Chapter 12

If the bid price for a stock is 20.50 and the ask price is 20.60, a client who enters a market order to sell the stock will most likely receive:

*$20.50 minus a commission* A client who enters a market order to sell stock will generally receive the bid price minus a commission.

test q's

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proceeds from short sales cannot be used to pay for purchase of new stock idk why

What type of order is used if a customer wants to sell stock at $25 although the stock is currently trading at $20? A. Stop order B. limit order C. Market order D. All or none order

*B. limit order* A sell limit order is typically placed above the current market price and instructs a broker-dealer to sell at the limit price or higher. On the other hand, sell stop orders are placed below the current market price and are only executed if the market price falls to or below the stop price. Market orders don't specify a price and receive immediate execution.

exemptions from the 5% rule*

*Exemptions*: Securities that require the delivery of a prospectus or offering circular are *exempt* from the provisions of the 5% policy because these primary issuances are sold at a specific public offering price. Examples of the securities that are exempt include *initial public offerings, municipal bonds, and mutual fund shares.* Does this mean that the investors don't have to pay the 5% fee? Or does it mean that the sellers are exempt from limiting the markdowns?

Types of orders

*Market orders Limit orders Stop (Loss) Orders Stop-limit orders*

Which of the following statements regarding transactions is FALSE? A. Option purchases must be executed in a margin account. B. The sale of uncovered options must be executed in a margin account. C. Short sales must be executed in a margin account. D. The sale of covered options can be executed in either a cash or margin account.

*Option purchases must be executed in a margin account.* Option purchase (and the sale of covered options) may be executed in either a cash or margin account. However, short sales and the sale of uncovered options must be executed in a margin account.

A client is short stock that's trading at $35.00 and wants to buy, but only if he can buy at $34.00 or lower. He should place which of the following orders? A. A buy stop B. A buy stop-limit C. A buy limit D. Sell stop

*a buy limit* He should place a limit order to buy, which can only be executed at a specified price or lower. A buy stop and/or buy stop-limit order is placed above a stock's current value and is used to protect the short position in case it rises in value. A sell stop and/or sell stop-limit is used to protect a long stock position in case it falls in value.

The 5% markup policy applies to a: A. New issue of common stock B. Municipal bond trade C. Purchase of mutual funds D. Proceeds transaction

*proceeds transactions* The 5% markup policy does not apply to any trade requiring a prospectus (new issues, registered secondaries, and mutual funds) or a transaction involving an exempt security (municipal bond). The 5% policy applies to secondary market trades, which include proceeds transactions (using sale proceeds to buy another security) and riskless or simultaneous transactions.

short stock/short positions

A *short sale* is one in which the investor *sells shares that she doesn't own;* therefore, the shares must be *borrowed.* As long as the shares are able to be borrowed, the short seller's broker-dealer will execute the short sale. Since the borrowed shares will ultimately need to be returned to the lender, the *short seller will need to buy back the stock at some point in the future.* A *profit for the short seller is realized if she's able to buy the shares back at a price that's less than the price at which they were originally sold.* The strategy for a short seller is *bearish (i.e., she will profit if the price of the stock falls)*. On the other hand, if the price *rises,* the investor's loss could be significant since the stock would need to be purchased at a price that's higher than the price at which the shares were originally sold. For example, an investor sells shares short 100 shares at $50. The investor receives proceeds of $5,000 into her account, but will need to spend money to buy the shares back at some point in the future. Later, if the stock is trading for $40, the investor can buy the stock back to cover the short position and realize a profit of $1,000 ($5,000 sales proceeds - $4,000 total purchase). However, if the share price had risen to $60 and the investor bought the shares back, she would realize a loss of $1,000 ($5,000 sales proceeds - $6,000 total purchase).

Good til cancelled order (GTC) or Open Order

A GTC order is one that *remains in effect* on a broker- dealer's order book until it's *either executed or cancelled*. Any firm that accepts GTC orders should periodically update them with the exchange(s). GTC orders must also be updated due to any partial fills. A customer may enter an order that's good for a *week, a month, or another specified time.* If the order is not executed by the end of the specified time, the customer's brokerage firm will simply *cancel* it.

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A buy stop and/or buy stop-limit order is placed above a stock's current value and is used to protect the short position in case it rises in value. A sell stop and/or sell stop-limit is used to protect a long stock position in case it falls in value, it is placed below a stock's current value.

buy stop order

A buy stop order is placed *above* the current market price of the security and is used to *limit a loss or protect a profit* on a *short sale.* Remember, *short sellers* anticipate that the security will *fall* in value (i.e. *bearish*), but they will *lose* money if the position *rises.* For example, a customer sells short 100 shares of ABC at $40 and is bearish. However, he would like to protect his position against a rise in the price of ABC and places a buy stop order at $45. If ABC stock rises to the stop price of $45 or above, the customer's order will be activated and he will *buy* 100 shares at the market to *close out (buy back)* the short position. Once the order is activated, he's *not guaranteed an execution price of $45,* but is guaranteed that the position will be *closed out (covered)* immediately.

Proceeds Transactions

A proceeds transaction occurs when a customer directs a member firm to sell a security and *uses the proceeds of the sale to buy another security.* For these types of transactions, the member firm must follow the 5% policy and compute the markup as if the customer had purchased the securities for cash. Therefore, the compensation received on the customer's *sale* is *added* to the compensation that the firm received on the customer's *purchase*. In other words, the charge assessed on the liquidation is added to the charge for the subsequent purchase. For example, a customer instructs her brokerage firm to sell $5,000 of ABC stock and use the proceeds to purchase $5,000 of XYZ stock. When computing the markup percentage, the member firm must use its total compensation (from both the customer's sale and purchase) as a percentage of $5,000. (??)

sell stop order

A sell stop order is placed *below* the current market price of the security and is used to *limit a loss or protect a profit* on a *long* stock position. For example, a customer purchases 100 shares of XYZ stock at $25 and determines that she would like to limit any losses to approximately 5 points; therefore, she enters a sell stop order at $20. If the stock falls to $20 (the stop price) or below, the sell stop order is triggered and becomes a market order to sell 100 shares of XYZ. With this order, the customer is attempting to limit the loss on her position immediately. Rather than XYZ stock declining in price, let's assume that it appreciates to $35. The customer may decide that she wants to *protect this profit* by entering a sell stop order at $33. If the stock subsequently falls and trades at or below $33, the order will be activated and when the customer sells the stock, she will have *protected a portion of her profits.*

stop-limit order

A stop-limit order is *similar to a stop order* in that if the market trades at or through the preset stop price, the order will be activated. However, once activated, a stop-limit order becomes a *limit order* and may be executed *only at a specified price or better.* These orders are a *combination of both stop orders and limit orders,* which means the customer *may not receive execution on the order.* Essentially, a *stop-limit order presents a risk/reward trade-off.* The risk is that since a specific limit price is set, the order may never receive execution. The reward is that, if the order receives execution, the customer will receive the preset limit price or better. Next cards explain the buy and sell sides of this

stop (loss) orders

Again, investors who enter either *market or limit* orders *want* to receive execution. However, *stop orders* are often entered by customers who are trying to *prevent a large loss or protect a profit* on an *existing* stock position. In most cases, these investors would rather *not* receive execution on their stop orders. A stop order is a contingent order, which means that it won't receive execution unless the market rises or falls to a certain price. This certain price that's specified by the investor is referred to as the *stop price.* If the market reaches the stop price, the stop order is activated *(triggered)* and *becomes a market order to buy or sell*. Since an activated stop order becomes a market order, the investor is guaranteed that the order will be executed; however, there's no guarantee as to the price of execution. *I don't really understand the difference between a stop loss order and a sell limit order*?? I think stop loss is to limit loss whereas limit sales are to gain profit Next cards explain the buy and sell sides of this

covered and uncovered options writers

As described in Chapter10, if the *seller of a call option owns the underlying stock*, she's considered to be the *seller of a covered call.* The position is *covered* because the client is able to *deliver the shares if the contract is exercised and she's assigned.* On the other hand, if the seller of a call *doesn't own the shares*, she's considered to be *uncovered or naked*. These terms indicate that, if assigned, the writer is at risk of being required to *buy shares at an unknown market price in order to complete the delivery of the shares to the call buyer.* *Uncovered call writing is riskier than covered writing and may only be executed in a margin account.*

buy stop-limit order

As with a buy stop order, a buy stop-limit order is placed *above* the current market price of the security and is used to limit the loss (or protect a profit) on a *short* position. However, once activated, the buy stop-limit order becomes a buy limit order and, therefore, execution will only occur if the stock can be purchased at the limit price or lower. For example, an investor sells short 1,000 shares of GHI at $20 and, fearing a rise in its price, places a buy stop-limit order at $24. After the order is entered, market transactions occur as follows: $23.55...$23.80...$23.95...*(trigger)$24.02*...$24.03...$24.02...*(execution)$24.00* The order is activated by the trade at $24.02 (notice that the market traded *through* the stop price of $24.00) and becomes a limit order to buy 1,000 shares at $24.00 or lower. After being triggered, notice that the stock subsequently rose above the stop price. The order was only able to be executed because the stock decreased back to $24.00. Remember, once activated, the *risk* is that, unless the order can be filled at the limit price or lower, the order will *not receive execution.*

sell stop-limit order

As with a sell stop order, a sell stop-limit order is placed *below* the current market price of the security and is used to limit the loss (or protect a profit) on a *long* position. However, once activated, the sell stop-limit order becomes a sell limit order and, therefore, execution will only occur if the stock can be sold at the limit price or higher. For example, an investor purchases 1,000 shares of DEF at $15 and, fearing a decline in its price, places a sell stop-limit order at $10. After the order is entered, market transactions occur as follows: $10.70...$10.45...$10.05...*(trigger)$10.00*...$9.97...$9.97...(*execution)$10.00* The order is activated by the first trade at $10.00 and becomes a limit order to sell 1,000 shares at $10.00 or higher. After being triggered, notice that the stock subsequently fell below the stop price. The order was only able to be executed because the stock increased back to $10.00. Remember, once activated, *the risk is that, unless the order can be filled at the limit price or higher, the order will not be filled.*

Fair prices and commissions - The 5% Markup Policy

FINRA members are prohibited from charging prices or commissions that are unfair or excessive. To assist members in determining the appropriate level of charges, FINRA has developed the 5% Markup Policy. Although stated in terms of a markup, the policy applies to *markups, markdowns*, and *commissions.* The guideline applies when a broker-dealer is acting in an *agency or principal* capacity for transactions involving *both exchange-listed and non-exchange-listed securities.* In some ways, the 5% Policy seems like a fairly simple principle. For example, at a time when a stock's market price is $20, a broker-dealer sells stock to a customer at $21 per share. The firm charged a $1 per share markup which is exactly 5%. The percentage is calculated by dividing the markup of $1 by the prevailing market price of $20. However, part of the determination regarding an acceptable markup involves the *consideration of all relevant factors.* Over the years, FINRA has taken many enforcement actions against firms that it believes have charged excessive markups. By reviewing those decisions, it has developed some guidelines for determining the fairness of transaction compensation.

discretionary order/discretion not exercised

If a client has granted discretionary authority to his registered representative, this should be indicated for each discretionary order. When completing an order ticket, if a client consents to a specific trade recommendation before execution, it's important for the RR to check off *discretion not exercised.* The importance lies in the fact that *discretionary trades have more heightened supervisory requirements.* Keep in mind, indicating discretion not exercised is *NOT* the same as indicating that the trade was unsolicited. If placing a trade was the client's idea, the order ticket is marked *unsolicited.* On the other hand, if the trade was recommended by the registered representative, the ticket should be marked *solicited.*

margin requirement

Short sales must be executed in a *margin account*. Brokerage firms provide short sellers with stock that has been borrowed from other margin customers. However, the other margin customers must provide *permission* for the firm to lend their securities to short sellers. The permission is obtained through the signing of a *loan consent agreement* at the time that the account is opened. As long as the short seller's margin account maintains the minimum required equity, there's *no set time* by which the short seller must repurchase the borrowed shares. While maintaining a short position, if a cash dividend is paid on the borrowed stock, the short seller is responsible for *paying the dividend to the lender.*

Factors that influence level of markups

Since FINRA emphasizes that 5% is merely a guideline, it's possible that *certain circumstances will justify higher markups; while conversely, there are other times when even 5% is too much.* The following factors are considered when determining whether a markup is excessive: *The type of security involved* - Some securities carry higher markups than others as a matter of industry practice. For example, the markups on *common stocks or limited partnership units typically are higher than the markups on bonds.* *The availability of the security in the market* - If more effort is required to locate a particular security and execute a transaction, then a *higher* markup is justified. *The price of the security* - The percentage of markup generally *increases* as the price of the security *decreases*. This is due to the fact that lower-priced securities may require more handling and expense. *The amount of money involved in a transaction* - A transaction for a *small total dollar amount* may require greater handling expenses on a proportionate basis than a larger transaction. *Disclosure* - Disclosing to the customer that the circumstances may warrant a higher-than-normal markup helps to make the dealer's case. However, the circumstances also must justify the charges. *The pattern of markups* - FINRA's punishment tends to be most severe on firms that show a persistent pattern of excessive markups. However, the markup in each transaction must be justified on its own merits. *The nature of the broker-dealer's business* - Firms that offer certain *additional services* to customers (e.g., research) may justify charging *higher* markups than firms that don't offer these services. However, if a firm has high expenses for services that provide no benefit to customers, then these expenses don't justify higher charges.

market orders

The *most basic* type of order is a market order. When placing this order, the client *doesn't specify a price*. Instead, the order will be executed at the *best available price* when the order is entered (i.e., the *highest bid* for market orders to *sell* and the *lowest offer* for market orders to *buy*). Although market orders will be immediately executed, the client is *not assured of a specific execution price.* Market orders are often used for stocks that have *active (liquid)* markets in which the *spread* (difference between the bid and ask price) is *narrow.*

day order

Unless otherwise specified, every order is considered a day order and will be available for execution from *9:30 a.m. to 4:00 p.m. Eastern Time* (ET). If the order is *not* executed during the normal trading day, it's *cancelled* at the end of the day.

Dealers (Principals)

When a *firm buys securities for, or sells securities from, its own account (inventory), it's acting as a dealer (principal)*. A dealer that always stands ready to buy or sell a specific stock is also referred to as a *market maker* in that stock. As both a buyer and a seller, a market maker provides a *two-sided quote*—its *bid* is the price at which it's willing to buy stock and its *ask (offer)* price is the price at which it will sell the stock. For example, if a dealer (market maker) is quoting a stock at $19.90 - $20.25, it's willing to buy stock at $19.90 per share and sell it for $20.25 per share *to other dealers.* The $.35 difference between the bid of $19.90 and the ask of $20.25 is the *spread*—a source of profit for the market maker. Bids and offers are typically posted in *round lots (i.e., 100-share multiples).* Investors who want to trade less than 100 shares are trading in *odd lots.* For example, if an investor buys 567 shares of XYZ stock, she's purchasing five round lots of 100 shares plus an odd lot of 67 shares. This order may be placed on one ticket. *Markups/Markdowns*: When acting in a dealer capacity, a firm will adjust its prices for retail customers, in other words, the dealer will include either a markup or markdown. All markups and markdowns are calculated from a security's inside market. The inside market represents the highest bid and the lowest ask (offer) of any market maker in a given security. Let's assume that a security's inside market is of $20.00 - $20.20. In this case, if a client wants to sell stock to a dealer, the firm may pay her $19.95 net per share—a $.05 markdown from the prevailing market price. On the other hand, if the client wants to buy stock, a dealer may offer to sell her the shares at $20.26—a $.06 markup. The dealer profits by purchasing securities from customers at one price and selling those securities to other customers at a higher price. These price adjustments are built into the net price of the trade, but are generally required to be noted on the client's trade confirmation. *PDM*: Firm acts in a *P*rincipal agency, as a *D*ealer, earning a *M*arkup Here, the firm assumes risk

to help explain last card: A customer requests that a broker-dealer sell stock that she owns and, at the same time, use the proceeds of the sale to purchase a different stock. For this transaction: *The broker-dealer is permitted to charge a markup on both transactions, but is required to compute the markup based on the amount of money involved in the sale to the customer*

When a customer directs her broker-dealer to use the proceeds generated by the sale of one stock and, at the same time, purchase another stock, the transaction is referred to as a proceeds transaction. When the broker-dealer determines the markup it will charge, industry rules state that the firm may charge a markup or commission on both transactions, but should compute the markup based solely on the amount of money involved in the sale to the customer. The regulatory focus is to be certain that the total amount received for executing a proceeds transaction does not violate the 5% Markup Policy.

Types of Transactions/long stock

When an order is placed, the first determination to verify for the order ticket is the *client's desired action or intent*. These may include: --*A purchase --A long sale --A short sale* When *purchasing* securities, the client must designate whether the trade is to be paid in full or being paid for with borrowed funds (*on margin).* When *selling* securities, the process can be a bit more complicated. With sales, the issue becomes whether the customer is *selling securities that she owns or selling securities that she doesn't currently own (i.e., securities that have been borrowed)*. If the customer sells stock that she currently *owns*, it's referred to as a *long sale* and she must either have the securities in her account with the broker-dealer or be able to deliver them promptly. Conversely, what if the customer doesn't currently own the stock being sold? Short sale

limit order

When customers want to buy or sell securities at a *specific price*, they enter limit orders. A limit order may be executed only at the specified price or better. A buy limit order may only be executed at the limit price or lower, while a sell limit order may only be executed at the limit price or higher. A buy limit order is placed below the current market price of a security. A sell limit order is placed above the current market price of a security. This is what dad did with tesla stock Since limit orders are entered away from the market price, a person who places a limit order must be patient. Depending on which way the market moves, he *may not receive an execution*. If the market price doesn't trade at or better than the customer's limit price, the client will not receive a trade execution. If the customer's order was entered as a day order (only good for one day) and it didn't receive execution, it would need to be reentered on the following day. *Limit orders are often used for large orders in thinly or infrequently traded securities* in which the *spread is wide* (i.e., a larger distance between the bid and ask prices). Although an investor is able to specify the price of a limit order, the risk is that the order may never be executed.

Brokers

When executing trades, broker-dealers can act in two capacities—as a broker and as a dealer. However, to execute a customer transaction, a firm may act in only one of the two capacities. (Sometimes they flip flop which is why we call them broker-dealers. Regardless of whether a client wants to buy or sell a security, a firm that acts as a *broker (agent)* is attempting to *find the other side of the trade on behalf of its client.* If a client wants to buy, a broker will try to find a seller. On the other hand, if a client wants to sell, a broker will attempt to find a buyer. The *firm is not buying or selling shares for its own account;* instead, the broker tries to find a buyer or seller for its customer. This activity is also referred to as brokering a trade. *Commissions*: When a firm acts in a broker (agent) capacity, it earns a commission for its efforts. The commission is a separate dollar amount that must be noted on the client's trade confirmation. However, if a trade is not executed, no commission is earned. *ABC:* Acting in an *A*gent capacity, as a *B*roker, earning a *C*ommission. Here, the firm does not assume risk

order qualifiers

When orders are being placed, there are several different qualifiers that may be used. However, let's consider two of the more important order qualifiers. *day order* and *good 'til cancelled (GTC) or Open order*