Chapter 5-2 ECNs

As the stock market has become more technologically advanced new tools have arisen which when utilized properly can provide detailed insight and produce greater profitability.  The ECN market is relatively new in comparison to the NYSE, but with each passing day more and more volume is redirected away from the NYSE to ECNs, such as ARCA and NASD.  Why is this occurring?  Some of the main reasons include speed, better rate incentives, and most importantly the ability to hide.

Hiding Orders

Before only NYSE floor traders had the capability to hide orders on NYSE stocks.  These hidden orders, known as “crowd”, provided a huge advantage to floor traders.  Now however, with ECNs any trader can legally hide limit orders.  The act of hiding orders basically means to only show a specific number of shares such as 100 shares when actually limiting much more (this also sometimes referred to as an iceberg).  This ability is an extremely affected tool, because when executed properly a trader can enter or exit a position without sending signals to other traders of his intentions.

Higher Rate Incentives

Another main reason for ECNs popularity is due to its rate incentives.  While it does cost more to take liquidity from ECNs compared to NYSE, ECNs reimburse you more when providing liquidity.  This is possibly the biggest reason why it is so common now to see such large orders limiting on ECNs compared to years past.

Speed

The third major reason for the ECN volume increase is its speed.  Keep in mind, ECNs are speculating on the NYSE quote.  The speed of ECN activity is so fast that it is common to have ECNs trade at prices so quickly that it is not even visible by the human eye.  When an NYSE stock moves quickly and violently ECNs seem to trade twice as fast, as speculation causes traders to take positions at outlier prices.  Furthermore, when an NYSE stock hits its liquid refreshment point (LRP) due to a quick and significant rise or drop in price, trading through the NYSE is halted for a few seconds as the NYSE quote temporarily freezes.  ECNs during this time however remain live, thus allowing speculation to continue as traders enter and exit positions while the stock momentarily frozen at its LRP.

Partial Fills

One common problem though with ECNs is partial fills.  While the NYSE does not permit odd lots, ECNs do thus causing the issue of partial fills.  Should you find yourself with an odd lot totaling over 100 shares (for example: 142 shares) you can choose to send a market order through the NYSE or a limit order on ECNs.  However, if you have an odd lot totaling less than 100 shares (for example: 42 shares), than you must do one of two things, either take out of the odd lot on ECNs or buy/short more shares to total 100 shares and take out on NYSE or ECNs.  You can identify an odd lot ECN order on the Level 2 by the asterisk displayed next to the number of shares.  Though partial fills do slow you down it should not deter you from trading with ECNs as the advantages greatly outweigh the disadvantages.

Conclusion

Watching the Level 2 for ECN activity is now just as important as watching the NYSE limit order book.  Therefore, always evaluate both before and during a trade in order to insure your best course for entry and exit.  Utilizing the ECN’s speed, rate incentives, and hiding feature will aide you in your quest to maximize your probability and profitability when trading.

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Questions