When you click "buy" on your trading app, your order embarks on a journey through the financial system before finding a match. Understanding order routing helps you know where your trades go, how they get executed, and why execution quality matters.
The Journey of a Trade
Here is what happens when you place an order:
- You submit a buy order for 100 shares of AAPL at market price
- Your broker receives the order
- The broker's routing system decides where to send it
- The order is sent to a venue (exchange, market maker, or other)
- The order matches with a seller
- The trade is executed and reported
- You receive confirmation
This entire process typically takes milliseconds, but the decisions made in step 3 significantly impact your execution quality.
Key Insight: The same order can be filled at different prices depending on where it is routed. A few cents per share adds up over many trades.
Where Orders Can Be Routed
Stock Exchanges
Traditional exchanges like NYSE and NASDAQ are the primary venues for stock trading. They operate as public order books where buyers and sellers can meet.
- NYSE: The New York Stock Exchange, home to many large-cap stocks
- NASDAQ: Electronic exchange, heavy in tech stocks
- CBOE: Multiple equity exchanges
- IEX: "Investors Exchange" designed to protect against high-frequency trading
Market Makers
Market makers are firms that buy from sellers and sell to buyers, profiting from the spread. They provide liquidity and often handle retail order flow.
- Citadel Securities: Largest retail market maker
- Virtu Financial: Major market making firm
- Wolverine Trading: Options and equity market maker
Market makers pay brokers for the right to execute their customers' orders through payment for order flow (PFOF).
Electronic Communication Networks (ECNs)
ECNs are electronic matching systems that connect buyers and sellers directly. They often offer faster execution and access to liquidity outside traditional exchanges.
Dark Pools
Dark pools are private exchanges where institutional investors can trade large blocks without revealing their orders to the public market. They offer anonymity but less price transparency.
How Brokers Decide Where to Route
1. Payment for Order Flow (PFOF)
Many retail brokers sell their order flow to market makers. The market maker pays the broker (typically fractions of a penny per share) for the right to fill the orders. This is how zero-commission brokers make money.
2. Best Execution Obligation
Brokers are legally required to seek "best execution" for customer orders. This means they should route orders to venues that provide the best combination of price, speed, and likelihood of execution.
3. Rebates and Fees
Exchanges have complex fee structures. Some pay rebates for adding liquidity (posting limit orders) and charge fees for removing liquidity (taking existing orders). Brokers may factor these into routing decisions.
4. Speed and Fill Rates
Different venues have different execution speeds and fill rates. A venue that fills orders quickly but at worse prices may not be better than a slower venue with better prices.
Conflict of Interest
When brokers receive payment for order flow, there is an inherent conflict between maximizing PFOF revenue and getting the best price for customers. This is why PFOF is controversial and banned in some countries.
Smart Order Routing
Smart Order Routing (SOR) is technology that automatically routes orders to the best available venue. A good SOR system considers:
- Current prices across all venues
- Available liquidity at each price level
- Exchange fees and rebates
- Historical execution quality
- Speed of execution
Professional traders often use sophisticated SOR to optimize their executions across dozens of venues.
Order Types and Routing
Market Orders
Market orders execute immediately at the best available price. They are typically routed to venues with high liquidity for fast fills. The downside is you may get a worse price than expected, especially in fast-moving markets.
Limit Orders
Limit orders specify a maximum (buy) or minimum (sell) price. They may be posted on an exchange order book, adding liquidity. Routing decisions can affect whether you receive exchange rebates.
Stop Orders
Stop orders trigger market or limit orders when a price is reached. Routing becomes important once the stop is triggered and needs execution.
Execution Quality Metrics
Brokers are required to publish execution quality statistics. Key metrics include:
Price Improvement
Did you get a better price than the quoted bid or ask? For example, if the ask is $50.00 and you buy at $49.99, you received $0.01 of price improvement.
Fill Rate
What percentage of orders are fully filled? Partial fills can be inconvenient and costly.
Speed
How quickly are orders executed? Faster is generally better, especially for active traders.
Effective Spread
The effective spread measures the actual cost of execution versus the midpoint price. Lower is better.
What This Means for You
For Small Traders
For orders under 1,000 shares in liquid stocks, routing differences are minimal. The price improvement or degradation might be fractions of a penny. Focus on other factors like platform quality and fees.
For Larger Orders
Larger orders can experience significant slippage if routed poorly. Consider using limit orders, breaking up large orders, or using a broker with better routing technology.
For Active Traders
If you trade frequently, small execution differences add up. Look at your broker's Rule 606 report (required quarterly disclosure) to see where your orders are routed and consider whether better execution would help.
How to Get Better Execution
1. Use Limit Orders
Limit orders give you more control over your execution price. You may miss some fills, but you avoid bad executions in volatile conditions.
2. Avoid Market Orders in Volatile Times
During high volatility or at market open/close, spreads widen and execution quality suffers. Use limit orders or wait for calmer conditions.
3. Check Execution Reports
Some brokers show execution quality on your confirmations. Compare your fill prices to the quoted prices at the time.
4. Consider Your Broker
Different brokers have different routing practices. Fidelity, for example, does not accept payment for order flow and focuses on price improvement. Compare broker execution quality reports.
5. Use Direct Access for Large Orders
For significant positions, consider a broker offering direct market access where you control routing decisions.
Track Your Execution Quality
Pro Trader Dashboard helps you analyze your trade executions and overall performance. See how your fills compare to market prices and identify patterns in your trading.
Summary
Order routing determines where and how your trades get executed. Your broker makes these decisions based on various factors including payment for order flow, exchange rebates, and execution quality metrics. While retail traders have limited control over routing, understanding the system helps you make better decisions about order types, timing, and broker selection.
For most investors trading liquid stocks in moderate sizes, the routing differences are small. But if you trade actively or handle larger positions, execution quality can significantly impact your results. Choose a reputable broker, use limit orders when appropriate, and stay informed about where your orders go.
Want to learn more about trading infrastructure? Read our guides on payment for order flow and direct market access.