Subject: Trading - Price Improvement

Last-Revised: 26 Feb 1997
Contributed-By: John Schott (jschott at, Chris Lott (contact me)

In a nutshell, price improvement means that your broker filled an order at a price better than you might have expected from the bid and asked prices prevailing at the time you placed the order. More concretely, you were able to pay less than the asked price if you bought, and you received better than the bid price if you sold. Two of the ways that this happens imply extra work by your broker, the third is just luck.

First, a market order may be filled inside the spread. For example, a market order for 100 sh of IBM means that your broker should just buy the shares for you at the current asking price. If the price you pay is less than the current asking price, you experienced price improvement

Second, a limit order may be filled better than the limit. For example, if you wanted to buy 100 sh of IBM at a maximum price of 150, and you were filled at 149 7/8, that's price improvement also.

And third, the market may simply have moved in your favor during the time it took to route your order to the exchange, resulting in a lucky saving for you.

Price improvement is extremely important to people who frequently

trade large blocks of stocks. These people care more about superior executions (i.e., price improvement) than the brokerage house's commission. After all, a 1/8-point improvement on a 1000-share trade makes a $125 difference. So beware saving a penny on the commission and losing a pound on the execution price.

It is difficult for the small investor to determine independently whether his or her order was filled with price improvement or not. (I'm assuming that the average small investor doesn't have access to a live/delayed data feed.) However, there are several sources on the net for intraday price charts that may help you analyze your fills. On a lightly traded stock, spotting you own trade crossing the tape is easy - and a minor thrill.

In theory, when you place an order with a broker, the broker should search all possible places (be they markets or market makers) to get the best possible execution price for you. This is especially true with NASDAQ, where a host of market makers may trade in a given stock. In fact, many brokers (especially discounters or so-called "introducing brokers") simply dump their order on another firm for execution. This broker may not be so diligent in checking out all possible sources, due to a custom called "Payment for Order Flow" (PFOF). PFOF is a small (typically $0.03-0.06/share) payment made by the executing broker to the your broker for the privilege of handling the order. If you think about it, the money can only come from someone's pocket - and it might be from yours via a less than top-flight execution.

For many stocks, remember that there are a lot of places it may trade beyond the exchange it is listed on. Some large firms are trade on exchanges from Tokyo to London. Domestically, the same is true. For example, the Philadelphia stock exchange specialists make a market (i.e., offer quotes) on any stock listed on the NYSE. And then there are alternate (mostly electronic markets), like Reuters' Instinet.

Moreover, big brokers often have a small inventory of actively traded stocks they make a market in and can effectively cut-off (cross) an order before it hits the exchanges. A brokerage house can also program its computer to recognize when two orders flowing in from their regional offices make a pairing that can be summarily crossed. Generally, the broker keeps the spread, but some brokers give the advantage to the customer. Most notable in this respect is Schwab's new "no spread" trading system which crosses customer orders for participants. Instead of executing your order on the normal markets immediately, Schwab routes it to their "waiting room". If there is another order there that mates with yours the trade is immediate - if not, you sit there until that mating order shows up. In either case, Schwab takes its commission and splits the spread with the two customers. It remains to be seen how well this idea works. Evaluating the potential for a delayed trade and the price volatility of the stock itself versus the spread savings will make it difficult for an individual to decide whether to participate.

Due to the need for speed, your broker might be more interested in moving the order (and generating some PFOF revenue) than delaying the trade while looking around for a better price. For example, if you are trying to beat an anticipated market move, paying an extra 1/8th to get immediate execution can be a good investment.

Some regular and discount brokerage houses now advertise that they automatically attempt price improvement on all orders placed with them. One small West Coast discounter recently advertised that about 38% of its order flow achieved price improvement.

All this discussion shows that price improvement requires a little more work (and perhaps a little less profit) for the dealing brokers when compared to straight trading. It also shows that you should understand your broker's normal practice when you consider how and where to place your orders.

Related topics include the recent SEC-NASDAQ settlement.

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