. Cost and speed are the two crucial determinants of quality.
Best execution refers to the most advantageous execution of your order.
In simple words, you seek the best price to trade among multiple exchanges; the lowest available price when you buy and the highest available price when you sell.
The best quality of execution!
Quality matters since if you end up buying a financial security for 120€ when you could have bought it for 119€ you probably did not get the best quality.
Good trade execution largely depends on the number of exchanges your financial advisor offers.
If the advisor trades solely on a private trade venue you get a narrow range of prices, however, if he offers multiple exchanges he can select the best price from a wide range of prices.
SAMT AG has access to over 130 exchanges, and can buy securities at the best price. Later in this article we’ll show exactly how much money this could mean for you.
Order execution is not as straightforward as people believe it to be.
A misconception is that an investor’s online account directly connects with the securities market for untouched instant execution.
Your broker has several market options to send your trade order to. Take a look at the following figure:
- If a stock is listed on an exchange, say DAX, the broker might send your order to the DAX exchange, to a regional exchange (perhaps to earn better broker commissions) or to the third market maker (a firm ready to buy/sell stocks listed on an exchange at public quotes). Regional exchanges and third market makers might offer additional compensation to your broker to send orders their way, also known as ‘payment for order flow’.
- Your broker could send your order for a stock that trades in OTC (Over The Counter market), to its specific market maker. If your stock trades at Nasdaq (which is an OTC) your broker might send your order to the Nasdaq market maker, which pays brokers for sending them orders.
- Brokers can route your order - especially the limit order (see FAQs below for definition) - to ECN (Electronic Communications Network) that matches buy-sell orders automatically.
- Brokers use ‘internalization’ to fulfil orders in-house using their own inventory, and make money from the ‘spread’ (the difference between the bid and ask price).
Different Exchanges Different Prices
This might come as a surprise to you that the price of a security varies across different exchanges. And when you invest your broker may direct your order to a platform of his liking.
It is upon the broker’s discretion, if he trades in his best interest, or yours.
Say, you put a market order to buy Amazon (AMZN) stock. The stock price will vary across different execution venues.
The following screenshot shows its price over different exchanges simultaneously.
Let’s compare Tradegate and Frankfurt exchanges side by side.
The difference in prices and spreads is evident, but what’s in it for the broker if they execute on one exchange and not the other?
How much brokers earn from Low Execution Quality?
Imagine you press the buy button upon seeing Amazon’s price on the internet. Your order goes to the broker, then he had to decide to which exchange he should send this order to.
The norm is that broker firm deceive their customers. Chances are that your broker will buy Amazon on Frankfurt at 1425.09 EUR as he should since it is cheaper. However, you won’t see Frankfurt price.
The broker would show you the price of 1431.07 EUR on Tradegate despite executing on Frankfurt.
When selling, the broker would use the same tactic but in reverse, by selling on Tradegate at 1431.07 EUR but showing you the price of 1425.09 EUR on Frankfurt.
The result is that you lose money and the broker makes money.
How much you lose with Low Quality Execution?
This money that the broker made was yours. You should have gotten the best execution quality; lowest price when buying and the highest when selling.
In percentage terms, that’s a loss of 0.48% or 5.98€ each time you trade.
Imagine this loss accumulating over months or years!
No wonder investors don’t understand how they lose money despite investment planning.
Moreover, finding the optimal platform to trade can be tricky, the investor must carefully weigh his options.
For example, you want to buy ETF shares and realize that on one platform you can trade for free compared to others that charge money.
You might think to yourself, ‘Free! what could go wrong.’
In such cases, the other platforms usually offer the same ETF shares at a lower price.
And later when you compare the overall costs the ‘free’ exchange might in fact turn out to be more costly.
Yes, that ‘free trade’ is bait.
The switching of execution prices by brokers and the trap of ‘free’ are relatively straightforward to spot. However, there are many convoluted tactics that brokers readily use.
One needs to dig deep to reveal exactly how investor’s wealth keeps sapping.
Your Exchange might not even be executing your trades
Brokers and exchanges have leeway in executing your orders to the point that they won’t even be executing but still make money from it.
Here’s an example:
Say, client A sells a security for $9 and client B buys the same security for $11. The broker could show both these clients that their trades have been executed in their accounts.
In reality however, no trade would have occured. Irrespective of market swings, the broker made $2 from the Spread (difference between bid and ask).
In such cases where no trade occurs, the broker’s only risk is the difference between the number of customers buying and selling.
By effectively hedging this risk, the broker can easily make money since they’re not executing clients’ trades.
If the number of customers that are long is equal to the number that are short, the broker has virtually no risk.
How Execution Speed affects your Profits?
A popular misconception is that when you press the buy or sell button the order is immediately fulfilled.
The truth is there are many ways in which time delays between when you press the button and when the order is executed affects your costs of transaction.
Michael Lewis, the author of Flash Boys elaborates in his book, how the microseconds in between pressing the buy or sell button and order execution are critical.
Say, you want to buy a company share priced at $10, you press the buy button.
The owner of the exchange might buy the same share upon ‘seeing’ that your Robo Advisor has pressed the button in those microseconds (since your trade is not executed yet), and will sell it back to you at $11, without you noticing this change.
Unfortunately, the game of stock trading has become skewed towards the fastest trader.
The truth is that the security trades are ‘front run’; the other party knows that you want to buy 100 ETFs of xyz (for example) so he buys before you at cheaper rate and later sells it to you at a higher price.
The cycle repeats emphatically if your trade gets executed over a private venue like Lange and Schwarz or Gettex (where Baader Bank is the only market maker).
On venues like Gettex, one party (and their affiliates) own everything and assume the opposite position to your order, and then decide the price they want to give you since they are the other party.
You might ask, why would a Robo Advisor sell your trade execution to someone else and not execute itself?
The reason is that they get money by selling it to a bank or a private exchange. The exchange owner/bank gives you 1% to 3% worse price than the price on established exchanges.
The bank or private exchange owner gets this money directly in their pockets and pays some to the advisor for sending them the trade (Just like Robinhood, explained below).
Customers find it hard to understand as they would have to know the prices on other exchanges.
However, the clients can compare performances, which is especially true for passive investment products.
If your advisor’s performance regarding passive investing is much lower in comparison it’s probably due to bad execution.
Besides elaborating bad execution quality, Lewis reveals in his book the underworld of stock exchanges, dark pools.
What are Dark Pools?
Dark pools are private exchanges where investors can secretly trade high volumes of securities without making the information public.
As a result, even if the order size is large it gets fulfilled without altering the price.
Sounds fair, but the story doesn’t end there.
These pools offer higher commissions to brokers to direct the order flow towards them, which compromises execution quality.
These sketchy trading platforms are separate from public exchanges such as DAX and NASDAQ.
Note that the term ‘dark’ exhibits gradation - there are regulated exchanges where one bank trades and another bank is the market maker, free to make any price they want for the customers trading on this exchange.
Since these are regulated and only make inferior prices than the established exchanges, they are called ‘grey exchanges’.
When an advisor sends trades to such exchanges the customers pay 1% - 2% higher execution prices.
Tradegate, Gettex, and Lange and Schwarz are the biggest European “grey pools”. Even some of the exchanges on the Interactive Brokers’ bid-ask are private exchanges.
Dark and grey pools have turned into hunting grounds for High Frequency Traders.
As mentioned in the Flash Boys, several banks prefer dark pools because they make more commissions (note: many dark pools are commission free, they charge with the spread only) by trading there, moreover, they sell High Frequency Traders (HFTs) the rights to exploit orders inside these pools.
The practice is not that uncommon. One only needs to read the fine print of financial service companies and the so-called robo advisors.
How Robo Advisors make money from Dark Pools?
Stock trading app Robinhood is a good example how a Robo-advisor makes money by sending your orders to dark pools.
Robinhood is a smartphone app where investors can invest ‘commission free’ in publicly traded companies and ETFs.
The company makes money through interest from customers’ cash balances, what investors don’t know is that the app sends their trades to private exchanges or dark pools.
Following is a snippet of Robinhood’s disclosure with the Securities & Exchange Commission (SEC).
Notice the four routing venues they send customer’s orders to in the snippet below.
For the securities listed on other exchanges like Nasdaq and NYSE MKT, the data is more or less the same, you can read the complete document here.
The highlight of this disclosure is Robinhood’s monetary arrangement for sending the order flow to the following companies.
||Paid Robinhood 1st Quarter 2018
|Apex Clearing Corporation
||Up to $0.00008 per dollar of executed trade
|Citadel Execution Services
||Up to $0.00026 per dollar of executed trade
|Two Sigma Securities, LLC
||Up to $0.00026 per dollar of executed trade
|Wolverine Securities, LLC
||Up to $0.00026 per dollar of executed trade
Bear in mind that all four companies operate dark pools either directly or indirectly.
To be fair, it should not matter where the customer’s non directed orders are being executed as long as the customer is getting the “best execution” as required by the SEC or MiFid II.
But when your orders end up in dark pools, chances are that either your broker, or robo-advisor is not following this rule or is bending it, so that the requirement of “best execution” holds true only in the absence of a regular lead exchange.
The amount of $0.00026 that these dark pools pay to execute trades seems small but it accumulates quickly.
Over the years you can expect a loss of 1% - 3% or more solely due to low execution quality.
How important is Execution Quality?
The quality of execution depends greatly on the nature of the order and circumstances.
For example, if you place a limit order then you shouldn't worry about the execution quality since your only risk is that the order might remain unfulfilled.
But when you place a market order then the place (the exchange at which the order is executed) and speed become crucial.
How to get the best Execution Quality?
Here are a few pointers that can help you get the best execution quality:
- Select your advisor wisely. Research everything you can about them, their reporting and disclosures with FINMA, SRO, BaFin, SEC or whichever authority governs trading activity in your country. The devil is in the details, read the fine print.
- Only for self traders. Compare the performance of comparable trading approaches for different advisors. If a “buy and hold” approach delivers substantially less than the market which is bought, probably something’s wrong.
- Know your execution destinations. The revised trading regulations - MiFID II in Europe and FIDLEG in Switzerland - have made broker’s requirements more stringent. Now, they are required to take “sufficient steps” to ensure best execution for their clients as opposed to the previous requirement of “reasonable steps”. Also, under the new regulations, banks are required to publish annually their top five execution destinations based on trading volume.
- Seek minimum active trade intervention. Invest for long term. This way you can avoid major issues accompanying low quality of execution since trading is reduced to the minimum by removing brokers’ incentive to send your trades to dark pools or to misrepresent stock prices.
- Arrange a performance-based payment with your advisor. This will decrease the risk of your trades being sold to dark pools that cause a huge loss (High Watermark - Performance-based payment at SAMT AG).
Some investment advisor offer trading “commission free” but they might sell your order to a grey or black pool where you lose a couple of percents of your investment each time they trade.
Be sure that your advisor includes the established exchanges like SIX Swiss Exchange or Xetra in the best execution research.
If your investment performance lags the market or similar investments it can be an indicator of a grey or dark pool execution.
Trade Execution on SAMT AG
SAMT AG executes trades while checking the prices on 130 exchange which includes the following exchanges:
- Swiss Exchange
- BATS Europe (BATECH)
- Chi-X Europe Ltd Swiss
- Turquoise TRQXCH
- BATS Europe (BATEDE)
- CHI-X Europe Ltd Clearstream
- Frankfurt Stock Exchange
- Stuttgart Stock Exchange
- Tradegate Exchange
- Turquoise TRQXDE
And some US exchanges like:
- New York Stock Exchange
SAMT execution algorithm offers discounts on adding or removing liquidity, commissions and stock or etf prices.
What does it mean to execute an order?
When the buy or sell order is fulfilled it is termed as execution. One needs to separate the two events; when the investor places the order and when it is fulfilled (execution). When the investor places in order, it goes to the broker or dealer, who determines how to execute it.
How a stock trade is executed?
When you press the enter key on your online account to place an order (to buy or sell a stock), it goes over to your broker, who then selects a market to execute it. The process is exactly the same when you place the order by calling your broker over the phone.
How long does it take to execute the trade?
When the shares are bought or sold in the stock market, the seller is required to deliver the shares while the buyer is required to deposit the money with his broker. This is known as trade settlement. When you are looking at your online brokerage account, it might seem that the order is executed immediately however, as per SEC rule each side is given time to complete their respective transactions. As of July 2012, a trade is required to be settled within three days, also known as T+3 settlement.
What is a market order?
When an order is placed to be executed immediately at the next available (market) price by the end of the day, it is a market order.
What is a limit order?
When the order is placed to buy or sell a security at or below a specified price, it is a limit order. These remain valid until executed, expired or cancelled.
What is a stop order?
When an order is placed to sell a financial security, if it reaches a certain price. This can be used as a loss-prevention measure as well as to take profits.
What is a day order?
The order required to be executed the same day is "day order". Most market orders are day orders.
What is a fill-or-kill order?
A fill-or-kill order uses an ‘all or nothing’ approach; the order needs to be filled completely or not at all.