Online Trading

What is an ECN?

An electronic communication network, or ECN, is an order matching platform which connects investors directly to brokerage houses, rather than processing trades through a middle man. By providing direct access to the ECN, brokerage houses are able to bring down costs and consquently offer lower commission schedules to their clients. 

ECN's will have an order book for each security and will display all buy and sell orders in real time which were placed by individual traders, broker/dealer, institutional investors, and even market makers.  Individual traders must subscribe to an ECN through their online broker before they are able to transact on them.  Orders wi

ECN Variations

There are a few different ECNs that exist out there:

Instinet

Instinet is the oldest ECN out there, being established in 1969 to provide a block crossing capability for institutional investors.  Basically, it created a facility to allow large institutional block orders to be transacted directly between institutions without market maker or specialist intervention.  Today, Instinet has been expanded to trade many of the stocks listed on the Nasdaq Composite and many of the other major exchanges.  Instinet has also been cited as a pioneer for after hours trading.

Small Order Execution System (SOES)

SOES was established to resolve inefficiencies that would result in a panic type of market event where orders were coming in with enormous volume.  SOES was set up to provide liquidity and automate order execution on transactions of less than 1000 shares.  To trade on the SOES, a list of rules apply.  Firstly, a trader cannot perform a transaction of more than 1000 shares at a time and if they choose to trade that stock again, they must wait 5 minutes.  Secondly, no stocks over $250 are allowed to trade through this network.  At the end of the day, SOES gives individual investors the ability to achieve the same executions that larger institutions are receiving.

NYSE Arca

NYSE Arca, also known as ArcaEx or Archipelago, is an ECN which trades stocks listed in NYSE, AMEX & Nasdaq.  In addition to offering trading on equities, Arca Ex trades options on indices, ETFs, equities & foreign exchange currency pairs.  ArcaEx accounts for nearly 10% of NYSE volume and nearly 20% of volume at the Nasdaq.

What is Naked Short Selling?

Naked short selling is an illegal trading activity that occurs when a stock is sold short on the market without ever borrowing any shares.  In a normal trading transaction, the broker will provide the required shares in real-time or acquire them shortly thereafter to ensure there are shares on hand for the short position.  The end result of naked shorting is the price of the security is pushed lower by "fictitious" shares being sold on the open market.  This type of manipulation leads to bear raids that pushes prices to extremes and creates volatile moves in the market.

Tracking Naked Short Selling

Tracking naked short selling can be extremely difficult.  Since the short position is never opened, there is no buyback to close the position.  So, the trade is categorized as "having failed" to deliver and there is virtually no way of knowing who initiated the naked short.  This allows an unlimited number of sales orders to flood the market thus disrupting the normal supply and demand balance for the security. 

Naked shorting would not be possible without brokerage firms who allow the shorting of stocks that are not on the easy to borrow list, which leads to short sales for which the broker can not support.  As a result of the 2008 credit crisis the SEC finally admitted that naked shorting is a problem.  The SEC has now begun to place even further limits on short selling by amending the Regulation SHO rules to require short sellers to deliver securities a minium of three days later.  Many politicians are now pushing to have broker dealers be required to deliver the borrowed security on the actual settlement date.

What is Short Covering

Short covering is the act of buying back shares in order to close out a short position.  Short covering is often a tough concept for novice traders to grasp, because it is the exact opposite of going long in the market.  The majority of retail investors understand that if they buy a stock the only way to close out the position is to sell.  With the horrendous drop in the world markets as a result of the 2008 credit crisis, many novice investors are wondering how they could have profited from such destruction.  The answer to this question is shorting the market.

Example of Short Covering

Let's assume a trader was short Citigroup at $23.50 in early October.  In order to open this position the trader would sell short 500 shares by borrowing these from their broker and selling them on open market.  This creates a net short position for the trader.  So, the only way to close out this position is to buy back or cover the position.  In the below chart Citigroup experienced a free fall down to $3.  This lead to a massive short squeeze which shot the stock up over $8 in a matter of days.

Short Covering and the Market

Many investors believe that shorting is evil.  However, shorting is a normal part of the markets and adds to its liquidity.  For example, as a stock begins to fall precipitously, many traders that are short will begin to cover their position to get out with a profit.  This short covering sends a large number of buy orders into the market which in turn creates counter move rallies.  Without short covering, the market will just continue to float lower, as buyers are not willing to step in front of a falling knife.