Terminology

Before exploring who facilitates trades and what they cost, you need the vocabulary of the trading floor: the quotes, orders, accounts, and transaction types that make securities trading work.

Bid, Ask, and Spread

When a security is actively trading, two prices are typically quoted (a bid or ask can be one-sided or absent in illiquid or exceptional conditions):

• Bid: The highest price a buyer is willing to pay for a security
• Ask (Offer): The lowest price a seller is willing to accept for a security
• Quote: The current bid and ask prices displayed together (e.g., "50.00 bid / 50.25 ask")

The bid-ask spread is the difference between the bid and ask prices. It represents a potential implicit transaction cost when crossed; the wider the spread, the more expensive it generally is to trade.

• Narrow spread generally indicates high liquidity (many buyers and sellers, actively traded)
• Wide spread generally indicates low liquidity (fewer participants, thinly traded); note that spread alone doesn't capture available depth

Exam Tip: Gotchas

The bid-ask spread is a cost to the investor even though no one sends you a bill for it. If you buy at the ask and immediately sell at an unchanged bid, you lose one full spread over the round trip. The exam may test whether you recognize the spread as a trading cost.

Order Types

How you enter an order determines what you prioritize: guaranteed execution or guaranteed price. You cannot have both.

Market Orders

• Executed promptly at the best available price
• Offers the greatest certainty of execution, though execution still isn't guaranteed (trading halts or unavailable liquidity can prevent it); does not guarantee price
• Best for liquid securities where price is relatively stable
• Risk: In fast-moving markets, the execution price may differ significantly from the last quoted price (slippage)

Limit Orders

• Executed only at the specified price or better
• Guarantees price but not execution (the order may never fill if the market doesn't reach your price)
• Buy limit: Sets the maximum purchase price, commonly placed below the current market price (you want to buy cheaper)
• Sell limit: Sets the minimum sale price, commonly placed above the current market price (you want to sell higher)

Stop Orders (Stop-Loss Orders)

• A stop order becomes a market order when the stop price is reached
• Used to limit losses or protect profits
• Sell stop: Set below current market price; triggers a sale if the price drops to the stop level (protects a long position)
• Buy stop: Set above current market price; triggers a purchase if the price rises to the stop level (protects a short position or enters on a breakout)

Stop-Limit Orders

• A stop-limit order becomes a limit order (not a market order) when the stop price is reached
• Combines features of both stop and limit orders
• Provides more price control than a stop order, but execution is not guaranteed (the limit price may never be reached after triggering)

Exam Tip: Gotchas

A stop order becomes a market order when triggered. A stop-limit order becomes a limit order when triggered. This distinction may be tested. Remember: stop = market (execution likely), stop-limit = limit (price protected but may not fill).

Quick Reference: Where to Place Orders

Account Types

The type of account determines how trades are funded and what strategies are permitted.

Cash Accounts

• Securities must be paid in full by the applicable payment or settlement deadline (currently T+1 for most covered securities)
• No borrowing from the broker-dealer
• No short selling - you must own the security before you can sell it

Margin Accounts

• The investor can borrow from the broker-dealer to purchase securities (buying on margin)
• Borrowing amplifies both gains and losses (leverage)

Key margin rules:

• Margin call: A maintenance deficiency may prompt the broker-dealer to issue a margin call, but the firm is not required to notify the investor first
• The investor may be asked to deposit additional funds or securities
• The broker-dealer can liquidate positions to protect itself, with or without prior notice, if equity falls below the maintenance level

Exam Tip: Gotchas

Regulation T is set by the Federal Reserve (generally 50% initial). Maintenance margin is set by FINRA (generally 25% minimum for long equity positions). The exam tests who sets each requirement. Remember: the Fed sets the entry bar, FINRA sets the ongoing floor.

Short Sales

• Short selling means selling securities the investor does not own (borrowed from the broker-dealer)
• The investor profits if the price declines (buy back cheaper)
• Theoretically unlimited risk if the price rises, since a stock has no fixed ceiling on an unhedged short position
• Requires a margin account - short selling is not permitted in cash accounts
• Subject to Regulation SHO, which generally requires a documented locate before a short sale, subject to exceptions, and also governs order marking, a price-test circuit breaker, and fail-to-deliver close-outs

Transaction Types

How a broker-dealer is compensated depends on the role it plays in the transaction.

Principal (Dealer) Transactions

• The broker-dealer trades for its own account, including from existing inventory or by buying/selling to fill the order (a "riskless principal" transaction)
• On a sale to a customer, it charges a markup (price above the market)
• On a purchase from a customer, it charges a markdown (price below the market)

Agency (Broker) Transactions

• The broker-dealer executes the trade on behalf of the customer in the open market
• Charges a commission for the service

Payment for Order Flow

• Payment for order flow (PFOF) is compensation a broker-dealer receives from a market maker, exchange, or other venue for routing customer orders to it; the compensation can be cash, rebates, fee credits, or other benefits, not only a share of the spread
• PFOF must be disclosed through some combination of trade confirmations, account-opening and annual policy statements, and public quarterly order-routing reports, with the specific requirement depending on the security and order type
• Raises a potential conflict of interest: the broker may route orders to the market maker that pays the highest rebate rather than the one that provides the best execution

Exam Tip: Gotchas

A firm cannot charge both a commission and a markup on the same transaction. If it acts as principal, it charges a markup/markdown. If it acts as agent, it charges a commission. The exam tests whether you can identify the transaction type based on the compensation described.

What Should You Check on Exam Day?

• Bid = highest buyer price, ask = lowest seller price; the spread between them is an implicit trading cost, narrower with higher liquidity.
• Market orders offer the greatest certainty of execution (though not guaranteed) but not price; limit orders guarantee price (or better), not execution.
• A stop order becomes a market order when triggered; a stop-limit order becomes a limit order when triggered.
• Cash accounts require full payment by settlement, no borrowing, no short selling; margin accounts allow borrowing under Regulation T's generally 50% initial margin (Federal Reserve, new eligible equity purchases) and FINRA's generally 25% maintenance margin (long equity positions).
• Short selling requires a margin account, carries theoretically unlimited risk on an unhedged position if the price rises, and is subject to Regulation SHO (locate requirement plus order marking, price-test, and close-out rules).
• A principal (dealer) trade earns a markup or markdown; an agency (broker) trade earns a commission; a firm never charges both on the same transaction.
• Payment for order flow must be disclosed and raises a potential conflict of interest.