Trading costs depend not only on the spread but also on rules. Whether a trade is filled, and at what price, depends on a whole set of rules: order types decide how traders trade off price against certainty, priority rules decide who is filled first, and market structure decides who supplies liquidity. These rules look like technical details, but in fact they decide who bears the cost of trading.
1. Order types: trading off price against certainty
In Trading and Exchanges: Market Microstructure for Practitioners, Harris points out that choosing an order type is in essence a choice between two risks: the risk of not being filled, and the risk of being filled at a poor price.
Market order: filled immediately at the best opposing price in the market. It is almost certain to be filled, but the price is uncertain.
Limit order: filled only at the specified price or better. The price is guaranteed, but the order may never be filled.
Stop order: becomes a market order when the price reaches a set level. It is used to limit losses, but once triggered it may be filled at a price far worse than the set level.
Stop-limit order: becomes a limit order when triggered. The price is guaranteed, but if the price gaps, the order may not be filled at all.
Four orders in the same market move
The price starts at 100. Before the open on day 18, bad news breaks and the price jumps straight from 97 to 92. Choose an order to see when it is filled and at what price.
Illustrative price path. Orders are submitted after the close on day 0; the stop and stop-limit orders assume the investor already holds the stock. A triggered stop order becomes a market order and can only be filled at the first available price after the trigger.
2. Who is filled first: priority rules
Many orders often queue at the same price. Almost every exchange applies price priority first: buy orders with higher bids and sell orders with lower asks are filled first. Among orders at the same price, the most common second rule is time priority, first come, first served; some futures markets use pro-rata allocation, which allocates fills in proportion to the size of resting orders. Harris notes that priority rules decide who is willing to post orders and supply liquidity: time priority rewards those who post early, while pro-rata allocation encourages large orders.
At the same price, who is filled first
Four buy orders rest at 10.00 in order of arrival. A market sell order for 900 shares arrives. Switch the priority rule to see how the fills are allocated.
Market sell order, 900 shares
Price priority applies under both rules; the figure compares only the second rule at a single price. Pro-rata allocation is found in some futures markets, and in practice it is often combined with time priority.
3. Market structure: who supplies liquidity
By who supplies liquidity, markets fall into a few basic structures:
Quote-driven markets: market makers continuously quote bid and ask prices, and traders trade with them. Traditional bond and foreign-exchange markets are mostly of this kind.
Order-driven markets: traders' limit orders are gathered into an order book and matched by the exchange according to its rules. Most stock exchanges today are of this kind, and the traders who post limit orders are the suppliers of liquidity.
Brokered markets: brokers search for counterparties on their clients' behalf; this is common for block trades and very illiquid assets.
Most real markets are hybrids, for example with designated market makers alongside the order book. Madhavan (1992) compared the quote-driven and order-driven mechanisms.
Three market structures: who supplies liquidity
Switch structures to see how orders flow and who stands on the other side.
Classification follows Harris (2003) and Madhavan (2000). Most real markets are hybrids.
4. Call auctions: gathering orders to trade at once
In continuous trading, orders are matched as they arrive. A call auction instead collects orders over a period and, at the set time, fills them all at once at a single price: the price that maximizes the volume traded. Exchanges around the world commonly use call auctions at the open and close. For example, the Shanghai and Shenzhen stock exchanges run an opening call auction from 9:15 to 9:25 in the morning and a closing call auction from 14:57 to 15:00. Call auctions concentrate scattered orders and reduce price jumps at the open and close, and as a result the closing price serves as the settlement benchmark for many funds and derivatives.
Call auction: the price that maximizes volume
Green is the cumulative quantity buyers will take at each price; orange is the cumulative quantity sellers will offer. Volume is greatest where the two lines cross.
Auction price
Volume
Example orders. The volume at each price is the smaller of the buy and sell quantities at that price; the auction price is the one with the largest volume (actual rules also compare unfilled quantities and a reference price when volumes tie).
5. Circuit breakers and price limits
To keep prices from swinging violently over short periods because of panic or erroneous orders, many markets have mechanisms that halt trading. In China's A-share market, individual stocks on the main boards have a daily price limit of 10%; on ChiNext and the STAR Market the limit is 20%. The United States applies a "limit up–limit down" mechanism to individual stocks, halting trading for a few minutes when the price moves outside a band within a short time. For the market as a whole, there are three levels of circuit breaker: when the S&P 500 falls 7% or 13% from the previous close before 3:25 p.m. US Eastern Time, trading halts for 15 minutes; when it falls 20%, trading stops for the rest of the day, whenever this happens.
After the price hits a limit
The same sharp fall under two mechanisms.
Illustrative price path. The halt case is modelled on the US "limit up–limit down" mechanism for individual stocks: when the price moves outside the band, trading halts for a few minutes and then resumes with a call auction. The limit-down case is modelled on the 10% daily price limit on China's A-share main boards.
These mechanisms give the market time to calm down and replenish liquidity, at the cost of being unable to trade during the halt. For an investor who needs to exit immediately, that is itself a risk.
6. Best execution and order routing
The same stock often trades on several venues. When a broker receives a client's order, it must decide where to send it. Regulation NMS, issued by the US Securities and Exchange Commission in 2005, requires that trades not be executed at prices worse than the best prices publicly quoted on other venues. FINRA Rule 5310 requires brokers to seek "best execution" for their clients. Brokers must also disclose each quarter where they send orders and arrangements such as payment for order flow received from trading venues, so that clients can judge conflicts of interest.
Where an order can be sent
A client wants to buy 300 shares at market. The current lowest asks on each venue are shown below; the best ask across the market is 10.01. Choose a destination to see the result.
Client order Buy 300 shares
Choose a destination.
Example quotes. The rules follow the Order Protection Rule in the US Securities and Exchange Commission's Regulation NMS (2005) and FINRA Rule 5310 on best execution; quarterly disclosure of order routing and payment for order flow follows Rule 606 (as amended by the SEC in 2018). Rules differ across jurisdictions.
7. Implications for product design
Trading rules decide whether users are filled, at what price, and when the proceeds actually arrive. Products should explain these rules clearly.
Chapter summary: explain the trading rules clearly
Four design requirements, each tied to one mechanism in this chapter.
Order types are trade-offs between risksAt order entry, explain "may not be filled" and "may be filled badly"
Especially for stop orders: explain that once triggered they become market orders, and that in a gap the fill price may be far from the set price.
Call auctions and continuous trading follow different rulesExplain the rules by trading session
How orders are matched during the opening and closing auctions, and whether they can be cancelled, should be explained right on the order screen.
Circuit breakers and price limitsWarn that trading may be temporarily impossible
Near a price limit or during a halt, state clearly the order's status and how trading will resume, so users do not mistake it for a system failure.
Orders can be sent to different venuesDisclose order routing and conflicts of interest
Explain where the order was sent, how the fill price compares with the best price in the market, and whether there is payment for order flow.
References
Madhavan, A. (1992). Trading mechanisms in securities markets. Journal of Finance, 47(2), 607–641.
Madhavan, A. (2000). Market microstructure: A survey. Journal of Financial Markets, 3(3), 205–258.
Harris, L. (2003). Trading and exchanges: Market microstructure for practitioners. Oxford University Press.
SEC (2005). Regulation NMS. Release No. 34-51808.
FINRA. Rule 5310: Best execution and interpositioning (effective 2012).
SEC (2018). Disclosure of order handling information. Release No. 34-84528.