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Understanding Short-term Dynamics of Order Execution to Minimize Adverse Selection

02/10/2015 05:34 pm ET | Updated Apr 11, 2015

Co-authored with Steve Krawciw

When you trade, do you place market orders, limit orders or a combination of both? Do you or should you care? The answer is yes, you should care, particularly in today's volatile markets, and this article explains why.

When investors place a market order, say, an order to buy 100 shares of IBM at market, the investors are trying to tell the exchanges: "buy 100 shares of IBM for my account at the best available price." However, by the time the order is transmitted to their broker and then by their broker to the exchange, the best available price may have drifted away. The larger the intraday fluctuation of prices, known as volatility, the higher is the chance that the price has drifted away quite a bit, potentially erasing all intended profits from the trade. This drift of the price is known as slippage, and the risk of slippage presents a considerable problem with market orders. Particularly when the order is placed around major market movements, for example, those accompanying major economic news releases, the price obtained may be several dollars or percentage points higher than intended by the investor.

A sound alternative to market orders and the slippage that accompanies them is execution via limit orders. When directing the brokers and exchanges to trade via limit orders, say, buy 100 shares of IBM at $155.50 or a better price, if available, the investor's order will only be executed at the specified $155.50 or better (in the case of limit buy orders, lower) price.

Of course, while the limit orders specify the price, they do not specify exactly when the order will be filled. It is, therefore, entirely possible that from the time the investor places his limit order until that order is executed, market conditions change dramatically, and the order will be executed just as the markets are moving in the wrong direction. For an investor placing a limit buy order, this wrong direction would be a falling price.

This risk is particularly acute when the investor does not know all the news moving the markets at the moment he places his order. Such information asymmetry has its own name: adverse selection. Investors placing limit orders subject to adverse selection are literally taken by market orders placed by traders with better information. In the present age of Big Data, such better information may come from anywhere and at a lightning speed. One may spend millions of dollars just acquiring and aggregating various information sources, wiping out the investing profits.

AbleMarkets provides an alternative: tracking traders who already accumulated all the information. Indeed, AbleMarkets Aggressive HFT Index monitors activity of this well-informed class of market participants in any electronically-traded instrument. The activity is highly predictive of short-term market movements and helps investors considering limit orders to mitigate the risks of adverse selection by avoiding placing limit orders at the wrong time. Instead, the AbleMarkets Aggressive HFT Index pinpoints the right times to place limit orders: limit buy orders when the market for a particular financial instrument is about to rise, and limit sell order when the market is about to fall, saving investors millions on data and adverse selection losses in the process.

Steve Krawciw is CEO of AbleMarkets.com. Irene Aldridge is Managing Director of Able Alpha Trading, LTD., and AbleMarkets.com and author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (2nd edition, Wiley, 2013).