Electronic Trading: Small Order Execution System (SOES)

The lack of liquidity after the 1987 market crash lead the Nasdaq to implement a mandatory system to provide automatic order execution for individual traders with orders less than or equal to 1,000 shares. (For stocks with low volume, it may be less than 200 shares). Market makers must accept small order execution system (SOES) orders and so this provides excellent liquidity for smaller investors and traders.

There are several restrictions for those who are using SOES, rather than a traditional ECN, to place their orders.

1) Trades may not be in excess of 1,000 shares for a particular stock.

2) SOES doesn't not allow trades in stocks that are trading at prices greater than $250 per share.

3) Once a trader places an order through SOES, he or she must wait at least five minutes to place a trade through SOES on the same stock.

4) Short selling through SOES must comply with SEC rules and be on a zero plus tick basis only.

5) Institutions and brokers are not allowed to place orders for their own accounts through SOES, but they can for a client's account.

6) Market makers must honor their advertised bid/ask prices to SOES orders, provided that they are for the amount that the market maker is looking for.

Initially, when SOES was mandatory, it was met with heavy pessimism from Nasdaq member firms because it forced them to execute all SOES trades that met the market maker's advertised price. There were significant limitations implemented to prevent day traders from exploiting the system and taking advantage of old prices quoted by market makers.

SOES has revamped the trading market for individual investors. It has given small investors and traders the opportunity to compete on a level playing field for access to orders and execution.

Electronic Trading: SuperDOT

Initially introduced as DOT, the SuperDOT system (Super Designated Order Turnaround System) is an electronic system used to place orders for stocks that are listed, which usually refers to those trading on the New York Stock Exchange (NYSE). Keep in mind that SuperDOT is not to be confused with an electronic communication network (ECN), which we will discuss next.

The SuperDOT order-routing system facilitates the transmission of both market and limit orders directly to the trading post (and specialist) where the particular security is traded. This allows for a more efficient transaction because the order can be delivered directly to the specialist rather than phoned down to a floor trader and done manually. SuperDOT can be used for trades under 100,000 shares with priority given to orders of 2,100 shares or less. More than three-quarters of the orders executed through the NYSE are done through the assistance of the SuperDOT system.

After the order has been executed, the report of the transaction is sent back to the broker through the SuperDOT system. This means faster execution of the order and faster reporting of the trade. While most individual investors cannot have access to SuperDOT directly, there are complimentary systems offered by many brokers that replicate similar order executions provided by SuperDOT.

Originally, the SuperDOT system was designed for small order entry, but increasingly, SuperDOT has played a big role in portfolio or basket trading.

Electronic Trading: The Role of a Specialist

The NYSE facilitates trading through a human being who is known as the specialist. Each stock listed on the NYSE is allocated to a specialist and all the buying and selling of a stock occurs at the location of this person, known as "the trading post." Buyers and sellers represented by a floor trader will meet at the trading post to learn about the best current bid and ask price for a security. These bid and ask offers are called out loud and indicate the current prices to any interested party. A trade will be executed when the bid and ask orders meet. (For more insight, see Why The Bid-Ask Spread Is So Important.)

The specialist doesn't only match up buyers and sellers. Many specialists are forced to hold an inventory of shares themselves to minimize the imbalance of buy and sell orders. The specialist does this until an equilibrium price is reached, which is when demand and supply are very close. Buying an inventory of stocks is not a common occurrence. In fact, it is estimated that a specialist will be in on only one out of every 10-15 trades.

Another duty that a specialist attends to occurs if a customer's order is priced at a level higher than the lowest ask, or lower than the best bid price (known as a stop order). The specialist will then hold the order and execute it if and when the price of the stock reaches the level specified by the customer. (For related reading, check out Understanding Order Execution and The Basics Of Order Entry.)

A final responsibility of the specialist is to find a fair price for each of the stocks that he or she is responsible for at the beginning of every trading day. This fair price is based on the current supply and demand of the stock. The NYSE opens for trading at 9:30am, but if the specialist can't find a fair price, he or she may delay the opening of trading on a stock until that fair price is found.

It is the specialist's job to act in a way that benefits the public. Because specialists are responsible for keeping the market in equilibrium, they are required to execute all customer orders ahead of their own.

Electronic Trading: Introduction

When it comes to electronic trading, for most individual investors, taking a long-term buy-and-hold approach is probably the best strategy. Most of us simply don't have the time or the expertise to trade for a living. But for some investors, trading can be an extremely lucrative profession.

There have always been professionals who made their living off of trading. It wasn't until recently, however, that technology enabled individuals who weren't working for a brokerage to directly access the markets. This tutorial will delve into the workings of the electronic systems that allow this direct access. We'll also talk about the differences between the New York Stock Exchange (NYSE) and the Nasdaq and learn how market trades are executed, both by market makers and by specialists.

Whether you are an aspiring trader or a seasoned investor looking to find out how it all works, this tutorial explains all the nitty-gritty electronic trading systems in layman's terms. Is electronic trading a new way for you to build you own portfolio?

What's the difference between a stop and a limit order?

Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you place a stop or limit order, you are telling your broker that you don't want the market price (the current price at which a stock is trading), but that you want the stock price to move in a certain direction before your order is executed.

With a stop order, your trade will be executed only when the security you want to buy or sell reaches a particular price (the stop price). Once the stock has reached this price, a stop order essentially becomes a market order and is filled.

For instance, if you own stock ABC, which currently trades at $20, and you place a stop order to sell it at $15, your order will only be filled once stock ABC drops below $15. Also known as a "stop-loss order", this allows you to limit your losses. However, this type of order can also be used to guarantee profits.

For example, assume that you bought stock XYZ at $10 per share and now the stock is trading at $20 per share. Placing a stop order at $15 will guarantee profits of approximately $5 per share, depending on how quickly the market order can be filled.

Stop orders are particularly advantageous to investors who are unable to monitor their stocks for a period of time, and brokerages may even set these stop orders for no charge.

One disadvantage of the stop order is that the order is not guaranteed to be filled at the preferred price the investor states. Once the stop order has been triggered, it turns into a market order, which is filled at the best possible price. This price may be lower than the price specified by the stop order.

Moreover, investors must be conscientious about where they set a stop order. It may be unfavorable if it is activated by a short-term fluctuation in the stock's price. For example, if stock ABC is relatively volatile and fluctuates by 15% on a weekly basis, a stop loss set at 10% below the current price may result in the order being triggered at an inopportune or premature time.

A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. For instance, if you want to buy stock ABC, which is trading at $12, you can set a limit order for $10. This guarantees that you will pay no more than $10 to buy this stock. Once the stock reaches $10 or less, you will automatically buy a predetermined amount of shares.

On the other hand, if you own stock ABC and it is trading at $12, you could place a limit order to sell it at $15. This guarantees that the stock will be sold at $15 or more.

The primary advantage of a limit order is that it guarantees that the trade will be made at a particular price; however, your brokerage will probably charge a higher a commission for the limit order, and it's possible that your order will not be executed at all if the limit price is not reached.