A few days ago I put in an order to buy a stock at $2.77 limit,
before the market opened. The market opened at $2.65 but my order
did not execute. The brokerage provided the explanation below.
If you agree with me that their explanation is bogus, please post
some links and a persuasive argument supporting "our" position.
I fail to see how this is not a blatant violation of the SEC's  NBBO
rules, since whoever sold at $2.65 was clearly ripped off. I missed
the opportunity of buying the stock at a low price, as the stock
has since rallied 50% from my buy point.

-- begin explanation --

I am a supervisor in <Major Brokerage> Response department. I have
reviewed your recent order and can confirm that you were not due a
fill on the November 9, 2005 buy limit order to purchase 500 shares of
INSW at $2.77.

There was no error in routing or in a Market Maker refusing to fill
your order at the NBBO. Your order did not fill due to the nature of a
limit order and how it is executed. Buy limit orders for
over-the-counter (OTC) securities are eligible to be executed when the
Ask price reaches your limit price. Trades on the sell or bid side of
the market do not affect the eligibility of your order for execution.
Only the Ask side of the market has any bearing on a buy limit order.

The trade for $2.65 that you saw was on the bid side of the market,
not the ask. That trade was for 3000 shares, almost a third of the
volume for the stock that day. It lowered the price temporarily on the
bid side. The lowest ask price for the day was $3.17, well away from
your limit price of $2.77.

Please note that limit orders are secondary to market orders and are
guaranteed a price, not an execution. Even if the stock were to reach
your limit price, you are not guaranteed an execution. In order for a
limit order to execute, the appropriate bid or ask price would need to
remain at your limit price long enough for all market orders to
execute and any other limit orders placed before your limit order.
Once these criteria are met, then your limit order becomes eligible
for execution.

-- end explanation --

Unfortunately, what the brokerage firm told you is correct.  I would
like to explain to you why they are correct so that you can avoid
finding yourself in this situation in the future.  Understanding how
order fulfillment works, particularly with respect to limit orders, is
an important aspect of successful trading.  Please request
clarification if you have any questions about the following material
since the concept is a little complicated because there are actually
two prices that are quoted in the market for a stock: its bid price
and its ask price.

There are two prices because you do not actually directly buy a stock
from the seller; instead, there are one or more middlemen known as a
market makers who buy and sell the shares from investors like
yourself.  They maintain an inventory of shares so that they can sell
to investors even if no one else wants to sell and can buy from
investors even if no one else wants to buy. This is how they "make"
the market. However, this involves risk that they must be compensated
for. "In the OTC market, trading occurs via a network of middlemen,
called dealers, who carry inventories of securities to facilitate the
buy and sell orders of investors, rather than providing the order
matchmaking service seen in specialist exchanges such as the NYSE." 
"Over-The-Counter Market" Investopedia.com (2005)
http://www.investopedia.com/terms/o/over-the-countermarket.asp.

The bid price represents the price at which you can sell a stock to a
market maker.  The ask price is the price at which you can buy a stock
from a market maker.  The difference between these is known as the
bid-ask spread.  The National Best Bid and Offer rule recognizes that
there are both bid and ask prices, which govern selling and buying,
respectively.  "A term applying to the SEC requirement that brokers
must guarantee customers the best available ask price when they buy
securities and the best available bid price when they sell
securities."  "National Best Bid and Offer-NBBO" Investopedia.com
(2005) http://www.investopedia.com/terms/n/nbbo.asp.  Since the ask
price did not reach your limit price, your trade was properly not
executed.   As an individual investor, you cannot directly buy a stock
for the bid price nor sell it for the ask price through the market. 
Only market makers can do that; it is how they make money.

"Why is there a bid-ask spread? To compensate for the risk that they
run, Market Makers seek to buy shares at a lower price and sell at a
higher price. The bid-ask spread is, therefore intended to compensate
Market Makers for the risk they take in dealing with the stock and
keeping the markets liquid.

The size of the bid-ask spread on a particular stock depends on
several factors. In general, the more liquid (volume) a stock is the
smaller its bid-ask spread will be. Less liquid stocks usually have
larger spreads, as do lower priced stocks (in percentage terms). For a
fairly liquid stock priced at around $100, a spread of around 75 cents
or so is not uncommon.

Note that the bid-ask spread is a "hidden" cost for day traders and
other investors. It is a cost that is additional to the normal
commissions paid for executing trades. For frequent traders, the
bid-ask spread can rapidly erode trading capital. These traders should
avoid stocks with inordinately high bid-ask spreads, particularly when
using market orders. In particular, it is best to avoid thinly traded
stocks or stocks priced under $5.00."

"The Bid-Ask Spread" Alvaro Oliveira, About.com (2005)
http://daytrading.about.com/cs/educationtraining/a/bidask.htm

"But what about the ticker itself? If there are all those tiers and
orders out there, which ones do we see?

If XYZ is NYSE (three digits), the quote might look like: 

20-20-1/4 200X50 50,000 

$20 is the bid price. Of all the tiers and prices anywhere in the
market, $20 at this moment is the highest price a buyer is willing to
pay for XYZ. Since this has to be a limit order, the bidder is not
willing to pay a dime more than $20.

Of all the selling tiers and orders in the market, at this moment,
20-1/4 is the ask price, or the lowest price a seller is willing to
accept for XYZ. This is, in effect, the best offer in the market for
XYZ at this moment in time.

Since both are limit orders, must a trade be executed? Absolutely not.
These are merely the bait put out there by the pros as a negotiation
tool."

"What we are witnessing in bid-ask spreads is negotiation-in-process.
Limit orders carry risk - the risk of non-execution on both sides. To
make money anywhere, we have to take risk, but not the risk of "Intel
looks low today". The risk successful traders take is the willingness
to take a stand and walk away in the bid-ask process, through limit
orders. "

"Why The Bid-Ask Spread Is So Important" By Investopedia Staff,
Investopedia.com (December 17, 2001)
http://www.investopedia.com/articles/trading/121701.asp

Sincerely,

Wonko

Search terms: bid ask spread

---

Request for Answer Clarification by atr-ga on 08 Dec 2005 06:47 PST

Wonko,

There are a couple of serious flaws in your answer. I will let you look
into this further before I rate your answer. My first inclination is to
give it zero-stars and to request a refund. So please address this 
thoroughly!

First problem is, INSW is not an Over The Counter stock! It is NasdaqNM 
(Nasdaq National Market) listed. So, the OTC part of the discussion,
including the "[buyers] do not actually directly buy a stock from the
seller" part, is completely inacurate. The fact is there are multiple
market-makers and ECNs on Nasdaq, and when I place my bid I can see it 
on the Level II quote (provided there aren't higher bids from the same 
broker), and my bid is there ready and waiting for either 1) a seller 
to hit it directly by using direct-trading (or autorouting) if they 
are in a  direct broker like Ameritrade, or 2) for another brokerage 
to hit it on behalf of one of their customer's orders.

Second, you have included a section on NYSE stocks which is not relevant
to my question. Again, INSW is a Nasdaq exchange stock.

Third, the sections you have quoted regarding the bid-ask spread as a
"hidden cost" only applies to market orders, not limit buy orders placed
below the market (or conversely, a limit sell placed above the market).

Also, stocks have not traded in fractions for years, although that
is a minor detail, that is a general sign that some of the info may
be outdated.

The comment from canadianhelper-ga is probably more to the point.

Thanks.

---

Clarification of Answer by wonko-ga on 08 Dec 2005 09:57 PST

I appreciate you giving me the opportunity to explain the situation to
you again.  There is some confusion regarding my use of the term "over
the counter," so I have found references to explain why that term is
relevant to your situation and the NASDAQ.

Because it does not have specialists, the NASDAQ stock market is
considered to be an over the counter market in terms of its
operational structure.  This is a different use of the term from its
application to stocks traded on the Pink Sheets and the Over the
Counter Bulletin Board.  The following references explain the
different usages of the term OTC.  I observe that the definition of
over the counter I am using is the same one used by the brokerage firm
representative.

"The phrase "over-the-counter" (OTC) can be used to refer to stocks
that trade via a dealer network as opposed to on a centralized
exchange."

"Although Nasdaq operates as a dealer network, Nasdaq stocks are
generally not classified as OTC because the Nasdaq is considered a
stock exchange."

"Over-The-Counter - OTC" Investopedia (2005)
http://www.investopedia.com/terms/o/otc.asp

"An example of a dealer market is the Nasdaq, in which the dealers,
who are known as market makers, provide firm bid and ask prices at
which they are willing to buy and sell a security. The theory is that
competition between dealers will provide the best possible price for
investors.

Sometimes you'll hear a dealer market referred to as an
over-the-counter (OTC) market. The term originally meant a relatively
unorganized system where trading did not occur at a physical place, as
we described above, but rather through dealer networks. The term was
most likely derived from the off-Wall Street trading that boomed
during the great bull market of the 1920s, in which shares were sold
"over-the-counter" in stock shops. In other words, the stocks were not
listed on a stock exchange - they were "unlisted".

Over time, however, the meaning of OTC began to change. The Nasdaq was
created in 1971 by the National Association of Securities Dealers
(NASD) to bring liquidity to the companies that were trading through
dealer networks. At the time, there were few regulations placed on
shares trading over-the-counter - something the NASD sought to
improve. As the Nasdaq has evolved over time to become a major
exchange, the meaning of over-the-counter has become fuzzier. Today,
the Nasdaq is still considered a dealer market and, technically, an
OTC. However, today's Nasdaq is a stock exchange and, therefore, it is
inaccurate to say that it trades in unlisted securities."

"Markets Demystified" Investopedia (November 10, 2005)
http://www.investopedia.com/articles/02/101102.asp

The second area of confusion relates to the role of bid and ask.  None
of the broker dealers will sell you a stock at the bid price.  They
will only sell it to you at the ask price.  Your limit order
establishes the maximum ask price you are willing to pay.  Therefore,
since the ask price did not fall to the level of your limit order, it
was not filled.  My explanation of the bid ask spread was included to
explain why the market has two prices and why you cannot buy at the
bid price unless you are a broker dealer.

"A broker-dealer firm that accepts the risk of holding a certain
number of shares of a particular security in order to facilitate
trading in that security. Each market maker competes for customer
order flow by displaying buy and sell quotations for a guaranteed
number of shares. Once an order is received, the market maker
immediately sells from its own inventory or seeks an offsetting order.
This process takes place in mere seconds.

The Nasdaq is the prime example of an operation of market makers.
There are over 500 member firms that act as Nasdaq market makers,
keeping the financial markets running efficiently because they are
willing to quote both bid and offer prices for an asset."

"Market Maker" Investopedia (2005)
http://www.investopedia.com/terms/m/marketmaker.asp

"Each market maker on the Nasdaq is required to give a two-sided
quote, meaning they must state a firm bid price and a firm ask price
that they are willing to honor."

"What's the difference between a Nasdaq market maker and a NYSE
specialist?" Investopedia (2005)
http://www.investopedia.com/ask/answers/128.asp

Third, there is confusion about the nature of NASDAQ transactions.  

"Dealer vs. Auction Market 
The fundamental difference between the NYSE and Nasdaq is in the way
securities on the exchanges are transacted between buyers and sellers.
The Nasdaq is a dealer's market, wherein market participants are not
buying from and selling to one another but to and from a dealer,
which, in the case of the Nasdaq, is a market maker."

"The Tale Of Two Exchanges: NYSE And Nasdaq" Investopedia (October 31,
2003) http://www.investopedia.com/articles/basics/03/103103.asp

You asked about the role of ECNs.  They still deal with bid and ask
prices.  "Electronic Trading: Electronic Communications Networks
(ECNs)" Investopedia (2005)
http://www.investopedia.com/university/electronictrading/trading5.asp

In conclusion, the brokerage firm is correct because you cannot buy a
stock for less than the best ask price, nor can you sell it for more
than the best bid price, prevailing in the market while your limit
order to buy is in effect.

I hope this additional information aids you in understanding why this
happened and how to prevent it in the future.  Please request further
clarification if you need any since I do want you to understand my
Answer.

Sincerely,

Wonko

I think the broker is right in this case:

Limit Orders
To avoid buying or selling a stock at a price higher or lower than you
wanted, you need to place a limit order rather than a market order. A
limit order is an order to buy or sell a security at a specific price.
A buy limit order can only be executed at the limit price or lower,
and a sell limit order can only be executed at the limit price or
higher. When you place a market order, you can't control the price at
which your order will be filled.

For example, if you want to buy the stock of a "hot" IPO that was
initially offered at $9, but don't want to end up paying more than $20
for the stock, you can place a limit order to buy the stock at any
price up to $20. By entering a limit order rather than a market order,
you will not be caught buying the stock at $90 and then suffering
immediate losses if the stock drops later in the day or the weeks
ahead.

Remember that your limit order may never be executed because the
market price may quickly surpass your limit before your order can be
filled. But by using a limit order you also protect yourself from
buying the stock at too high a price. Some firms may charge you more
for executing a limit order than a market order.

For more information on the different types of orders you can place
when you buy or sell a stock, please read "Brokerage Orders" in our
Fast Answers databank.

This is from the SEC: http://www.sec.gov/answers/limit.htm

Look at this from the perspective of the guy/gal who sold 3,000
shares at $2.65. That guy was not given the best available price:
I was offering $2.77 for 500 shares. All the guy's shares were sold 
at $2.65. Whether his order was a Market or a Limit order doesn't
matter: a better price was available in the market and he was 
ripped off. I was too but that is less clear.

My 500 shares should have resulted in a partial fill of the other
guy's trade at $2.77, with his remaining $2,500 sell filled at $2.65.

Not that it is necessary but the fellow selling may have requested NO partial sales.