Nasdaq's AI Order Type (Dynamic M-ELO): What to Know - Investopedia

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When buying or selling securities, investors place different types of orders, each with unique requirements. The order type determines how and when the trade is executed. For instance, some orders aim for the best price, while others specify a fixed price. Nasdaq says its artificial intelligence (AI)-powered order type, called Dynamic Midpoint Extended Life Order (M-ELO), provides a more efficient way for investors to trade, helping to improve their rate of executed orders and reduce markouts, bad trades where the market immediately moves against you.

Key Takeaways

Dynamic M-ELO uses AI to adjust the waiting period for M-ELO orders.
Where M-ELO orders have a 10-millisecond waiting period, Dynamic M-ELO orders have waiting periods from 0.25 to 2.5 milliseconds.
Dynamic M-ELO aims to improve fill rates and reduce markouts.

What Is Dynamic M-ELO?

Dynamic M-ELO is an order type that investors can use when buying or selling securities, the first powered by AI. Nasdaq said it had obtained Securities and Exchange Commission approval in September 2023.

Nasdaq is positioning the order type for traders with a longer-term investment horizon, not day traders or others looking to move into and out of positions frequently. M-ELO orders execute only against other M-ELO orders at the midpoint of the spread between the bid price and ask price.

Dynamic M-ELO makes a slight change to the standard M-ELO order type. AI analyzes more than 140 data points every 30 seconds to assess market conditions for a security. It then adjusts the waiting period for investors who submit a Dynamic M-ELO order within a range of 0.25 and 2.5 milliseconds, with a jump to 12 milliseconds during market instability.

Midpoint Execution

Imagine two traders submitting M-ELO orders. John wants to buy 100 shares of XYZ, and Jane wishes to sell 100 shares of XYZ.

If the highest bid for XYZ is $20 and the lowest ask is $21, their M-ELO order will execute at $20.50, the midpoint of the bid-ask spread.

How Does This AI-Powered Order Type Work?

The process starts when a buyer enters an M-ELO order to buy a security. After a waiting period of 10 milliseconds, that order becomes eligible to execute against other M-ELO orders. Once a seller arrives, places a M-ELO sell order, and the 10-millisecond waiting period passes, the buyer and seller get matched, and the trade is executed.

M-ELO orders can help protect investors from undesired trade executions during market movements. Before the buyer's trade can execute, if a sell immediate or cancel order sweeps the bids, the M-ELO order won't execute.

Buyers are also protected if numerous sell orders enter the market and the price of a share drops. The midpoint of the bid-ask spread will also drop, causing the buy price of the M-ELO order to adjust to this level.

Hence, M-ELO buyers and sellers will not receive order executions as quickly as someone using an order with no waiting period. However, they are protected from quick market movements because the price of their offer automatically adjusts with the bid-ask spread of the underlying security.

Advantages and Disadvantages of AI-Powered Order Types

AI-powered order types can help investors make more complicated trades or get better prices, but they are not without drawbacks.

Advantages of AI-Powered Order Types

Here are some of the benefits of AI-powered orders:

M-ELO orders only match with other M-ELO orders, allowing you to trade with like-minded investors.
The price of your order automatically moves with the bid-ask spread, helping you avoid trading for a price that does not match the market value of a security.
M-ELO and other AI orders may be off-book, functioning like dark pool trading.
M-ELO is compatible with existing exchange connectivity.

Disadvantages of AI-Powered Order Types

AI-powered order types do have drawbacks. Here are some downsides to consider:

You rely on the AI to set the price for you, which could lead to buying or selling for a price far from what you expect.
Automated trading systems and AI could be subject to technical failures.
AI-powered order types like M-ELO can potentially obscure moves in the market. Decisions by algorithms may not be easily understandable by even the developers of the algorithms. As a result, it could be difficult to predict how these order types would behave under diverse market conditions.

Dynamic M-ELO's Impact on the Stock Market

Dynamic M-ELO is still a new order type, so it's difficult to observe its effects on the stock market. However, Nasdaq has released data showing that M-ELO on its own has helped improve order execution. According to Nasdaq, orders using M-ELO had a 50% hit rate, meaning half of all orders received at least one execution, compared with 36% for orders with a holding period of 500 milliseconds. Similarly, the average fill rate was 49% for M-ELO orders compared with 35% for orders with a 500 millisecond holding period.

Nasdaq says that by leveraging AI, Dynamic M-ELO can improve trade execution even further, improving fill rates and reducing markouts. The data indicates that it improves fill rates by more than 20% and reduces markouts by more than 11%, according to Nasdaq.

The Future of AI-Powered Order Types

Dynamic M-ELO is the first AI-powered order type to be approved by the SEC, but it likely will not be the last. AI is already being used in the world of finance, with many major companies, including Deloitte and BlackRock integrating AI into their firms' work.

If Dynamic M-ELO proves successful, more AI-powered order types are likely to follow. Further advances in technology could lead to more efficient, agile, and responsive trading systems. They would, in theory, offer better liquidity, reduced trading costs, and improved execution quality. However, their evolution may also pose challenges regarding market fairness, regulation, and systemic risks.

What Are the Risks Associated with AI-Powered Order Types?

AI-powered order types rely on a machine rather than a person to handle order execution. If the AI becomes unresponsive because of a technical issue, it could lead to poor order fulfillment. The AI could also experience errors, leading to buying or selling securities at a subpar price.

What Is an M-ELO Order Type?

M-ELO orders allow investors to place buy or sell orders with a short waiting period. These orders only execute against each other and do so at the midpoint of the bid-ask spread.

How Is Priority Determined for M-ELO Orders?

M-ELO orders are ranked in time priority among other M-ELO orders when they complete their waiting period and become eligible for execution.

Are There Scenarios When Dynamic M-ELO Might Be Particularly Useful?

Dynamic M-ELO could be most helpful in volatile market conditions or when trading fewer liquid securities. Its AI-driven algorithms could navigate complex price fluctuations more effectively than traditional order types.

What Are the Risks of Using Dynamic M-ELOs?

While Dynamic M-ELO aims to improve fill rates and reduce markouts, it's not a guarantee against risks in the market. In addition, the AI algorithms can't perfectly predict market behavior, and there may be a learning curve for traders new to this order type.

Bottom Line

Dynamic M-ELO is an AI-powered order type that adjusts the waiting period for a M-ELO order based on market conditions. It is the first AI-powered order type to receive SEC approval, and preliminary data indicates that it could help improve trade execution. If that proves lasting, Dynamic M-ELO is likely to open the doors for future AI-based products that power stock market orders.

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Nasdaq's AI Order Type (Dynamic M-ELO): What to Know - Investopedia
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