What Are Matching Orders?

What Are Matching Orders?

Let me explain matching orders directly: it's the process where a securities exchange pairs one or more unsolicited buy orders with one or more sell orders to complete trades. This differs from requesting a quote to proceed with a trade.

If you're an investor wanting to buy a certain quantity of stock and another wants to sell the same amount at the same price, your orders match, and the transaction happens. I'm talking about the core work of order matching, where exchanges identify bids (buy orders) with corresponding asks (sell orders) and execute them. Over the last decade, this has shifted to being almost entirely automated.

Key Takeaways

Understand this: matching orders identifies and effects a trade between equal and opposite requests for a security, like a buy and a sell at the same price. It's how exchanges pair buyers and sellers at compatible prices for efficient, orderly trading. And yes, this process is now almost fully automated.

How Matching Orders Works

Matching buyers' and sellers' orders is the main job of specialists and market makers on exchanges. These matches occur when compatible buy and sell orders for the same security are submitted close in price and time.

A buy order and a sell order are compatible if the buy's maximum price meets or exceeds the sell's minimum price. From there, the computerized systems on different exchanges use various methods to prioritize orders for matching.

Here's a fast fact you should know: today, most exchanges match orders using computer algorithms, but historically, brokers did this through face-to-face interactions on a trading floor in open-outcry auctions.

Quick and accurate order matching is essential for any exchange. If you're an active investor or day trader, you'll seek to minimize trading inefficiencies from every angle. A slow system could force you to trade at suboptimal prices, cutting into your profits. If protocols favor one side over the other, they become exploitable.

This is where high-frequency trading has boosted efficiency. Exchanges prioritize trades to benefit buyers and sellers equally, aiming to maximize order volume, which keeps the exchange running.

Popular Algorithms for Matching Orders

All major markets have moved to electronic matching. Each exchange has its own algorithm, but they generally fall into two categories: first-in-first-out (FIFO) and pro-rata.

FIFO

Under a basic FIFO algorithm, also known as price-time-priority, the earliest active buy order at the highest price gets priority over later ones at that price, which then take priority over lower-priced orders. For instance, if you place a buy order for 200 shares at $90 per share before someone else orders 50 shares at the same price, the system must match the full 200 shares to sell orders before touching any of the 50-share order.

Pro-Rata

With a basic pro-rata algorithm, the system prioritizes active orders at a specific price based on their relative sizes. Say there's a 200-share buy order and a 50-share buy order at the same price when a matching 200-share sell order comes in; the system would match 160 shares to the larger order and 40 to the smaller one.

Since the sell order isn't enough for both, it partially fills them proportionally—in this case, filling 80 percent of each order.