Execution, validity, and clearing instructions

45.g: Execution, validity, and clearing instructions

Trading involves buying and selling of securities. Price at which trader is willing to buy securities is called bid price while the price at which the counterparty is willing to sell is called ask price. The highest price offered by the buyer is called the best bid while the ask price is called the best offer. The difference between the two is market bid-ask spread.

Bid size and ask size is the quantity that traders are willing to buy and sell respectively.

Execution instructions

A market order is one where the trader instructs the broker to execute or fill the trade (buy or sell) at the best price immediately available. These orders are generally settled quickly but can be costly if the volume involved is larger than usual as the counterparties can start bidding higher or lower (on buy or sell).

A limit order, on the other hand, is one where the trader puts a limit on the highest or lowest price at which she is willing to buy or sell the security. These orders take some time to fill but generally give a better price to the trader. The interplay of limit price vs. the market price decides the marketability of an order:

• Limit buy order is aggressively priced if the limit price is higher than the current market bid/ask price

• Marketable order is one where the limit buy price is placed higher than the best offer price

• If the limit price is set below the offer price but above the best bid, then a new market with new best bid is set

• Limit price set at the current bid makes a market. It will be executed only when all other orders placed before it are filled

• Limit price set below the best bid will be filled if security prices drop. Such orders are said to be behind the market


Along with price, traders can set limits of quantity or order size as well. All or nothing orders are filled only if all the available quantity is bought/sold.

Making and taking the market: A trader makes a market when she offers to trade and takes a market when she accepts an offer to trade. Market orders and marketable orders take the market while standing limit orders make the market. There is execution certainty with the orders that take the market and price certainty with the orders that make the market.

Instructions

Exposure instructions regulate the dissemination of order knowledge to market participants by large traders. It helps the trader fend off any possible collusion by other traders that may hurt her profitability.

Hidden orders are known only to the exchanges/brokers who receive them. Such orders can, however, be difficult to execute. Hence, some traders indicate some part or display size of their order while keeping the total quantity a secret. These are also known as iceberg orders.

Validity instructions indicate the duration in which orders can be executed.

• Day orders are valid on the day they are issued and expire at the end of day if not executed.

• Good-till cancel orders by definition should remain valid until they are executed, but most brokers set a limit of few months to avoid any confusion with the client.

• Immediate or cancel orders have to be executed in part or in whole or they cancel immediately. They are also known as fill or kill orders.

• Good-on-close orders can be executed only at the closing of trading hours. Mutual funds often use these orders as their NAVs are calculated at day’s closing prices.

Stop orders: If the trader has specified a stop price condition, then the order is called as a stop order. The orders will be fulfilled only after the stop price condition has been satisfied. A sell order with a stop condition becomes valid only after the price falls below the specified stop price. A buy order with a stop condition becomes valid only after the price rises above the specified stop price.

These stop orders are generally referred to as stop-loss orders. A trader that had shorted a security would put a stop buy order and a trader that had bought a security would put a stop sell order. The stop orders could be either market orders or limit orders. For example, if a trader bought a share at $50.50 and put a stop sell order of $49.90 as a limit order, then an order will be placed at $49.90 once the price falls to $49.89 or lower. The problem with the limit order is execution uncertainty that defeats the purpose of stop loss. So, most of the traders put stop loss market orders.

Clearing instructions represent communication regarding the final settlement of trades and include details of which entities would be responsible for clearing and settling of trades. In the case of retail investors, customer brokers are usually the entity, while institutional investors may use different brokers and custodian to take advantage of their specialized services. An important part of clearing instruction is an indication of whether the security sales order is a long sale or short sale so that the broker arranging the trade can be sure of delivering securities.

Check your concepts:

(45.21) The last traded price for a stock is $45.01. The best bid and the best ask in the market are at $45.04 and $45.06 respectively. A trader places a buy order for 100 shares at the last traded price. The order is most likely to be classified as a:

(a) Marketable limit order
(b) Market order
(c) Standing limit order

(45.22) The bid-ask prices for a stock are at $23.19 and $23.26 respectively. A trader places a sell order at a price of $23.21. The order is most likely to be:

(a) Taking the market
(b) Making the market
(c) Making a new market

(45.23) In which of the following orders, a trader is most likely to get the worst price for her order?

(a) Market order
(b) Limit order
(c) Stop order

Solutions:

(45.21) Correct Answer is C: The buy order is placed behind the best bid and this type of order is called standing limit order.

(45.22) Correct Answer is C: When an order is placed in between the best bid and best ask, then the order is said to be making a new market.

(45.23) Correct Answer is C: A limit order is placed behind the best bid and generally gets the best price. A market order is an order that is ready to take the market at any price. A stop-buy order is generally placed at a price above the best ask price and a stop sell order is generally placed at a price lower than the best bid price. So, a stop order is most likely to get the worst executed price.