Smart order routing (SOR) is an automated trading technique used by institutional traders to ensure that orders are executed at the best available price across multiple markets or trading venues. Instead of manually searching for the best price, SOR technology uses algorithms to assess the price, liquidity, and order characteristics across different markets. Its algorithms consider various factors such as market data, transaction fees, and order execution speeds, making it easier for traders to obtain optimal execution for their trades.
The popularity of smart order routing has grown tremendously in recent years, as market fragmentation has increased. Institutional investors, in particular, use SOR technology to trade large orders and mitigate risk.
This article will provide an in-depth analysis of smart order routing and the role it plays in optimising trading performance in today's complex financial markets.
What is a route in the stock market?
Before diving into smart order routing, it's essential to understand the concept of a "route" in the stock market. In simple terms, a route refers to the pathway that a trader's order takes from initiation to execution. These routes can vary in complexity, and the choice of route can have a significant impact on the outcome of the trade.
To navigate this complex trading landscape, smart order routing systems have emerged to help traders optimise their trading performance. SOR allows traders to access multiple liquidity pools, assess the price, liquidity, and order characteristics across different markets, and execute trades at the best available price.
What is a smart order route?
A smart order route is the path that a trade takes when using a smart order routing system. smart order routes are designed to optimise trade execution, providing traders with access to multiple liquidity pools and ensuring that their orders are executed at the best available price across the various trading venues.
Smart order routes can be customised to meet the specific requirements of the trader. For example, a trader may need to execute an order quickly to take advantage of a market opportunity. In this case, a smart order route may prioritise the fastest execution venues to minimise the risk of missing out on the opportunity.
Alternatively, a trader may be interested in minimising market impact, in which case a smart order route may prioritise venues with low market share or use a hidden order to avoid detection.
Types of smart order routes
There are several types of smart order routes available to traders. Each type is designed to meet specific trading objectives and optimise trade execution. The most common types of smart order routes are explained below:
1. Cost-based smart order route:
Cost-based smart order route prioritises execution venues based on the cost of execution, including transaction fees that are processed by exchanges or brokers. The algorithm aims to execute the order at the lowest possible cost by analysing the fees of each venue and selecting the venue with the lowest fee.
2. Time-based smart order route:
Time-based smart order route prioritises the execution of an order based on the speed of execution required to take advantage of market opportunities. This type of smart order route is used when speed is critical, and execution time must be minimised to capture the best price. The algorithm aims to execute the order as fast as possible by selecting the fastest venue and routing the order accordingly.
3. Liquidity-based smart order route:
Liquidity-based smart order route prioritises execution venues based on available liquidity. The algorithm aims to execute the order with minimum market impact by selecting the execution venue with the highest liquidity. By doing so, the algorithm reduces the risk of slippage and ensures that the order is executed at the best possible price.
4. Volume-weighted average price (vwap) smart order route:
VWAP smart order route prioritises execution venues based on the volume-weighted average price (VWAP). The VWAP is calculated by dividing the total value of the trades by the total volume traded during a specific time. This algorithm is used for large orders, as it aims to execute the order at a price as close to the VWAP as possible, reducing market impact.
5. Dark pool smart order route:
Dark pool smart order route prioritises execution venues that are dark pools, which are anonymous trading venues that do not display orders publicly before execution. The algorithm aims to execute the order with minimum market impact by routing the order to dark pools, reducing the risk of opportunistic traders taking advantage of predictable market moves.
Each type of smart order route comes with unique benefits that can help traders optimise trade execution. By understanding the types of smart order routes available, traders can select the type that meets their specific trading objectives and reduce market impact while ensuring a better execution price.
Smart order route configurations
Smart order route configurations refer to the settings, preferences, and parameters that a trader can customise within the smart order routing system. These configurations are flexible and can be adjusted to meet a trader's specific objectives and preferences.
Here are some common smart order route configurations:
1. Routing order slicing:
Routing order slicing is an effective way to execute larger orders with minimal market impact. This method breaks down a large order into several smaller orders and distributes them across multiple venues. The system will trade these smaller orders over a specific time interval until the entire order is filled.
2. Venue prioritisation:
Venue prioritisation determines the order in which the system will prioritise each venue. This configuration considers variables such as trading speed, cost, and liquidity. For instance, if the trader is looking for faster execution, the configuration can prioritise a venue with better speed and responsiveness.
3. Order type selection:
This configuration enables traders to select the most suitable order type to be used in smart order routing. The strategy applies to specific orders, such as market, limit, or stop. For instance, if a trader is interested in executing a limit order, she can choose a limit order in the configuration.
4. Time weighting:
Time weighting determines how quickly the trader wants the order to be fulfilled. The configuration can split the order to be filled over a specific period, and orders are executed based on the trader's preferred timeframe. For example, a trader who wants to sell 10,000 shares of stock over six months can configure the system to distribute the trade into equal chunks for each day of trading over that period.
5. Risk tolerance:
Risk tolerance determines the level of risk the trader is willing to take based on market conditions. The configuration includes the maximum bid-ask spread, liquidity level, best execution price, and other limits. The system will not accept orders that exceed these limits.
smart order routes are customisable and offer many configurations that allow traders to optimise trade execution. Choosing the right configuration, depending on the specific context of a trade, can help traders ensure they achieve the best price and minimise market impact. By leveraging the flexibility of smart order routing configurations, traders can increase their chances of trading success in today's complex and fragmented markets.
How do you close out your SOR orders in case of intraday trades?
Suppose you placed an intraday order for ABC Corporation shares using SOR. You ordered a total of 500 shares, and the SOR system executed 300 shares on the NSE and 200 shares on the BSE. In intraday trading, the goal is to open and close positions within the same trading day. Here's how to handle the complexity of closing these intraday trades:
Manual management: To effectively close your intraday positions, you'll need to manually execute sell orders for the shares on both the NSE and the BSE. In this case, you should sell 300 shares on the NSE and 200 shares on the BSE, respectively.
Review your order history: To ensure accuracy in closing out your intraday positions, review your order book and trade book. These records will help you confirm the exact number of shares executed on each exchange.
Prompt action: Timing is critical in intraday trading. Act swiftly to execute your sell orders, aiming to secure your intraday gains or limit potential losses efficiently.
When closing out intraday SOR orders, it's vital to manage your positions carefully. Manually selling the shares on the exchanges where they were executed and cross-referencing your order and trade records will help you navigate the complexity of intraday trading effectively.
General restrictions on SOR
- Order types: Some brokers restrict the types of orders you can place on the SOR platform. While some may allow both normal and limit orders, others might only permit normal orders.
- Stock liquidity: Most brokers limit SOR to highly liquid stocks with substantial trading volumes on both exchanges. This ensures that SOR is effective in achieving the best price.
- Live market: SOR is designed for use in live markets. You cannot use it for placing off-market orders, as its primary goal is to optimize trade execution during active trading hours.
Pros and cons of smart order routing system
Pros:
- Helps traders obtain optimal prices: Smart order routing systems analyse data from multiple markets, exchanges, and trading venues to ensure orders are executed at the best possible prices.
- Provides access to multiple liquidity pools: Smart order routing systems connect traders to various liquidity pools such as exchanges, Alternative Trading Systems (ATSs), and dark pools, enabling them to choose the best venues for their trades.
- Reduces market impact on trades: Smart order routing systems can break large orders into smaller ones and route them to different venues to minimise the market impact and prevent significant price movements.
- Eliminates the need for manual searching for the best prices: Smart order routing systems automate the search for the best execution prices, saving traders time and effort.
- Can be programmed to meet specific trading objectives: Smart order routing configurations can be highly customised to meet specific trading objectives.
Cons:
- Can be complex and difficult to understand: Understanding and configuring smart order routing systems can be challenging for traders, especially those who are less experienced.
- May experience technology problems or failures: Technical problems or software failures can negatively impact the efficiency and accuracy of smart order routing systems.
- Cannot guarantee best price execution: Smart order routing systems make decisions based on variables such as market data, transaction fees, liquidity, and volatility, but they cannot guarantee that the orders will be executed at the best possible price.
- May be affected by market volatility: Smart order routing systems are designed to perform well in a stable market environment. However, market volatility can negatively impact the efficiency of smart order routing systems.
