Investors can enter various types of orders to buy or sell securities. Some orders guarantee that the investor's order will be executed immediately. Other types of orders may state a specific price or condition under which the investor wants their order to be executed. All orders are considered day orders unless otherwise specified. All day orders will be canceled at the end of the trading day if they are not executed. An investor may also specify that their order remain active until canceled. This type of order is known as Good 'Til Cancel or GTC.
A market order will guarantee that the investor's order is executed as soon as the order is presented to the market. A market order to either buy or sell guarantees the execution but not the price at which the order will be executed. When a market order is presented for execution, the market for the security may be very different from the market that was displayed when the order was entered. As a result, the investor does not know the exact price at which their order will be executed.
A buy limit order sets the maximum price that the investor will pay for the security. The order may never be executed at a price higher than the investor's limit price. Although a buy limit order guarantees that the investor will not pay over a certain price, it does not guarantee them an execution. If the stock continues to trade higher away from the investor's limit price, the investor will not purchase the stock and may miss a chance to realize a profit.
A sell limit order sets the minimum price that the investor will accept for the security. The order may never be executed at a price lower than the investor's limit price. Although a sell limit order guarantees that the investor will not receive less than a certain price, it does not guarantee them an execution. If the stock continues to trade lower away from the investor's limit price, the investor will not sell the stock and may miss a chance to realize a profit or may realize a loss as a result.
A stop order or stop loss order can be used by investors to limit or guard against a loss or to protect a profit. A stop order will be placed away from the market in case the stock starts to move against the investor. A stop order is not a live order; it has to be elected. A stop order is elected and becomes a live order when the stock trades at or through the stop price. The stop price is also known as the trigger price. Once the stock has traded at or through the stop price, the order becomes a market order to either buy or sell the stock depending on the type of order that was placed.
A buy stop order is placed above the market and is used to protect against a loss or to protect a profit on a short sale of stock. A buy stop order also could be used by a technical analyst to get long the stock after the stock breaks through resistance.
A sell stop order is placed below the market and is used to protect against a loss or to protect a profit on the purchase of a stock. A sell stop order also could be used by a technical analyst to get short the stock after the stock breaks through support.
An investor would enter a stop limit order for the same reasons they would enter a stop order. The only difference is that once the order has been elected, the order becomes a limit order instead of a market order. The same risks that apply to traditional limit orders apply to stop limit orders. If the stock continues to trade away from the investor's limit, they could give back all of their profits or suffer large losses.
There are several other types of orders that an investor may enter. They are:
All or None Orders: These orders may be entered as day orders or GTC. As the name implies, all or none orders indicate that the investor wants to buy or sell all of the securities or none of them. All or none orders are not displayed in the market because the required special handling and the investor will not accept a partial execution.
Immediate or Cancel Orders: The investor wants to buy or sell whatever they can immediately and whatever is not filled is canceled.
Fill or Kill Orders: The investor wants the entire order executed immediately or the entire order canceled.
Not Held Orders: The investor gives discretion to the floor broker as to the time and price of execution. All retail not held orders given to a representative are considered day orders unless the order is received in writing from the customer and entered GTC.
Market on Open/Market on Close Orders: The investor wants their order executed on the opening or closing of the market or as reasonably close to the opening or closing as practical. If the order is not executed, it is canceled. Partial executions are allowed.
The most recognized stock exchange in the world is the New York Stock Exchange or the NYSE. There are, however, many exchanges throughout the United States that all operate in a similar manner. Exchanges are dual-auction markets. They provide a central market place where buyers and sellers come together in one centralized location to compete with one another. Buyers compete with other buyers to be the highest price anyone is willing to pay for the security and sellers compete with other sellers to be the lowest price at which anyone is willing to sell a security. All transactions in an exchange-listed security that are executed on the exchange have to take place in front of the specialist or designated marker maker (DMM) for that security. The specialist/DMM is an exchange member who is responsible for maintaining a fair and orderly market for the stock in which they specialize. The specialist/DMM stands at the trading “post” where all the buyers and sellers must go to conduct business in the security. This is responsible for the crowd that you see on the news and financial reports when they show the floor of the exchange. All securities that trade on an exchange are known as listed securities.
Orders that are routed to the trading post for execution are prioritized according to price and time. If the price of more than one order is the same, orders will be filled as follows:
The specialist is an independent exchange member who has been assigned a stock or group of stocks for which they are the designated market maker (DMM). They are responsible for:
A large amount of capital is required in order to fulfill the requirements of a specialist/DMM. As a result, most specialists/DMMs are employees of specialist firms. Although the specialist is not required to participate in every transaction, every transaction for that security that is executed on the exchange must take place in front of the specialist. The specialist may act as either an agent or as a principal if they play a role in the transaction.
In the absence of public orders the specialist/DMM is required to provide liquidity and price improvement for the stocks in which they are the designated market maker. Specialists/DMMs are required to trade against the market and may now trade for their own account at prices that would compete with public orders.
The specialist/DMM is also required to execute orders that have been left with them. Orders that have been left with the specialist/DMM for execution are said to be left or dropped on the specialist's/DMM's book. The specialist/DMM is required to maintain a book of public orders and to execute them when market conditions permit. The types of orders that may be left with the specialist are:
The specialist/DMM will execute the orders if and when they are able to and will send a commission bill to the member who left the order with them for execution. This is known as a specialist bill and is usually only a cent or two per share. The specialist/DMM is also required to quote the best market for the security to any party that asks. The best or inside market is comprised of the highest bid and lowest offer. This is made up from bids and offers contained in the specialist's/DMM's book and in the trading crowd. The inside market is also the market that is displayed to broker dealers and agents on their quote system.
When quoting the inside market, the specialist/DMM will add all of the shares bid for at the highest price and all of the shares offered at the lowest price to determine the size of the market. There are certain types of orders that are not included when determining the inside market; they are:
A specialist/DMM may not accept the following types of orders:
Market orders and immediately executable limit orders are filled as soon as they reach the crowd so there is nothing to leave with the specialist. In the case of a not held order, once a floor broker is given discretion as to time and price, they may not give it to another party.
A specialist's/DMM's book may look something like the following example:
| Buy | XYZ | Sell |
5 Goldman 10 JPM |
20 | |
| 20.05 | ||
| 20.10 | 1 Prudential 5 Fidelity |
|
| 20.15 | 2 Morgan | |
| 5 Merrill Stp | 20.20 |
The inside market for XYZ based on the specialist's/DMM's book would be:
| Bid | Ask | |
| 15 × 6 | 20.00 | 20.10 |
Buyers are bidding for 1,500 shares and sellers are offering 600 shares of XYZ.
A floor broker from time to time may get an order from both a buyer and a seller in the same security. The floor broker may be allowed to pair off or cross the orders and execute both orders simultaneously. In order for the floor broker to cross the stock, the specialist/DMM must allow it and the floor broker must announce the orders in an effort to obtain price improvement for the orders. The floor broker must offer the stock for sale at a price above the current best bid and may purchase the stock using the buy order if no price improvement has been offered. This then will complete the cross and both orders will be filled.
GTC orders that are placed underneath the market and left with the specialist/DMM for execution will be reduced for the distribution of dividends. Orders that will be reduced are:
These orders are reduced because when a stock goes ex dividend, its price is adjusted down. To ensure that customer orders placed below the market are only executed as a result of market activity, the order will be adjusted down by the value of the dividend.
GTC orders that are left with the specialist must be adjusted for stock splits. Orders that are placed above and below the market will be adjusted so that the aggregate dollar value of the order remains the same.
Notice that in all of the examples, the value of the customer's order remained the same. To calculate the adjustment to an open order for a forward stock split, multiply the number of shares by the fraction and the share price by the reciprocal of the fraction. Such as:
The value of the order was $5,000 both before and after the order.
As a courtesy to a public customer, a specialist/DMM may guarantee an execution price while trying to find an improved or better price for the public customer. This is known as stopping stock if an order comes in to the crowd to purchase 500 ABC at the market when ABC is quoted as follows:
| Bid | Ask | |
| 15 × 20 | 40 | 40.20 |
If the specialist/DMM stopped the customer, they would guarantee that the customer would pay no more than 40.20 for the 500 shares. The specialist then would try to obtain a better price for the customer and would try to attract a seller by displaying a higher bid for that customer's order. ABC may now be quoted after the specialist/DMM stopped the stock as:
| Bid | Ask | |
| 5 × 20 | 40.10 | 40.20 |
In this case, the specialist/DMM is trying to buy the stock for the customer 10 cents cheaper than the current best offer. If, however, a buyer comes into the crowd and purchases the stock that is offered at 40.20, the specialist must sell the customer 500 shares from their own account no higher than 40.20.
A commission house broker is an employee of a member organization and will execute orders for the member's customers and for the member's own account.
A two-dollar broker is an independent member who will execute orders for commission house brokers when they are too busy managing other orders.
A registered trader is an exchange member who trades for their own account and for their own profit and loss. Orders may not originate on the floor of the NYSE; however, registered traders are active on other exchanges such as the Amex (now part of NYSE). A supplemental liquidity provider/SLP is an off-the-floor market maker that directs orders to the floor of the NYSE for its own account. The SLP may compete with the DMM for order execution and must display a bid or offer at least 5% of the time. The SLP will receive a rebate from the NYSE when an order is executed against the SLP's quote that added liquidity to the market. Allied members of the NYSE are given direct phone and electronic access to the trading floor but may not trade on the floor itself.
Most customer orders will never be handled by a floor broker. Floor brokers usually only handle the large complex institutional orders. Customer orders will be electronically routed directly to the trading post for execution via the super display book system. The super display book bypasses the floor broker and sends the order right to the specialist/DMM for execution. If the order can be immediately executed, the system will send an electronic confirmation of the execution to the submitting broker dealer. All listed securities are eligible to be traded over the super display book system. All preopening orders that can be matched up are automatically paired off by the system and executed at the opening price. Any preopening orders that cannot be paired off are routed to the trading post for inclusion on the display book.
An investor who believes that a stock price has appreciated too far and is likely to decline may profit from this belief by selling the stock short. In a short sale, the customer borrows the security in order to complete delivery to the buying party. The investor sells the stock high hoping that they can buy it back cheaper and replace it. It is a perfectly legitimate investment strategy. The investor's first transaction is a sell and they exit the position by repurchasing the stock. The short sale of stock has unlimited risk because there is no limit to how high the stock price may go. The investor will lose money if the stock appreciates past their sales price.
The SEC continues to adopt new rules relating to the short sale of securities. Regulation SHO has been adopted to update prior short sale regulations and covers:
Under Regulation SHO, the SEC has prohibited any SRO from adopting any price criteria as a requirement of executing a short sale.
Rule 200 updates the definition of who is determined to be long a security. As new derivatives and trading systems and strategies have been introduced, amendments to the short sale rules under the Securities Exchange Act of 1934 needed to be updated. Most of the prior rules and definitions remain unchanged. The new updates under Rule 200 are:
A broker dealer may qualify to have its various trading departments determine their net long or short positions independently if:
The order marking requirements of Rule 200 require the broker dealer to mark all orders long, short, or short exempt. The definition of long and short include the definitions in the affirmative determination rule and have been expanded to include the following:
A broker dealer may not accept an order to sell short an equity security for the account of a customer or for its own account without having borrowed the security, having arranged to borrow the security, or without having a reasonable belief that the security can be borrowed. A broker dealer can rely on an easy-to-borrow list of securities as long as the list is less than 24 hours old. For sell orders that were marked long, the broker dealer must deliver the securities by settlement date and may not borrow the securities to complete delivery. However, a broker dealer may borrow securities to complete delivery under the following exceptions:
A broker dealer must close out all customer fails to deliver within 35 days of the trade date. The broker dealer must borrow the securities or buy in the securities of a like kind and quantity.
A broker dealer is exempt from the locating requirements for short sales if:
The firm must file a short interest report twice per month for short positions that have settled by the 15th and as of the last trading day of each month, using FINRA's Regulation Filing Application (RFA). All reports are required to be filed with the firm's designated examining authority (FINRA or NYSE) by the end of the second business day following the settlement date.
Securities that are not listed on any of the centralized exchanges trade over the counter or on the Nasdaq. Nasdaq stands for National Association of Securities Dealers Automated Quotation System. It is the interdealer network of computers and phone lines that allows securities to be traded between broker dealers. Nasdaq is not an auction market but has been granted exchange status by the SEC. It is a negotiated market. One broker dealer negotiates a price directly with another broker dealer. None of the other interested parties for that particular security have any idea of what terms are being proposed. The broker dealers may communicate over their Nasdaq workstations or can speak directly to one another over the phone.
Because there are no specialists for the over-the-counter markets, bids and offers are displayed by broker dealers known as market makers. A market maker is a firm that is required to display a two-sided market. A two-sided market consists of a simultaneous bid and offer for the security quoted through the Nasdaq workstation. The market maker must be willing to buy the security at the bid price, which they have displayed, as well as be willing to sell the security at the offering price, which they have displayed. These are known as firm quotes. There is no centralized location for the Nasdaq market; it is simply a network of computers that connects broker dealers throughout the world. Market makers purchase the security at the bid price and sell the security at the offering price. Their profit is the difference between the bid and the offer known as the spread. Rule changes and new trading systems known as ECNs, or electronic communication networks, have narrowed the spreads on stocks significantly in recent years.
Broker dealers will subscribe to the Nasdaq workstation services that meet their firm's requirements. The levels of service are:
Most actively traded Nasdaq stocks are quoted by a large number of market makers. As market makers enter their quotes, some will be above or below the inside market. A market maker whose quote is above or below the inside market is said to be away from the market. As the market makers adjust their quotes, the market maker who is publishing the highest bid for the security has their bid displayed at the top of the list and their bid is published as the best bid to anyone with a Nasdaq Level I subscription. The market maker publishing the lowest offer will have their offer listed at the top of the list and published as the lowest offer to anyone with a Nasdaq Level I subscription. As a result, the best bid and offer from any two market makers will make up the inside market.
All quotes published over the Nasdaq workstation are firm quotes. A dealer who fails to honor their quotes has committed a violation known as backing away. Dealers who provide quotes over the phone that are clearly indicated as being subject or nominal cannot be held to trade at those prices. Nasdaq qualifiers are:
A response of “it is” would indicate a firm quote. A firm quote is always good for at least one round lot or 100 shares.
Most Nasdaq trades are executed over the Nasdaq workstation using one of its automated execution systems. These systems allow dealers to execute orders without having to speak with one another on the phone.
The Nasdaq Market Center Execution System also known as NMCES accepts market orders and immediately executable limit orders for both customer and firm accounts. Orders may be entered for up to 999,999 shares per order. The orders will immediately be routed to dealers on the inside market for automatic execution. Larger orders may be split up to meet the maximum order volume. However, a broker dealer may not split orders that would otherwise be able to be entered into the Nasdaq system in an effort to increase fees or rebates. This would be considered order shredding and is a violation. Orders executed through the Nasdaq execution system are automatically reported to ACT.
The Nasdaq opening cross begins at 9:28 am. At this time, the Nasdaq execution system automatically executes orders. Orders placed after 9:28 am may not be canceled. Orders placed after 9:28 am may be changed only if the change to the order makes the order more aggressive. A change that increases the size of the order or improves the price would make the order more aggressive. For a buy order, an improved price would be a higher limit price; for a sell order, an improved price would be a lower limit price. The opening cross creates the Nasdaq official opening price (NOOP). Like the opening cross, Nasdaq has developed the closing cross to determine the Nasdaq official closing price.
The OTC bulletin board provides two-sided electronic quotes for OTC securities that cannot meet the listing standard of an exchange or Nasdaq. DPPs and ADRs will often be quoted on the OTCBB.
Securities that do not qualify for listing on the Nasdaq, or that have been delisted from Nasdaq or one of the exchanges, may be quoted on the Pink OTC. The Pink OTC Market is operated as an electronic marketplace. The Pink Sheets displayed in the Pink OTC Market are firm quotes. The Pink OTC Market also provides a list of phone numbers for market makers who display subject quotes. Stocks quoted on the Pink OTC Market trading at under $5 per share are known as penny stocks. A firm that executes a customer's order for a Pink OTC security is required to make a reasonable effort to obtain the best price for the customer. The firm is required to obtain quotes from at least three market makers for the security prior to executing the customer's order. If the security has less than three market makers, the firm is required to obtain a quote from all market makers.
The third market consists of transactions in exchange-listed securities executed over the counter through the Nasdaq workstation. A broker dealer may wish to simply purchase or sell an exchange-listed security directly with another brokerage firm instead of executing the order on the floor of the exchange. These transactions are known as third-market transactions. All third-market transactions are reported through TRF to the consolidated tape for display.
A fourth-market transaction is a transaction between two large institutions without the use of a broker dealer. The computer network that facilitates these transactions is known as INSTINET. Large blocks of stock, both listed and unlisted, trade between large institutional investors in the fourth market. While many trades in the fourth market are executed through the INSTINET system, many large portfolio managers execute internal crosses that go unreported. Proprietary trading systems are not considered part of the fourth market because these systems are either registered as broker dealers or are operated by broker dealers.
The term broker dealer actually refers to the two capacities in which a firm may act when executing a transaction. When a firm is acting as a broker, it is acting as the customer's agent and is merely executing the customer's order for a fee known as a commission. The role of the broker is simply to find someone willing to buy the investor's securities if the customer is selling or to find someone willing to sell them the securities if they are buyers. The firm acts as a dealer when it participates in the transaction by taking the opposite side of the trade. For example, the firm may fill a customer's buy order by selling the securities to the customer from the firm's own account or the dealer may fill the customer's sell order by buying the securities for their own account. A brokerage firm is always acting as a dealer or in a principal capacity when it is making markets over the counter.
| Broker | Dealer |
| Executes customer's orders | Participates in the trade as a principal |
| Charges a commission | Charges a markup or markdown |
| Must disclose the amount of the commission | Makes a market in the security Must disclose the fact that they are a market maker, but not the amount of the markup or markdown |
FINRA has set a guideline to ensure that the prices investors pay and receive for securities are reasonably related to the market for the securities. As a general rule, FINRA considers a charge of 5% to be reasonable. The 5% policy is a guideline, not a rule. Factors that go toward what is considered reasonable are the:
When a customer is executing an order for a low price or low total dollar amount, a firm's minimum commission may be greater than 5% of the transaction.
A firm that executes customer orders on a principal basis is entitled to a profit on those transactions. If the firm is selling the security to the customer, they will charge the customer a markup. In the case of the firm buying the securities from the customer, they will charge the customer a markdown. The amount of the markup or markdown that a firm charges the customer is based on the inside market for the security.
If a brokerage firm receives a customer order to buy or sell a security and the firm does not have an inventory position in the security, the firm still may elect to execute the order on a principal basis. If the firm elects to execute the order on a principal basis, this is known as a riskless principal transaction. Because the dealer is only taking a position in the security to fill the customer's order, the dealer is not taking on any risk. As a result, the markup or markdown on riskless transactions will be based on the dealer's actual cost, not on the inside market. Let's look at an example:
In a proceeds transaction, the customer sells a security and uses the proceeds from that sale to purchase another security on the same day. FINRA's 5% policy states that a firm may only charge the customer a combined commission or markup and markdown of 5% for both transactions, not 5% on each.
Arbitrage is an investment strategy used to take advantage of market inefficiencies and to profit from the price discrepancies that result from those inefficiencies. There are three types of arbitrage. They are:
Market Arbitrage: Securities that trade in more than one market will sometimes be quoted and traded at different prices. Market arbitrage consists of the simultaneous purchase and sale of the same security in two different markets to take advantage of the price discrepancy.
Security Arbitrage: Securities that give the holder the right to convert or exercise the security into the underlying stock may be purchased or sold to take advantage of price discrepancies between that security and the underlying common stock. Securities arbitrage consists of the purchase or sale of one security and the simultaneous purchase or sale of the underlying security.
Risk Arbitrage: Risk arbitrage tries to take advantage of the price discrepancies that come about as a result of a takeover. A risk arbitrageur will short the stock of the acquiring company and purchase the stock of the company being acquired.