Likelihood of execution

What Is Likelihood of Execution?

Likelihood of execution refers to the probability that a trading order, whether to buy or sell a financial asset, will be completed at a specific price or at all. This concept is fundamental to order execution within the broader field of market microstructure. It's a critical consideration for investors and traders, influencing their choice of order type, trading venue, and overall strategy. A high likelihood of execution means an order is very likely to be filled, which is often a priority, especially for urgent trades or those in highly liquid markets.

History and Origin

The concept of assessing the probability of a trade being completed has existed as long as organized markets. Early forms of trading involved physical exchanges where a broker would manually attempt to match buy and sell interests. The success of a trade depended on factors like the presence of a counterparty, the willingness to agree on a price, and the size of the order relative to available interest. With the advent of electronic trading and computerized order book systems, the factors influencing the likelihood of execution became more quantifiable.

Modern regulatory frameworks, such as best execution rules, explicitly incorporate the concept. For instance, the Financial Industry Regulatory Authority's (FINRA) FINRA Rule 5310. Best Execution and Interpositioning, requires broker-dealers to use reasonable diligence to ascertain the best market for a security. While the rule itself doesn't explicitly use the phrase "likelihood of execution," it refers to factors like market liquidity and the "terms and conditions of the order," which directly influence this probability. More recently, discussions around proposed regulations, such as the SEC's Regulation Best Execution, have highlighted factors like "timing, likelihood of execution, conflicts of interest, and not just price" when determining best execution.

Key Takeaways

• Likelihood of execution quantifies the probability that a trading order will be filled.
• It is a crucial factor in best execution, alongside price and speed.
• Factors like market liquidity, market depth, and order type significantly influence the likelihood of execution.
• Understanding this probability helps traders choose appropriate strategies, especially when dealing with large orders or volatile assets.

Interpreting the Likelihood of Execution

Interpreting the likelihood of execution involves assessing various market conditions and the characteristics of the order itself. For a broker-dealer or an algorithmic trading system, a high likelihood suggests ample interest in the market to absorb the order without significant price impact. Conversely, a low likelihood indicates potential difficulty in filling the order, possibly leading to partial fills, significant price deviations from the desired execution price, or complete non-execution.

Traders often infer the likelihood of execution by examining the bid-ask spread and the market depth presented in the order book. A narrow spread and substantial depth on both the buy and sell sides indicate high liquidity and, consequently, a higher likelihood of execution. In contrast, wide spreads and thin order books suggest lower liquidity and a reduced likelihood of execution, particularly for larger orders.

Hypothetical Example

Consider an investor, Sarah, who wants to buy 1,000 shares of TechCo stock, currently trading at $50 per share.

1. Market Scenario A (High Likelihood): Sarah checks the order book and sees there are buyers willing to purchase 5,000 shares at $49.95 and sellers offering 6,000 shares at $50.05. The bid-ask spread is narrow ($0.10), and the market depth is significant. If Sarah places a market order to buy 1,000 shares, the likelihood of execution at or very close to the current ask price of $50.05 is extremely high due to the readily available liquidity.

2. Market Scenario B (Lower Likelihood): Sarah looks at a different stock, BiotechX, and finds that there are only sellers offering 100 shares at $25.50 and buyers for 50 shares at $24.50. The spread is wide ($1.00), and the market depth is very shallow. If Sarah places a limit order to buy 1,000 shares of BiotechX at $25.00, the likelihood of execution is very low. Not only is her order size far greater than the available shares at or near her desired price, but the significant spread suggests considerable uncertainty about finding a counterparty quickly, or at all, at her specified price. She might only get a partial fill or no fill.

Practical Applications

The concept of likelihood of execution is deeply embedded in various aspects of financial markets and analysis:

• Order Routing Decisions: Broker-dealers consider likelihood of execution when routing customer orders to different trading venues. They seek the venue that offers the best opportunity for a trade to be completed efficiently, considering factors like available liquidity and potential market impact.
• Algorithmic Trading Strategies: Sophisticated algorithmic trading systems constantly monitor market conditions, including market depth and order flow, to predict the likelihood of execution for large orders. This helps them slice orders into smaller pieces to minimize transaction costs and avoid signaling their intentions to the market.
• Risk Management: Investors and institutions managing large portfolios factor in the likelihood of execution when planning to enter or exit significant positions. Illiquid assets with low execution likelihood pose higher liquidity risk. The Federal Reserve Bank of San Francisco published a primer on Market Liquidity, emphasizing its importance for financial stability and the ability of market participants to execute trades.²
• Market Quality Assessment: Regulators and market participants use the likelihood of execution as an implicit measure of market efficiency and quality. Markets where orders consistently execute with high probability and minimal price impact are generally considered more efficient. The rise of high-frequency trading has significantly impacted the speed and complexity of order execution, altering how market participants perceive and achieve execution likelihood.¹

Limitations and Criticisms

While critical, relying solely on the likelihood of execution has limitations:

• Price vs. Likelihood Trade-off: Sometimes, a higher likelihood of execution might come at the expense of a less favorable execution price. For instance, a large market order guarantees execution (high likelihood) but can "walk the book," filling at progressively worse prices and increasing transaction costs.
• Dynamic Market Conditions: The likelihood of execution is not static. It can change rapidly due to news events, sudden shifts in liquidity, or large institutional orders entering the market. What appears to have a high likelihood one moment might suddenly face challenges.
• Market Impact: For very large orders, attempting to maximize the likelihood of execution by trying to fill it all at once can create significant market impact, pushing prices unfavorably. This paradox means that actively pursuing 100% likelihood can erode the desired price.
• Hidden Liquidity: Not all liquidity is visible in the public order book. Dark pools and other alternative trading systems offer hidden liquidity, which can make a trade more likely to execute at a better price, but the initial visibility for assessing that likelihood is absent.

Likelihood of Execution vs. Fill Rate

The terms "likelihood of execution" and "fill rate" are closely related but represent different aspects of order fulfillment.

While a high likelihood of execution aims for a high fill rate, unexpected market movements can lead to a low fill rate even if the initial assessment of likelihood was high. Conversely, a low initial likelihood might, by chance, result in a high fill rate if market conditions unexpectedly align.

FAQs

What factors affect the likelihood of execution?

Several factors influence the likelihood of execution, including the overall liquidity of the asset, the market depth at various price levels, the size of the order relative to available interest, the type of order placed (e.g., market orders generally have higher likelihood than limit orders), and market volatility. High volatility can reduce the predictability of execution.

Why is likelihood of execution important for investors?

It's important because it directly impacts an investor's ability to enter or exit positions effectively. A high likelihood ensures that an investor can complete their desired trade promptly, which is crucial for managing portfolios, reacting to news, or rebalancing. A low likelihood can lead to missed opportunities, significant price slippage, or holding unwanted positions.

How do brokers ensure a high likelihood of execution for their clients?

Broker-dealers are legally and ethically obligated to seek best execution for their clients. This involves using reasonable diligence to route orders to trading venues that offer the most favorable terms, considering factors like price, speed, and the likelihood of execution. They often employ sophisticated order execution algorithms and monitor market conditions across multiple venues to maximize this probability.

Is a high likelihood of execution always desirable?

While generally desirable, a high likelihood of execution is not always the sole objective. Sometimes, an investor might prioritize achieving a very specific execution price over immediate execution, in which case they might use a limit order, accepting a lower likelihood of execution in favor of price control. For very large orders, a broker might strategically split the order into smaller pieces to avoid significant market impact, even if it means a slightly lower immediate likelihood of the entire order filling at once.