The Specialist's Discretion: Stopped Orders and Price Improvement

Abstract

When a market order arrives, the NYSE specialist can offer a $1/8 better price to gain priority over the limit orders on the book and trade for his own account. Alternatively, the specialist can stop the market order, which means he guarantees execution at the current quote but provides the possibility of price improvement. I show that specialists can use stops to sample the future order flow before makinga commitment to trade. I also present evidence that unadvertised liquidity, in the form of both stops and immediate price improvement, imposes adverse selection costs on limit order traders.

JEL Classification: D43, G10