What Is Order Flow and How Does It Work?

When an investor decides to buy or sell a stock, the order typically goes through a brokerage firm. This order is routed and executed rapidly in today’s electronic trading environment. The path these orders take is broadly referred to as “order flow,” a fundamental concept that underpins how trades are processed in modern financial markets.

Defining Order Flow

Order flow is the continuous stream of buy and sell orders from investors directed to various trading venues for execution. It represents the collective intentions of market participants, reflecting real-time supply and demand dynamics.

Orders come in different forms:
Market orders: Instructions to buy or sell a security immediately at the best available current price. This order type prioritizes execution speed.
Limit orders: Instructions to buy or sell a security at a specified price or better. A limit buy order executes at the specified price or lower, while a limit sell order executes at the specified price or higher.

The constant movement of these orders contributes to market liquidity. Liquidity is the ease with which an asset can be converted into cash without affecting its market price. High order flow indicates a liquid market with many buyers and sellers, making trades easier and faster at stable prices. Conversely, low order flow can signal an illiquid market, potentially leading to larger price fluctuations and difficulty in executing trades.

Various participants generate order flow, ranging from individual retail investors to large institutional investors like mutual funds and hedge funds. Each participant’s orders contribute to the overall market volume and direction. Institutional investors, trading in larger volumes, can have a more pronounced impact on market prices.

Order flow represents supply and demand imbalances. When buy orders outnumber sell orders, it indicates stronger demand, which can push prices upward. An excess of sell orders suggests greater supply, potentially driving prices downward. This interplay of buy and sell intentions forms the foundation of price discovery.

How Order Routing Works

Once an investor places a buy or sell order with their retail broker, that order begins a complex journey through the financial system, known as order routing. The broker acts as an intermediary, responsible for sending the order to an appropriate trading venue for execution.

Brokers have several choices for where to send these customer orders. Orders can be directed to national stock exchanges, such as the New York Stock Exchange (NYSE) or Nasdaq. Alternatively, orders might be routed to alternative trading systems (ATS), which are electronic trading networks. Another common destination for orders is directly to market makers, firms that provide liquidity by standing ready to buy and sell securities.

A core obligation for brokers in this routing process is the duty of “best execution.” This means that brokers are generally required to seek the most favorable terms reasonably available for their customers’ orders. Best execution involves evaluating various factors, including the price of the security, the speed of execution, and the likelihood of execution. Brokers must periodically assess which competing markets, market makers, or ATSs offer the most favorable terms of execution.

Technology plays a fundamental role in enabling this rapid and complex order routing. High-speed trading systems and sophisticated algorithms analyze market conditions across multiple venues in real-time, identifying the best available prices and routing orders accordingly. These automated systems allow for orders to be processed and executed at incredibly fast speeds.

Market Makers and Order Flow Payments

Market makers play a central role in the functioning of financial markets by ensuring there is always a counterparty for buy and sell orders, thereby facilitating trading. These firms are financial institutions that stand ready to quote both a buy price (bid) and a sell price (ask) for a given security, continuously. By doing so, they provide liquidity to the market, making it easier for investors to buy or sell shares without significant delays.

Market makers primarily generate their profits from the “bid-ask spread.” This spread is the difference between the price at which they are willing to buy a security (the bid price) and the price at which they are willing to sell it (the ask price). For instance, if a market maker bids $10.00 for a stock and asks $10.01, they profit by one cent per share. They aim to execute a high volume of trades to accumulate these small profits.

A significant practice within this ecosystem is Payment for Order Flow (PFOF). PFOF refers to the compensation that market makers pay to retail brokerage firms for directing customer orders to them for execution. This practice has become a substantial revenue stream for many retail brokers.

Market makers are willing to pay for order flow for several reasons. One primary reason is access to retail order flow, which is often considered “uninformed” compared to institutional order flow. Retail orders are typically smaller and less likely to be based on proprietary information that could move the market significantly. This predictability allows market makers to manage their risk more effectively and to capture the bid-ask spread more consistently.

The mechanics of PFOF typically involve a payment per share or a percentage of the spread. This arrangement creates a financial incentive for brokers to direct customer orders to specific market makers. Brokerage firms are generally required to disclose how much they receive in payment for order flow annually. This compensation helps brokers offer commission-free trading to their customers, as the revenue from PFOF offsets the lack of direct trading commissions.

Implications for Retail Investors

While retail investors expect seamless execution, the underlying mechanics of order flow and payment for order flow can influence their trading experience. Investors do not directly see the routing decisions or financial arrangements between their broker and market makers, but these processes affect how their trade is handled.

The routing of an order, potentially influenced by PFOF, can impact the speed at which a trade is executed. The chosen routing venue may offer varying execution speeds, which affects how quickly an investor’s order is filled.

Order flow dynamics can also affect the final price an investor receives. While brokers are obligated to seek best execution, PFOF can sometimes lead to slight deviations from the best displayed price on an exchange. However, market makers often provide “price improvement,” executing an order at a better price than the current best publicly quoted price. For example, if a stock is quoted at $50.00, a market maker might fill a buy order at $49.99, saving the investor a penny per share.

The system, with its order flow and routing mechanisms, aims to facilitate efficient trade execution for all market participants. Retail investors primarily interact with their brokerage firm, which manages the order flow process on their behalf. The broker’s choice of where to route an order is made with the intention of fulfilling its best execution duty, even as it may benefit from PFOF arrangements.