Terminology

This section works through each piece of that vocabulary in turn: how quotes are built, what each order type promises and does not promise, the extra risks of short selling, and how cash and margin accounts, trading capacity, and payment for order flow fit together.

What Are Bid, Ask, and the Spread?

• Bid: the highest price a buyer (dealer) is willing to pay for a security
• Ask (Offer): the lowest price a seller (dealer) is willing to accept
• Bid-ask spread: Ask minus Bid; the dealer's compensation in market making

Investor perspective:

• Buying: investor pays the ask (the higher price)
• Selling: investor receives the bid (the lower price)
• The spread is an implicit transaction cost; a round-trip trade loses the spread

Example: Bid $50.00 / Ask $50.20; investor who buys immediately and sells immediately loses $0.20 per share.

How Does Spread Width Relate to Liquidity?

• Narrow spread = highly liquid (large-cap stocks, major exchange-traded funds)
• Wide spread = thinly traded, illiquid (small-cap over-the-counter stocks, penny stocks, bonds)

Quote: the current bid and ask prices displayed for a security.

Exam Tip: Gotchas

• Investors buy at the ask (higher) and sell at the bid (lower). The dealer does the opposite.

What Are the Four Main Order Types?

What Does a Market Order Guarantee?

• Executed immediately at the best available price
• Guarantees execution, not price
• Default order type if none is specified

What Does a Limit Order Guarantee?

• Customer specifies maximum price to pay (buy) or minimum price to accept (sell)
• "Better" means lower for buy limits and higher for sell limits
• Guarantees price, not execution

How Does a Stop Order Work?

A stop order requires two events:

1. Trigger: stock trades at or through the stop price (activates the order)
2. Execution: order becomes a market order and executes at the next available price

How Does a Stop-Limit Order Differ from a Stop Order?

• Combines a stop order with a limit order
• Once triggered, becomes a limit order (not a market order)
• Provides price protection after trigger but may not execute if the market gaps through the limit

Exam Tip: Gotchas

• Market order guarantees execution but not price. Limit order guarantees price but not execution.
• Stop order becomes a market order at the trigger price; no price guarantee; can slip in fast markets. Stop-limit order becomes a limit order; price protected but may not execute if the market gaps through.
• Buy limits and sell stops are placed below the market. Sell limits and buy stops are placed above the market. The exam tests which side of the market each order sits on.

What Are the Risks and Requirements of a Short Sale?

• Short sale: borrowing and selling a security the investor does not own, with the obligation to buy it back later
• The short seller profits when the price falls (buy low, return the borrowed shares)
• Unlimited loss potential: the price can rise indefinitely
• Short sales require a margin account: they cannot be executed in a cash account
• The short seller must eventually cover (buy back) the shares to return them to the lender
• Short sellers are responsible for paying any dividends declared while the position is open

Exam Tip: Gotchas

• Short sellers have theoretically unlimited loss potential. The stock price can rise without limit.
• Short selling requires a margin account. You cannot short in a cash account. A common exam distractor states that risk can be reduced by confining short sales to cash accounts; this is wrong because cash accounts cannot hold short positions at all.
• The short seller owes dividends to the share lender while the position is open.

What Are the Rules for Cash Accounts?

• Investor pays 100% of the purchase price within one Reg T payment period: the standard settlement cycle (T+1) plus two business days, not merely by settlement date
• No borrowing of funds from the broker-dealer
• Cannot execute short sales or strategies with unlimited loss potential
• Regular-way settlement: T+1 (one business day after trade date) for stocks, bonds, exchange-traded funds (ETFs), mutual funds, and options
  • Changed from T+2
  • U.S. government securities also settle T+1
• If payment is not received in time, the broker-dealer must cancel or liquidate the position. That alone does not freeze the account

What Is Free Riding and What Happens If It Occurs?

• Free riding: buying a security in a cash account, then selling it before paying for the original purchase, using the sale proceeds to fund the purchase
• The customer never puts up their own capital; the sale covers the buy before payment was ever due
• Free riding violates Regulation T and results in the account being frozen for 90 days
• During the freeze, the customer may still buy securities but must pay in full with already-settled funds before placing the trade

Exam Tip: Gotchas

• Free riding requires a sale. It's buying, then selling before paying, funded by the sale proceeds, not simply missing a payment deadline. A customer who never sells and just fails to pay gets the purchase canceled or liquidated, which is a separate (and less severe) outcome.
• Free riding penalty = 90-day account freeze. Only settled funds may be used for new purchases during the freeze.
• Settlement is T+1 for most securities. The exam may still reference T+2 in older contexts, but T+1 is the current standard.

How Do Margin Accounts Work?

Margin accounts allow investors to borrow money from the broker-dealer to purchase securities (buying on margin). Governed by Regulation T (Federal Reserve Board), the FINRA margin rule, and individual firm requirements.

What Are the Key Margin Thresholds?

What Triggers a Margin Call?

• Issued when account equity falls below the maintenance margin requirement
• The investor must deposit additional cash or securities to restore equity
• If the margin call is not met, the broker-dealer can liquidate securities without the customer's consent

How Is Buying Power Calculated?

• With 50% initial margin, an investor who deposits $10,000 can purchase up to $20,000 in securities ($10,000 cash + $10,000 borrowed)
• Margin amplifies both gains and losses (leverage risk)

Exam Tip: Gotchas

• The $2,000 minimum equity is a FINRA self-regulatory requirement, not a Regulation T rule. On a purchase, the deposit need not exceed the cost of the security, so a small purchase can require less than $2,000.
• A small initial short position (e.g., $400 worth of stock) still requires a $2,000 deposit. For short sales, the $2,000 minimum applies regardless of position size.
• The firm (house) maintenance requirement can be higher than FINRA's 25% minimum. Many firms require 30-35%. The exam tests FINRA's 25% unless stated otherwise.
• BD can liquidate securities without the customer's consent if a maintenance call is not met. The customer does not choose which positions are liquidated.

How Do Principal and Agency Trades Differ?

A broker-dealer can execute trades in two capacities:

• A firm cannot act as both principal and agent on the same transaction without disclosure and customer consent
• Riskless principal: dealer receives a customer order, immediately buys the security in the market for its own account, then resells to the customer (technically principal, functionally like agency)

Exam Tip: Gotchas

• The key to identifying capacity is compensation. Commission = agency. Markup/markdown = principal. The exam describes a scenario and asks you to identify which capacity the firm is acting in.
• Riskless principal = principal trade (markup applies) even though the BD had no inventory risk.

What Is Payment for Order Flow and How Is It Disclosed?

• Payment for order flow: compensation that a broker-dealer receives from a market maker or other venue for routing customer orders to that venue for execution
• The broker-dealer is paid by the market maker in exchange for the opportunity to execute those orders
• PFOF is legal but must be disclosed to customers
• The order-routing disclosure rule imposes two separate duties:
  • a public quarterly report on the routing of non-directed orders
  • on a customer's request, disclosure of where that specific customer's orders were routed
• A firm receiving PFOF must still satisfy its best execution obligation
• PFOF may create a conflict of interest: the firm may route orders to the venue that pays the most rather than the venue offering the best price

Exam Tip: Gotchas

• PFOF does not automatically violate best execution. However, a broker-dealer must not allow PFOF to interfere with its duty to obtain the best reasonably available price for customers.
• PFOF is paid by the market maker to the broker, not by the investor directly.

What Should You Check on Exam Day?

• Investors buy at the ask and sell at the bid; the spread is the dealer's implicit compensation
• Market orders guarantee execution, not price; limit orders guarantee price, not execution
• A stop order becomes a market order at the trigger; a stop-limit becomes a limit order at the trigger
• Buy limits and sell stops sit below the market; sell limits and buy stops sit above the market
• Short sales require a margin account and carry unlimited loss potential; the short seller owes any dividends declared while the position is open
• Cash accounts require full payment within one Reg T payment period (T+1 plus two business days), not merely by settlement date; nonpayment alone triggers a mandatory cancel-or-liquidate, not a freeze
• Free riding (selling before paying, funded by the sale) triggers a 90-day account freeze; nonpayment without a resale is not free riding
• Initial margin is 50% of purchase price under Regulation T (or a higher regulatory-authority percentage, whichever is greater); maintenance margin is a FINRA self-regulatory 25% minimum
• The $2,000 minimum equity to open a margin account is a FINRA rule, not Regulation T, and does not apply to a purchase costing less than $2,000; it does apply to short sales regardless of size
• Compensation identifies capacity: commission means agency, markup/markdown means principal; riskless principal is still a principal trade
• PFOF is legal but must be disclosed: a public quarterly routing report plus, on customer request, that customer's own routing disclosure