What Is Price Improvement?
Price improvement occurs in securities trading when an investor's order is executed at a more favorable price than the prevailing best available quote at the time the order was placed. This concept is central to market microstructure and the duty of best execution, where broker-dealers strive to achieve the most advantageous terms for their clients. For a buy order, price improvement means acquiring shares at a price lower than the lowest displayed ask price. Conversely, for a sell order, it means selling shares at a price higher than the highest displayed bid price. This often happens within the bid-ask spread or beyond the National Best Bid and Offer (NBBO), leading to reduced transaction cost for the retail investor. Price improvement is a key metric used to assess the quality of order execution.
History and Origin
The concept of price improvement has evolved alongside the modernization of equity markets, particularly with the advent of electronic trading and increasing market fragmentation. Before widespread electronic communication networks (ECNs) and stricter regulations, much trading occurred on physical exchanges, where brokers often negotiated prices directly on behalf of their clients. The push for greater transparency and fairness in pricing gained significant momentum in the early 2000s, culminating in the U.S. Securities and Exchange Commission's (SEC) adoption of Regulation National Market System (Reg NMS) in 2005. Reg NMS aimed to promote fair and efficient markets by ensuring orders were executed at the best available prices. This regulation solidified the obligation for market participants to seek the best available prices, making price improvement a formal measure of execution quality. More recently, the SEC has continued to amend Regulation NMS to further reduce transaction costs and improve market quality, for instance, by adjusting minimum pricing increments and access fees.6,5
Key Takeaways
- Price improvement is the difference between an order's execution price and the prevailing best quoted price (NBBO) at the time of order receipt.
- It signifies a more favorable transaction for the investor, such as buying below the offer or selling above the bid.
- Price improvement is a key component of a broker-dealer's best execution obligation.
- It is most frequently observed in markets with substantial liquidity and through off-exchange trading.
Formula and Calculation
Price improvement is quantified as the difference between the execution price and the prevailing National Best Bid and Offer (NBBO) at the time an order is received by the execution venue.
For a buy order:
For a sell order:
Where:
- National Best Offer (NBO): The lowest available ask price across all markets for a given security.
- National Best Bid (NBB): The highest available bid price across all markets for a given security.
- Execution Price: The actual price at which the investor's market order or limit order was filled.
A positive value indicates price improvement. For example, if the NBBO for a stock is $20.00 (bid) and $20.05 (ask), and a buy order is executed at $20.03, the price improvement would be $0.02.
Interpreting Price Improvement
Interpreting price improvement involves assessing how effectively a broker-dealer is obtaining favorable prices for customer orders. A higher average price improvement amount or percentage generally indicates superior execution quality. However, it is crucial to consider the context, including market volatility, order size, and the bid-ask spread of the security. In highly liquid stocks with narrow spreads, even a small amount of price improvement can be significant. Market participants often analyze execution quality reports, which detail metrics like the frequency and average amount of price improvement, to evaluate different trading venues and brokers. Brokers are required to conduct "regular and rigorous" reviews of the execution quality provided to their customers.4
Hypothetical Example
Consider a scenario where an investor places a market order to buy 100 shares of Company XYZ. At the moment the order is received by the execution venue, the National Best Bid and Offer (NBBO) for XYZ stock is $50.00 (bid) and $50.05 (ask).
The investor's broker routes the order to a market maker. Due to available liquidity within the market maker's internal book or a beneficial interaction with another order, the market maker is able to execute the buy order at $50.02 per share.
In this instance, the price improvement for the buy order is calculated as:
For the 100 shares, the total price improvement for the investor is (100 \text{ shares} \times $0.03/\text{share} = $3.00). This means the investor paid $3.00 less than they would have if the order was filled at the National Best Offer. This small gain per share can add up, benefiting investors by reducing their overall acquisition cost.
Practical Applications
Price improvement is a critical metric across various facets of the financial markets:
- Retail Brokerage Services: For individual investors, price improvement directly translates into better returns or lower costs on trades. Many online brokers highlight their average price improvement statistics to demonstrate the quality of their order execution.
- Regulatory Compliance: Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), mandate best execution rules (e.g., FINRA Rule 5310) which require broker-dealers to use reasonable diligence to ensure the resultant price to the customer is as favorable as possible. Price improvement is a key factor in assessing compliance with these obligations.3
- Market Structure Analysis: Academics and market regulators study price improvement to evaluate the efficiency and fairness of different trading venues, including exchanges and off-exchange market makers. The presence and magnitude of price improvement can indicate the health of market liquidity and competition among market participants.
- Algorithmic Trading Strategies: Sophisticated algorithmic trading systems are designed to capture even sub-penny price improvements by intelligently routing orders across multiple venues.
Limitations and Criticisms
While price improvement is generally beneficial for investors, its measurement and implications are subject to certain limitations and criticisms. One common critique revolves around the "phantom" nature of some reported price improvement, particularly in the context of payment for order flow (PFOF). Some critics argue that brokers routing orders to off-exchange market makers in exchange for PFOF may not always achieve the absolute best price for the client, even if it appears to be price improvement over the publicly displayed NBBO. The concern is that if the order had been exposed to a broader pool of competitive interest, an even better price might have been achieved.2
Furthermore, the calculation of price improvement often uses the NBBO at the moment the order is received, which might not fully capture the dynamic nature of fast-moving markets. In highly volatile conditions, the NBBO can change rapidly, potentially affecting the perceived amount of price improvement. Some studies have suggested that while payment for order flow does not inherently harm price execution, the methods of self-reporting can be inconsistent across brokers, making direct comparisons difficult.1 The debate continues regarding whether current market structures optimally balance factors like speed, liquidity, and explicit price improvement.
Price Improvement vs. Best Execution
Price improvement is a subset or an outcome of the broader concept of best execution. Best execution is a regulatory and ethical obligation for broker-dealers to execute customer orders in a manner that ensures the most favorable terms reasonably available under prevailing market conditions. This encompasses multiple factors beyond just price, including the speed of execution, the likelihood of execution, the size of the order, and the overall transaction cost.
While price improvement specifically refers to obtaining a price better than the prevailing public quote, a broker could achieve "best execution" even without explicit price improvement if, for example, a large order is executed quickly and with minimal market impact in a highly illiquid security, where getting any fill at the NBBO is an accomplishment. Conversely, a firm might claim price improvement, but if the execution venue consistently provides slower fills or has a higher likelihood of non-execution for certain order types, it might not fully satisfy the holistic best execution duty. Therefore, price improvement is a crucial metric, but it is one of several considerations within the comprehensive framework of best execution.
FAQs
How is price improvement different for buy and sell orders?
For a buy order, price improvement means you pay less than the lowest advertised asking price (the National Best Offer). For a sell order, it means you receive more than the highest advertised bidding price (the National Best Bid). It's always about getting a better deal than what was publicly available.
Do all orders receive price improvement?
No, not all orders receive price improvement. Whether an order receives price improvement depends on market conditions, the specific security, the order type (e.g., market order vs. limit order), and the execution venue. Many orders are filled directly at the National Best Bid or Offer (NBBO) or, occasionally, at a worse price, especially in highly volatile markets.
Why do some brokers offer more price improvement than others?
Differences in price improvement among brokers can stem from their order routing practices, relationships with various market makers, and the sophistication of their algorithmic trading technology. Off-exchange market makers, for instance, often compete for order flow by offering small amounts of price improvement to retail orders that they can profitably internalize.
Is price improvement guaranteed?
No, price improvement is never guaranteed. Market conditions, such as high volatility or low liquidity, can make price improvement difficult to achieve. The goal of a broker-dealer is to seek the most favorable price reasonably available, but actual outcomes vary.