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 available for trading, two prices are always quoted:
- 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 an implicit transaction cost; the wider the spread, the more expensive it is to trade.
- Narrow spread = high liquidity (many buyers and sellers, actively traded)
- Wide spread = low liquidity (fewer participants, thinly traded)
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 the bid, you lose the spread. 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.
| Order Type | Guarantees | Does NOT Guarantee | Becomes |
|---|---|---|---|
| Market | Execution | Price | N/A (executes immediately) |
| Limit | Price (or better) | Execution | N/A (stays as limit) |
| Stop | N/A (triggers action) | Price or execution | Market order when triggered |
| Stop-limit | N/A (triggers action) | Execution | Limit order when triggered |
Market Orders
- Executed immediately at the best available price
- Guarantees execution but not 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: Set below the current market price (you want to buy cheaper)
- Sell limit: Set 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. The exam frequently tests this distinction. Remember: stop = market (execution likely), stop-limit = limit (price protected but may not fill).
Quick Reference: Where to Place Orders
| Order | Placement | Purpose |
|---|---|---|
| Buy limit | Below market | Buy at a lower price |
| Sell limit | Above market | Sell at a higher price |
| Sell stop | Below market | Limit losses / protect profits on a long position |
| Buy stop | Above market | Limit losses on a short position / enter on breakout |
Account Types
The type of account determines how trades are funded and what strategies are permitted.
Cash Accounts
- Securities must be paid in full at the time of purchase
- 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:
| Rule | Set By | Requirement |
|---|---|---|
| Regulation T (initial margin) | Federal Reserve Board | Investor must deposit at least 50% of the purchase price |
| Maintenance margin | FINRA | Investor must maintain at least 25% equity at all times |
- Margin call: Issued when the investor's equity falls below the maintenance level
- The investor must respond by depositing additional funds or securities
- If the investor fails to meet the margin call, the broker-dealer can liquidate positions without the investor's consent
Exam Tip: Gotchas
Regulation T is set by the Federal Reserve (50% initial). Maintenance margin is set by FINRA (25% minimum). 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)
- Unlimited risk if the price rises (there is no ceiling on how high a stock can go)
- Requires a margin account - short selling is not permitted in cash accounts
- Subject to Regulation SHO (SEC rule requiring brokers to locate shares before executing a short sale)
Transaction Types
How a broker-dealer is compensated depends on the role it plays in the transaction.
| Role | Acting As | Compensation | Trades From |
|---|---|---|---|
| Principal (dealer) | Dealer | Markup (on sale) or markdown (on purchase) | Own inventory |
| Agent (broker) | Broker | Commission | Customer's order |
Principal (Dealer) Transactions
- The broker-dealer trades from its own inventory
- 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 received by a broker-dealer from a market maker for routing customer orders to that market maker
- The market maker profits from the spread on the routed orders and shares a portion with the routing broker
- PFOF must be disclosed to customers (SEC Rule 607)
- 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.