Terminology
This section covers the core trading terminology tested on the Series 65 exam: bids and offers, order types, short sales, cash and margin accounts, principal versus agency trades, and payment for order flow.
Bids, Offers, 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
| Party | Buys At | Sells At |
|---|---|---|
| Dealer/Market Maker | Bid price | Ask price |
| Investor | Ask price | Bid price |
Example: Bid $50.00 / Ask $50.20; investor who buys immediately and sells immediately loses $0.20 per share.
Spread Width and 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.
Order Types
| Order Type | Execution | Price Guarantee | Execution Guarantee | Use Case |
|---|---|---|---|---|
| Market | Immediate at best price | No | Yes | Speed over price |
| Limit | At specified price or better | Yes | No | Control over price |
| Stop (stop-loss) | Becomes market order at trigger | No | No | Limit losses or protect gains |
| Stop-limit | Becomes limit order at trigger | Yes | No | Price control with protection |
Market Orders
- Executed immediately at the best available price
- Guarantees execution, not price
- Default order type if none is specified
Limit Orders
- 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
| Order Type | Placed | Executed At |
|---|---|---|
| Buy limit | Below current market | Limit price or lower |
| Sell limit | Above current market | Limit price or higher |
Stop Orders
A stop order requires two events:
- Trigger: stock trades at or through the stop price (activates the order)
- Execution: order becomes a market order and executes at the next available price
| Order Type | Placed | Triggered When | Purpose |
|---|---|---|---|
| Buy stop | Above current market | Price rises to/through stop | Protect short position; catch breakout |
| Sell stop | Below current market | Price falls to/through stop | Protect long position; catch breakdown |
Stop-Limit Orders
- 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.
Short Sales
- 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.
Cash Accounts
- Investor pays 100% of the purchase price 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
- Effective May 28, 2024 (changed from T+2)
- U.S. government securities also settle T+1
- If payment is not received by settlement, the broker-dealer may liquidate the position and freeze the account for 90 days (free-riding violation)
Exam Tip: Gotchas
- Free riding = selling before paying. Penalty = 90-day account freeze.
- Settlement is T+1 for most securities (effective May 28, 2024). The exam may still reference T+2 in older contexts, but T+1 is the current standard.
Margin Accounts
Margin accounts allow investors to borrow money from the broker-dealer to purchase securities (buying on margin). Governed by Regulation T (Federal Reserve Board), Financial Industry Regulatory Authority (FINRA) Rule 4210, and individual firm requirements.
Key Margin Thresholds
| Requirement | Rule | Amount |
|---|---|---|
| Initial margin | Regulation T | 50% of the purchase price (or $2,000 minimum, whichever is greater) |
| Minimum maintenance margin | FINRA Rule 4210 | 25% equity for long positions |
| Minimum equity | Regulation T | $2,000 to open a margin account |
| Pattern day trader minimum | FINRA Rule 4210 | $25,000 equity |
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
Buying Power
- 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
- Even a small position requires a minimum deposit of $2,000 in a margin account. 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 sell any securities if a maintenance call is not met. The customer does not choose which positions are liquidated.
Principal vs. Agency Trades
A broker-dealer can execute trades in two capacities:
| Capacity | Role | Compensation | Disclosure |
|---|---|---|---|
| Principal (dealer) | Trades from its own inventory | Markup (sell to customer) or markdown (buy from customer) | Must disclose capacity on trade confirmation |
| Agency (broker) | Intermediary between buyer and seller | Commission | Must disclose commission amount on trade confirmation |
- 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.
Payment for Order Flow (PFOF)
- 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
- Disclosure required under Securities and Exchange Commission (SEC) Rule 606 - quarterly public reports on order routing practices
- 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.