Series 7 Study Guide Navigation
- Series 7 Study Guide Home
- 1.1 Contact with potential and current customers, marketing material development, approval, and distribution
- 1.2 Describing investment products to potential and current customers
- 2.1 Tells potential customers about the account types available and discloses their restrictions
- 2.2 Secures and updates information about customers along with relevant information and documents
- 2.3 Gather customer investment profile information
- 2.4 Get necessary supervisory approval to open accounts and make account changes
- 3.1 Passing on all investment strategy information to customers
- 3.2 Analyze customer’s portfolio of investments as well as product options to determine suitability
- 3.3 Disclose to clients characteristics and risks of investment products
- 3.4 Communications with customers
- 4.1 Providing current quotes for investors
- 4.2 Processing and confirming customers’ transactions as per regulations
- 4.3 Notifies the correct supervisor, helps with solving discrepancies, disputes, errors, and all complaints
- 4.4 Dealing with margin issues
Part of the tasks of a registered representative will involve entering orders for customers.
This means that not only should they understand the various types of orders but also how they are to be applied when called upon to carry out this task.
But there’s more that they need to understand, for example, various securities quotations.
We will cover this and more in this first section of the module.
Customer order types
There are various types of orders available to customers.
Let’s look at them.
When an order restricts the price of an order, it’s commonly called a price-restricted order.
This included limit and stop-limit orders.
The following are typical orders found in the securities world:
- Market: This is an order that’s executed immediately and always at the market price
- Limit: This will limit either the amount paid for the securities or the amount received for the securities
- Stop: When the stock reaches or goes above the stop price, a stop order will become a market order. The stop price is also called the trigger or election price.
- Stop-limit: This starts life as a stop order but when the stock reaches or goes higher than the stop price, it is then changed to a limit order.
That’s the basics but let’s look at these all in a little more detail.
We start with market orders which have priority over any other type of order.
There are no restrictions or limits on these orders.
When received, they will be sent to the trading floor without delay and executed.
This will take place at the current price of the stock the order is for.
When the market order is executed to buy, this will be for the lowest offering price available for the particular stock the order covers.
When the market order is executed to sell, this will be for the highest bid price that can be found.
Typically those prices are often called the inside market or the inside quote.
A market order will always be executed as long as the security it is written for is currently trading.
Market orders are the proper order to use if a client requests an immediate execution.
We’ve already mentioned how a customer can use this type of order to limit the acceptable selling or purchase price.
And remember, that means that only when the price reaches that specified level (or above) will the limit order be executed.
Should this not occur immediately once the order is placed, it then moves to the designated market marker’s (DDMs) book.
This means that should the market price meet that stipulated in the limit order, it will be executed.
It’s important to note that:
- When a buy limit order is placed, it will be below the current market. Investors use this when they believe that the price of the stock is higher than it should be. They do want to buy the stock, but only when there is a dip in the market.
- When a sell limit order is placed, it will be above the current market. When investors who own stock want to sell but believe that is currently priced too low, they use limit orders to sell when the stock price reaches the level they believe it is worth.
When it comes to the length of time that limit orders operate for, well there are two options.
The first is a day order and it only operates on the day it is entered.
The second is a GTC or good ’til canceled order.
Also known as an open order, this will remain open until the point that it’s canceled.
While on the subject of limit orders, we have to discuss the risks associated with them.
The biggest risk is when the market moves away from the limit price
When this happens, the chance to buy or sell is missed by the customer that entered the limit order.
Also, markets are fickle and may never drop to the low point or rise to the high point the limit price is set at.
Even when the stock starts trading at the price set out by the limit order, it still might not be executed.
The main reason for this is because of the term stock ahead.
This means that a stock order at the same price superseded the limit order.
And that’s because when limit orders at the same price are arranged in the DMM’s book, they are done so as to when the order was received.
So with two orders of the same price, the one that was received first will be the order executed first.
Next up we look at stop orders, sometimes called a stop loss order.
The main aim of a stop order is twofold.
It either prevents a loss or protects a profit should the stock move in the opposite direction that was envisaged.
Once the stock either moves through a certain price or trades at it, the stop order then becomes a market order.
This price through which the stock must first move for this to happen is known as the stop price.
Note that stop orders will be left with the DMM and when the stock hits the stop price, they will execute the stop order into a market order as we have described above.
Unlike a limit order price, however, the executed price might not be the stop price.
There are two types of stop orders:
- Buy stop orders: Here the stop order is entered higher than the current market
- Sell stop orders: Here the stop order is entered lower than the current market
The order is triggered by a trade taking place at the stop price and as we’ve mentioned it then becomes a market order.
Stop orders are executed through two trades that need to take place:
- Trigger: This is the transaction through or at the stop price that will initiate the trade
- Execution: This is when the stop order now turns into a market order. The trade is completed when this market order is executed at the next price
Let’s look at buy stop orders in a little more detail.
The main aim of this type of stop order is simple.
When an investor holds a short stock position, this can be used to either limit a loss or protect a profit.
Using a buy stop order will see it entered at a price that is higher than the current market.
When the market price reaches or goes through the buy stop price, that’s when the buy stop order will be triggered.
There’s another way in which buy stop orders are used and that’s by technical traders to check stock resistance levels and to track support.
For example, they can place a buy stop order at a certain resistance level for a stock.
If it then breaks that price level, the order will then buy the stock at that price before it can gain momentum and the price moves even higher.
This is only relevant for certain stocks which these technical traders believe will climb in price rapidly if they break their resistance.
As for a sell stop order, when a long stock position is held, this is also used to either limit a loss or protect a profit.
Using a sell stop order will see it entered at a price that is lower than the current market.
Like buy stop orders, technical traders also make use of sell stop orders in situations where they think a stock price will fall significantly should it break through a certain level.
So before that does happen, when it breaks through a certain support level, the sell stop order will become a market order and before the price falls even further, they will sell the stock.
Lastly, there is the limit stop order.
This kind of stop order will become a market order when triggered but a limit order instead.
So when would an investor use a buy stop order?
Well, there are three reasons in particular:
- When holding a short stock position, a buy stop order can protect against loss
- When holding a short stock position, a buy order can protect a gain
- If a breakout occurs higher than the line of resistance, a buy stop order can help establish a long position
Then when would an investor use a sell stop order?
There are three reasons in particular for that as well:
- When holding a long stock position, a sell stop order can protect against a loss
- When holding a long stock position, a buy order can protect a gain
- If a breakout occurs lower than the line of support, a sell stop order can help establish a short position
When a stop order is triggered (or deleted), it’s not set in stone the investor either receives or pays the stop price.
That’s because once triggered, a market order is entered.
That means the price can either be higher, lower, or the same as the stop price.
A stop-limit order is the best bet when an investor is looking for a specified price or higher.
There is a risk here, however, as we learned earlier.
And that’s that while the order might be triggered, sometimes it doesn’t get carried out.
When a stock goes ex-dividend, some orders found in the order book of the DMM are then reduced.
This includes those orders entered below the market.
They will be reduced on the ex-date also called the ex-dividend date.
But when is that exactly?
Well, the ex-dividend date is the first date when the purchaser of the stock (the new owner, in other words) isn’t entitled to the current dividend as they do not qualify for it.
This means that taking the amount of distribution into account, the stock price will be lower when it opens on the ex-dividend date.
There is a do not reduce order (DNR) as well.
An ordinary cash dividend will not reduce this type of order.
What that means is that if an execution takes place exclusively to the ex-date reduction, the customer won’t worry about it at all.
In the Series 7 exam, you may be quizzed when it comes to cash dividends and which orders will be reduced for them.
Those that will be reduced automatically are the orders that are below the market price when placed.
Buy Limits and sell stops (BLiSS) orders are such orders.
They are always reduced for cash dividend distributions because they are placed below the market price.
No matter if an order is placed above or below the market, they are adjusted for stock splits and stock dividends.
What about reductions for stock splits?
Well, all open orders will be adjusted by the DMM if there is a stock split or stock dividend.
There are a fair few of these.
Let’s begin with day orders.
An open order, whether it be a stop or limit, is seen as a day order unless it is marked differently.
This means that on the day that it is entered, the order will be valid until the close of trading.
Note that day orders are canceled at the end of the day’s trading should they have not been filled.
Then there are Good Till Canceled (GTC) orders.
These remain valid until they reach a point where they have either been canceled or executed.
Note, however, that come the last business day of April as well as that of October, any GTC orders that are still valid are canceled automatically.
GTC orders will need to be re-entered should the customer want them to remain in operation beyond these two dates.
The third type of time-sensitive orders is At-the-Open and Market-on-Close orders.
Their names are an indication of how they operate.
So when the market opens, at-the open orders are executed with partial executions allowed, if necessary.
They will be canceled, however, if they do not reach the post by the opening of the security they are trading.
For market-on-close orders, these must be executed as near to or at the closing price of a security in the over-the-counter market.
The NYSE, however, is a little different.
Here, these orders will be executed at the securities closing price while the market-on-close order has a time deadline.
It must be entered before 3.40 pm ET.
Next, we have Not Held (NH) orders.
When a market order holds the NH code, this means that there is no specific price of execution or time for the order.
In other words, the customer doesn’t put those requisites to the broker-dealer or floor-broker regarding that particular security.
That puts the decision in their hands as to either the best price or moment as to when the trade should be executed.
The NYSE DDM does not allow these types of orders.
Also, as per FINRA Rule 3260, these orders only stand for the day that they are given to a broker-dealer.
An exception can be made should the customer confirm the order is a GTC.
This has to be done in writing, however.
There are Fill-or-Kill (FOK) orders too.
With these, the order must be filled straight away at equal to or better than the limit price.
Should the commission house broker not be able to do so, they will cancel the entire order.
They also must then tell the branch office that originated the order that it has been canceled.
Immediate-or-cancel (IOC) orders, while similar to FOK orders, do allow partial execution.
When a portion cannot be executed, it will then be canceled.
When an order must be executed in its entirety, it’s called an All-or-None (AON) order.
If this isn’t the case, the order is not carried out at all.
These orders can either be a day order or a GTC order but because they are not required to be filled immediately, they differ from FOK orders in that regard.
Do all exchanges accept these types of orders?
No, they don’t.
For example, GTC or stop orders are not accepted by either Nasdaq or the NYSE.
Their equity markets also do not allow the entry of AON or FOK orders.
Broker-dealers can, however, accept these orders and enter them on exchanges that do not accept them.
If this is the case, however, the status of each order has to be monitored manually.
Customers don’t just place orders.
Before they do, they will want to know the price they will be paying when buying securities or that which they will be receiving when selling securities.
Member firms or brokers pass on this information to their clients in the form of quotations and that’s what we are going to be looking at specifically in this section.
Quotes, bids, and offers
Should a client be interested in buying listed or unlisted securities, quotations are available for both types.
A member firm or broker cannot provide quotes for NYSE trade stock.
That must come from the DMM and can be viewed electronically.
Note that market makers that will originate quotations on the OTC market.
When it comes to understanding various quotes, the Series 7 exam is probably going to focus on those from OTC markets as opposed to those supplied by the DMM.
Because the OTC doesn’t have DMMs, FINRA must give approval for firms that have registered to make a market in a specific security.
This allows them to try to make a profit at their own risk as they buy and sell securities for their own inventories.
When a broker-dealer uses their account to buy and sell instead of arranging trades for other investors, they are not acting as an agent but instead, as a principal.
Proprietary trading is another way in which this process can be described.
Quotes that have a bid as well as an offer or ask price are said to be a full quote.
Should a market maker provide it, other than the bid and offer price, the quote will also include the size.
Two things to note here are:
- Current bid: This shows the market maker’s highest price they will pay to buy
- Current offer: This shows the market maker’s lowest price they will accept to sell
And we know that the spread is the difference between the bid and the ask price.
When a member firm acts as a principal and a customer buys stock from them, the ask price will be marked up so as to reach the net price to the customer.
In the case of a customer selling stock to a member firm that acts as a principal, the bid price will be marked down to reach the net proceeds to the customer.
So the bid price is the amount that a member firm is willing to pay for a stock they are purchasing from another firm.
The ask price is the price at which the stock is offered and that’s why it’s often referred to as the offer price as well.
When an order to buy a stock is entered by a member firm, they can pursue two courses of action.
If the stock is purchased at the asking price from the market maker, the firm is acting as the principal or in effect, a dealer.
FINRA then allows a markup to be added to the cost incurred by the firm for buying the stock.
Or, the member firm can add a commission but charge customers the price that was originally paid for this stock.
When this transpires, the member firm is acting as an agent, or in effect, a broker.
When a customer places a sell order, everything is the other way around.
When the member firm buys from the customers and the market maker buys the stock at bid price, they are acting as the principal.
This means the price the customer receives from the firm will be lower than that from the market maker.
The term markdown is used to describe the difference between the two.
Should the member firm act as an agent, however, they take a commission while paying the customer the bid price of the market maker.
For the Series 7 exam, remember that only one or the other of a markup (markdown) or commission can be charged by a broker-dealer on the same trade.
There is a range of different quote types that you will come across on the OTC market.
Here are those that you should know for the Series 7 exam.
We start with the firm quote.
When a market maker is ready to sell or buy one trading unit – the equivalent of five bonds or 100 shares of stock – at the price quoted, that is said to be a firm quotation.
Unless stated otherwise, all quotes are considered to be firm quotes.
As a registered representative of a broker-dealer, you will be expected to function as an OTC trader on occasions.
The task here is to take customer orders and see to it that you can get the best price for a customer when they are executed, be it buying or selling.
A counteroffer (counterbid) to a market maker can be used by a trader to negotiate a better price.
And when there is a fairly wide spread between the bid of the market maker and the ask, this is a strategy that is used often.
Immediate executions, however, are only possible when as a trader, you will either sell at the bid price or buy at the ask price put up by the market maker.
For the Series 7 exam, understanding how a firm quote might be shown in questions is essential.
For example, the exam could mention, ” it is 30-31″ and that phrasing would indicate that the actual quote on that security is 30-31.
Should trading activities or market conditions change, market makers will often revise a firm quote.
Market makers are said to be backing away should they not opt to do business at the current quote.
This is not allowed, however, so don’t be caught out by this violation on the exam.
When you compare this to a firm quote, it’s kind of the opposite.
That’s because a subject quote will still need further confirmation while a firm quote is a price that will be honored by a dealer.
For the most part, you won’t find a market maker providing a subject quote.
It’s more often than not used when an investor calls their registered representative to find out how a stock is doing.
They might not know the exact price now but could then give a subject quote based on the price they saw a couple of hours ago.
In this situation, the registered representative should confirm that it’s a subject quote, not a firm quote.
Get used to the kind of terminology used as well because this might well appear in the Series 7 exam.
For qualified quotes, thanks to certain qualifiers or provisos, should market conditions change, a dealer is allowed to back away because of these changes.
There are two types of qualified quotes: a workout quote and a nominal quote.
A workout quote is used when a certain trade will only be accommodated with special handling put in place.
For example, this could mean that the market would not be able to absorb the trade without disruption because of its order size.
Workout quotes are never a firm quote, they only indicate a price to the buyer or seller and are an approximate figure.
The terminology for these quotes might include the “workout” or “subject”.
A trader could even say “It’s around” a certain price.
You know that it’s not a firm quote because of the fact that the trader won’t say “it is current” or “the market is”.
With a nominal quote, you are giving an idea of where in an active market a security might trade.
This is not set in stone and is only the estimation of the person giving the quote.
These are used for an inactively traded security and just to give an idea of the market value thereof.
If a nominal quote appears in print, it must be labeled.
Because the market for municipal bonds isn’t that active, nominal quotes are often used here.
We already know that the spread is the difference between the bid price and ask (or offer) price of a security.
But what factors will influence this spread?
Well, there are several:
- The size of the issue
- The financial condition of the issuer
- The issue’s market activity
- Market conditions
Take note, the spread will be far narrower if a security is active and vice versa.
That’s something to remember for the Series 7 exam.
Customer orders and the best execution thereof
When dealing with customer orders, member firms must always show diligence when it comes to the security in question and the best market to deal with it.
The price that results through the execution of the sale or purchase of the said security should, depending on the current condition of the market, always provide a customer with as favorable a price as possible.
Reasonable diligence under FINRA Rule 4310 takes in a number of factors that help determine if member firms have done as well as they can in this regard.
These factors include:
- The market’s overall character with regards to that security. This involves relative liquidity, price, and volatility, amongst other factors.
- The type of transaction
- The size of the transaction
- The total number of markets checked
- The quotation’s accessibility
- The order’s terms and conditions that end in the transaction
Now that we have some background behind the best execution of customer orders, let’s look at securities with limited quotations or pricing information orders.
While FINRA Rule 5310’s best execution requirements cover all securities orders, it goes without saying that the markets for various securities are all different.
One area of critical importance when meeting best execution requirements for customer orders is when there are limited quotations or information on pricing available for certain securities.
This won’t ever be a problem for Nasdaq or NYSE trade stocks but if you look at those that change hands on the OTC Link, for example, finding pricing information can be difficult.
In fact, it’s a matter of weeks in some instances where a trade or quotes on a security might be made available.
But there is another problem when it comes to these securities because when a quote comes along, it’s usually just a single market that is providing it, so there isn’t much competition.
Ultimately, this means that the price can be set to their advantage.
Should this happen, it’s up to the member firm to try to find other sources for quotations or pricing information.
Often, if they have traded the security in question before, they can turn to those firms that they traded with.
Member firms must use the best available market when acting for a customer in the capacity of an agent.
This means that a third party cannot sit in between the best available market and the firm or in other words, orders cannot be routed through another brokerage.
This is commonly called interpositioning and it will mean that the customer will get a less than favorable price.
This is as a result of the third party trading adding all additional costs for itself while trading at the inside market.
If it means a better execution for a customer’s security, interpositioning can be acceptable.
This means that the price will need to be lower in the case of an insider offer or higher in the case of an inside bid.
When it comes to executing orders for securities on markets that are not the best available for that security, this can never be acceptable because of a member firm saying that their OTC order room is too busy (usually because it is understaffed).
Also, as a means to respond in kind for either business generated or services offered, orders should not be channeled to third parties either.
Both of these examples may be tested in the Series 7 exam.
Here are some other test topics regarding OTC quotes that may appear:
- When acting as a principal (or taking on financial risk while dealing from inventory), a market maker will charge markups and markdowns
- Firm quotes deal with only a round lot unless stated otherwise
- All nominal quotes are provided for informational purposes only. If they are to be printed, they must include a nominal quote label so as to identify them as such.
- When the spread is wide, the trading market for the associated security is thin
- Last sale information is not always available for securities that identify as OTC non-Nasdaq.
When you hear the term selling short, or short sale, or holding a short position means that a member firm is selling a security that they do not own.
Why would they do this, however?
Well, the view when holding a short position – which is considered to be a bearish strategy – is that soon, the price of the security will go down.
Should this occur, there is a profit to be made.
That’s because the borrowed security can be replaced by the short seller at a lower price than what it was initially sold for.
Of course, there is a significant risk in a strategy like this.
That risk comes in the fact that the price of the borrowed security could increase instead of drop.
In that scenario, the seller will have to pay a higher price than the sale price to replace the securities.
This is an unlimited loss potential too.
That’s because the price that the security can theoretically reach doesn’t have any limit.
When it comes to terminology, the phrase often used to describe a short sale is “covering the short” or “closing the short position”.
Also, the only account that can be used in short selling is a margin account.
This is due to the fact that borrowing is part of the process of short selling.
Rules of short sales
So we already know that a short sale sees a security sold that’s not owned by a customer.
When this happens, delivery of that sold security needs to be made to whoever bought it.
When the trade is then settled, the customer’s account will be credited with the proceeds of the sale by the broker-dealer.
Note, that the sale is always made before the securities are bought.
So how is a profit made?
Well, that happens when there is a decline in the value of the stock.
As we mentioned earlier, however, potential risk is high especially if the stock appreciates in value instead of going down.
When compared to maximum profit, well that’s not unlimited.
That’s due to the fact that a security can only fall so far in price.
That means that the difference between $0 and the sale price is the maximum profit that can be made by selling short.
Whenever a customer wants to sell short, the member firm must explain the risks involved.
As far as when short sales can take place, well that’s at any point during the day’s trade.
This includes the opening of trade as well as the closing of trade.
The one major requirement when it comes to short selling is that the share to lend must either already be held by the broker-dealer or they will be able to locate them easily as prescribed by Regulation SHO.
By ensuring that they can locate the securities, on the settlement date, the member firm can ensure that they are delivered.
If they don’t know where to locate the securities but still go ahead with the short sale, it’s known as naked short selling and this practice is against regulations.
There are regulations in place too that forbid insider short sales.
This means that the short-selling of stock in companies is not allowed by directors, officers, or principal stockholders of that company.
Let’s also briefly look at sell order tickets.
As per SEC regulations, all sell orders must be identified in two ways.
They are either long or short.
Unless the security that will be delivered following the sale to the broker by the settlement date is already in the customer’s account or owned by them, the sale cannot be deemed long.
When a customer is said to be long a security they:
- Have title to that security
- They have already purchased the security or
- They have an unconditional contract to do so but the security has not been received by the customer yet
- Have owned a security convertible or exchangeable
- Have an option and exercised the option to buy the security
The SEC requires that one or more of these conditions be met.
If not, all sales are then seen to be short sales.
Sometimes, investors can be both be long on a stock and short on it at the same time as well.
In that case, it must be determined if they are their net long or net short and this is achieved when both positions are netted.
As an example, an investor might be long 600 shares of stock ABC and short 100 shares of stock ABC at the same time.
Their net position is therefore 500 long shares.
If instead of being 100 shares short of stock ABC, let’s say they were short 700 shares.
Then their net position would be 100 short shares.
While we are discussing rules, we need to look at the borrowing of securities.
Should they not be able to borrow securities they are wanting to sell, an investor isn’t able to sell short.
But where can these securities be borrowed from?
Well, there are a few options:
- The investor will need a member firm to execute the short sale for them and the securities can be borrowed from this firm
- The member firm will also have margin customers and the securities can be borrowed from them too
- Other member firms that hold the securities in question can be borrowed from
- Custodial banks, pension plans, and other institutional investors are another source of securities that can be borrowed from
In most cases, a loan consent agreement will be signed by customers when they open a margin account.
This means that when their portfolio needs it, the customer is allowed to lend margin securities from custodians.
In many cases, as a way to improve income streams and generate more income, many institutional and sophisticated investors will lend securities that are scarce on the market.
They do this by charging those who lend these securities from them.
Next, we cover a rule known as market to market.
As the price of the underlying securities fluctuates, market to market involves a customer’s margin account and the process of making daily adjustments to it based on those fluctuations.
It’s also sometimes called marking to the market.
So the equity in their account will drop when the price of the stock goes up and vice versa.
For short sellers, stock prices moving down are favorable as it allows them to make a profit.
Last in this section on short sale rules, we cover shorting bonds.
With some securities, many that are equivalent will be trading at any one time.
An example of this is listed stocks.
This means that it’s pretty easy to cover any short selling when it comes to stocks like this.
When bonds are limited, like municipal bonds, for example, covering short sales isn’t that easy, as finding the stock to buy the short position back could prove difficult.
That’s as a result of the market being too thin.
On the Series 7 exam, you may find questions covering short selling of municipal bonds.
Just remember, that this is something that will almost never happen.
Securities marketplace rules
When it comes to stock exchanges, without a doubt, the most widely known is the NYSE.
You’ll find stocks that are listed here that are also then listed on regional stock exchanges, like the Chicago Stock Exchange, as one example.
Exchange listing requirements
When securities are listed on stock exchanges to trade, they are commonly known as listed securities.
They cannot just be placed on these exchanges, however, as there are certain listing requirements that they have to meet.
When it comes to the NYSE, only companies of sufficient size can be listed.
For example, with most stock exchanges, a corporation that wants its securities listed will need to have a certain number of shareholders as well as a certain number of publicly held shares.
On the NYSE exchange, when it comes to trading on the floor of the exchange, well that’s only reserved for members.
Don’t forget about regional exchanges as there are many broker-dealers and investors that trade there.
The focus of these regional stock exchanges is more on businesses that operate within the region where these stock exchanges are found.
In some cases, large organizations might list on a regional stock exchange and the NYSE in what is known as a dual listing.
It’s often easier to list on a regional stock exchange than the NYSE, for example.
That’s because the listing requirements simply are not as stringent.
You’ll also find that attracts newer companies as well as those that are smaller in size than what you would find on the NYSE.
While talking about listing on stock exchanges and the requirements thereof, let’s briefly chat about a designated market maker (DMM).
DMMs are involved in the trading of certain stocks, playing a role in the trading of the stocks by helping to maintain an orderly market and ensure that it remains fair.
Interestingly, DMMs operate both as brokers and a dealer in carrying out their function on a stock exchange.
That function is basically as an auctioneer.
Because of the service they provide to the stock exchange, if their quotes result in a trade, DMMs are given a rebate on exchange charged feeds.
The auction market itself is something we need to talk about as well because it’s here where various exchange securities are traded as they are bought and sold by various parties.
As both buyers and sellers of securities will call out their bids and offers as per their best prices, exchanges are sometimes referred to as double-action markets.
When a broker-dealer is wanting to buy on the exchange, they will first look at what the current best bid is.
To initiate their own bid, they need to place it at least $0.01 higher.
For those broker-dealers who are selling, they will look at the current best offer.
Their best offer then should be $0.01 lower than that.
Note that because bids are taking place at a fast rate when it comes to those that receive first consideration, it’s always the highest bids and lowest offers.
DMMs will award trades using the following order for when different brokers enter either the same offer or bid.
- Priority – which order was first in?
- Precedence – the largest order of the submitted orders is the next consideration
Various rules are in place to stop uncontrollable drops in the market.
One of these rules is Volatile Market Conditions Rule 80B.
This includes a set of levels that act as circuit breaker thresholds when there is a decline in the S&P 500 Index when compared to the closing price the previous day.
These levels, which cause a halt in the market, are:
- Level 1 halt: This occurs when the S&P 500 declines by 7%
If this happens before 3:25 pm, the market is halted for 15 minutes.
If it occurs at or after 3:25 pm, unless a level 3 halt is called, trading is allowed to continue.
- Level 2 halt: This occurs when the S&P 500 declines by 13%
If this happens before 3:25 pm, the market is halted for 15 minutes.
If it occurs at or after 3:25 pm, unless a level 3 halt is called, trading is allowed to continue.
- Level 3 halt: This occurs when the S&P 500 declines by 20%
When this happens all trading for the day is halted and will not resume.
When it comes to a Level 1 or Level 2 halt, these can only occur once on a trading day.
So should a Level 1 have already happened and these same conditions occur again, only if the market declines to the level as stipulated by Level 2 will trading be stopped again.
When trading halts occur for listed securities, it’s either the exchange or the SEC that would have initiated them.
When trading halts occur for OTC stocks, the trading venue, for example, Nasdaq or FINRA would have been the initiator.
When a trading halt occurs, while trading may not take place, any open orders entered previously can be canceled by investors if they so wish.
When we talk of arbitrage, we are actually discussing a specific trading strategy.
With this strategy, specialized traders, which are called arbitrageurs, will look to make a profit in a very unique way.
They do this by using the temporary price differences between securities and markets, specifically price differences in the same security or an equivalent.
Don’t be fooled on the Series 7 exam as questions mentioning this practice often are mentioned together with manipulation of the market.
Arbitrage is a perfectly legal strategy.
Let’s begin by covering market arbitrage.
This is a strategy used when a security doesn’t only trade on one market, for example, it might appear on two exchanges, a regional one, and the NYSE for example.
Because of this, it’s possible that the security might sell at different prices at the same time – one price on one exchange and another on the other.
In this situation, someone who uses a market arbitrage strategy will buy the lower-priced security on the one market and then sell it at the higher price simultaneously on the other, thus making a profit.
There’s convertible security arbitrage as well and this occurs with convertible bonds and their underlying stock.
In the right conditions, bonds can be converted to stock and then sold at a profit.
We talked about delivery versus payment (DVP) accounts and receipt versus payment (RVP) accounts normally used by institutional clients.
Generally, with these clients and accounts, securities that are purchased are then delivered to a third party that is performing the role of the purchaser’s agent.
This agent generally holds the institutions’ money and in most cases, they are banks. and payment will then be made once the delivery is made in a DVP scenario.
For an RVP scenario, it’s the other way around.
Here, the securities are delivered by the agent and at the same time, the purchaser will make the payment.
According to FINRA Rule 11860, these transactions are called collect on delivery (COD) or payment on delivery (POD).
Orders on COD or POD deliveries cannot be accepted by a FINRA member unless the rules and procedures are followed.
- The name and the address of the agent as well as the account number and time of the customer on that agent’s file as well as the institution number (if applicable) must be received from the customer by the member prior to or at the time of accepting the order
- Each order must have an indication that it is a POD or COD transaction
- Confirmation to the customer will be delivered by the member or all relevant data pertaining to it. This must be done by the next day’s close of business after the execution has taken place.
- An agreement between the member and customer must be reached so that the customer will provide instructions to the agent regarding the receipt or delivery of the securities as soon as possible following the customer taking receipt of the confirmation.
When trades are made in these accounts, there is a special rule under Regulation T that they qualify for.
When a security is purchased for or sold to a customer by a broker-dealer in a delivery against payment transaction, a period of 35 calendar days can pass before the broker-dealer gets payment if the securities delivery is delayed as a result of transaction mechanics and not a lack of ability to pay by the customer.