Matching Orders: What They Are, How They Work, and Examples

What Are Matching Orders?

Matching orders is the process by which a securities exchange pairs unsolicited buy orders to sell orders to make trades. This contrasts with requests for a quote (RFQ) in a security to proceed with a trade.

If investors want to buy and sell the same quantity of stock at the same price, their orders match, and a transaction is effected. Pairing these orders is the process of order matching, where exchanges identify buy orders (bids) with corresponding sell orders (asks) to execute them. This process has become almost entirely automated in the past decade.

Key Takeaways

• Matching orders is the process of identifying and effecting a trade between equal and opposite requests for a security.
• Order matching is how exchanges pair buyers and sellers at compatible prices for efficient trading.
• This process has become almost entirely automated.

How Matching Orders Works

Matching the orders of buyers and sellers is the primary work of specialists and market makers in the exchanges. Matches happen when compatible buy orders and sell orders for the same security are submitted in close proximity in price and time.

Generally, a buy order and a sell order are compatible if the maximum price of the buy order matches or exceeds the minimum price of the sell order. From there, computerized order-matching systems use various methods to prioritize orders for matching.

Most exchanges now match orders using computer algorithms. In the past, brokers matched orders through face-to-face interactions on a trading floor in an open-outcry auction.

Quick, accurate order matching is critical for an exchange. Investors, especially active investors and day traders, look to minimize inefficiencies in trading from every possible source. A slow order-matching system may cause buyers or sellers to execute trades at less-than-ideal prices, reducing investors’ profits. If some order-matching protocols favor buyers or sellers, these methods become exploitable.

This is an area where high-frequency trading (HFT) has improved efficiency. Exchanges aim to prioritize trades to benefit both buyers and sellers, maximizing order volume – the lifeblood of the exchange.

Popular Algorithms for Matching Orders

All major markets have transitioned to electronic matching. Each securities exchange uses its own specific algorithm to match orders. Broadly, they fall under two categories: first-in-first-out (FIFO) and pro-rata.

FIFO

Under a basic FIFO algorithm or price-time-priority algorithm, the earliest active buy order at the highest price takes priority over any subsequent order at that price, which in turn takes priority over any active buy order at a lower price. For example, if a buy order for 200 shares of stock at $90 per share precedes an order for 50 shares of the same stock at the same price, the system must match the entire 200-share order to one or more sell orders before beginning to match any portion of the 50-share order.

Pro-Rata

Under a basic pro-rata algorithm, the system prioritizes active orders at a particular price in proportion to their relative size. For example, if both a 200-share buy order and a 50-share buy order at the same price are active when a compatible 200-share sell order arrives, the system will match 160 shares to the 200-share buy order and 40 shares to the 50-share buy order.

Since the sell order is not large enough to fulfill both buy orders, the system will partially fill both. In this case, the pro-rata matching algorithm fills 80 percent of each order.