Order Flow: The Little Known Secret of Trading

There is a little known secret in the financial industry, and that is that order flow in itself is a commodity. An investor may read that and think that their particular order isn't big or modified enough to get special treatment and that no one cares about its existence. Not exactly. Where does it go between the time it's entered and when it comes back executed? Look at the fine print on any broker's website. It may read something like this:

That disclaimer is everywhere. But what does it really mean? Why would any market maker want an order to buy 1000 shares of

? That stock is as liquid as it gets; there is absolutely no wiggle room. Note the part of the aforementioned disclaimer put in bold. The broker isn't going to necessarily receive compensation per share/per order, but rather based on an amassed quantity over time. That means market makers are willing to execute orders they may break even or lose money on if they can also have a crack at the juicy stuff. Your personal account my not ever actually be the supplier of the juicy stuff, but it is definitely flowing in the same pipes and keeping wheels greased. What is the juicy stuff? The VWAP (or volume weighted average price), spread over the course of the day, not held orders. Those are what the few market makers that are left are clamoring over. Think of all those as instructions that a broker would give a trader. Over any period of time, a broker can request that the trader get the average price at which the stock traded. What if the trader beats it by .13 cents? He may pass on a few of the cents to the broker so then the broker can brag to his client that they “beat the VWAP." Psychologically, it always sounds good when a trader is able to give a broker a fill and be able to say that. A trader would also want to beat the VWAP so the next time that broker has a nice order, he sends it to the same hole. In a situation like that, the broker would understand that the trader needs to make some money somewhere, so he would likely leave a penny “on the desk." Not knowing, however, that there was already a dime there because the trader happened to beat the VWAP. “Spread over the course of the day” orders are very similar to VWAP orders, but would encompass the entire trading day. In an order such as this, the opportunity exists for the trader to make a lot of money simply trading around the position as the day goes by. A trader can trade a little ahead of volume and if the stock acts the right way, he can make some sales for his own account, all the while keeping an eye on the clock and the remaining quantity on the order, to make sure he finishes it up around 4:00 pm EST. “Not Held” is a clarifying instruction that can be placed on any order at any time, it just rarely is. When a broker gives a trader an order “not held,” he is letting the trader use his best judgement as to when to fill the stock. In both previous examples, VWAP and “spread over the course of the day,” orders are the optimal kind of 'Not Held' orders a trader can hope for. Complete discretion that allows the trader lots of time and wiggle room to maximize his profit. With just those few brief examples, it should now be obvious why market makers compete for order flow and why any and all order has worth. It's imperative as an investor and trader to understand the difference and the consequence of each cog in the wheel. Feel free to comment below and ask questions.