Chapter 9: The Secondary Market and Equity Trading

Secondary Market

The marketplace where investors buy and sell securities from one another, rather than from the issuing company. Transactions in the secondary market do not provide new capital to issuers, but they provide liquidity and price discovery, making primary markets possible.

Liquidity

The ability to quickly buy or sell a security without significantly affecting its price. Highly liquid markets have narrow bid-ask spreads, frequent trading, and many participants.

Securities Exchange Act of 1934 (’34 Act)

Federal law that regulates the secondary trading of securities. It requires registration and oversight of exchanges, broker-dealers, and market participants, and contains anti-fraud provisions prohibiting manipulation, misrepresentation, and deceptive practices.

Anti-Fraud Provisions

Rules under the ’34 Act that prohibit lying, misleading statements, omissions of material facts, and market manipulation in connection with securities transactions.

Material Information

Information that a reasonable investor would consider important when making an investment decision. Omitting or misrepresenting material information is considered fraud.

Statute of Limitations

Time limit for bringing legal action. Under the ’34 Act, lawsuits for market manipulation must be filed within 3 years of the violation and within 1 year of discovery.

Broker

A firm that acts as an agent, matching buyers and sellers. Brokers do not trade from inventory and are compensated through commissions.

Dealer

A firm that acts as principal, trading from its own inventory with customers. Dealers earn compensation through mark-ups (selling) or mark-downs (buying) rather than commissions.

Broker-Dealer

A registered firm that can act either as a broker or as a dealer, but never both in the same transaction.

Market Maker

A broker-dealer that maintains an inventory of a security and stands ready to buy and sell continuously at quoted prices during normal market hours.

Principal Trading

Trading in which a broker-dealer buys or sells securities for its own account. The firm is the counterparty to the customer.

Agency Trading

Trading in which a broker-dealer matches buyers and sellers without taking ownership of the securities.

Mark-Up

The amount added to a security’s price when a dealer sells from inventory. This is the dealer’s compensation on a sale.

Mark-Down

The amount subtracted from a security’s market price when a dealer buys from a customer. This is the dealer’s compensation on a purchase.

Commission

A fee charged to customers when a broker-dealer acts as an agent in an agency transaction.

Hidden Profits

A prohibited practice in which a firm attempts to charge both a commission and a mark-up/mark-down on the same transaction.

Fair and Reasonable Pricing

Requirement under FINRA rules that mark-ups, mark-downs, and commissions must be fair, considering factors such as security type, order size, liquidity, services rendered, and difficulty of execution.

FINRA 5% Policy

A guideline (not a rule) suggesting that mark-ups, mark-downs, or commissions should generally not exceed 5%, though higher charges may be justified for illiquid or risky securities.

Stock Exchange

A physical or electronic marketplace that facilitates trading, provides liquidity, guarantees settlement, and enforces listing standards.

New York Stock Exchange (NYSE)

The world’s largest stock exchange. Operates as an auction market with both floor-based and electronic trading and assigns one Designated Market Maker per stock.

Auction Market

A market where prices are determined by competitive bids and offers, with trades occurring at the highest bid and lowest ask.

Designated Market Maker (DMM)

A human overseer on the NYSE responsible for maintaining fair and orderly markets, especially during the open, close, and volatile periods.

Nasdaq

The world’s first fully electronic stock exchange. Operates as a negotiated market with multiple market makers per security and no physical trading floor.

Negotiated Market

A market where prices are determined through dealer quotations rather than centralized auctions.

Bid

The price a market maker is willing to pay to buy shares from a seller.

Ask (Offer)

The price a market maker is willing to accept to sell shares to a buyer.

Bid-Ask Spread

The difference between the bid and ask price. Represents transaction cost and dealer compensation.

Two-Sided Quote

A requirement that market makers continuously display both a bid and an ask during market hours.

Firm Quote

A binding quote that a market maker must honor for at least one round lot (100 shares).

Round Lot

A standard trading unit of 100 shares or multiples of 100.

Backing Away

A serious FINRA violation where a market maker fails to honor a firm quote.

Inside Market

The best (highest) bid and best (lowest) ask available from all market makers at a given time.

Over-the-Counter (OTC) Securities

Securities that are not listed on a national exchange and trade through dealer networks.

OTC Bulletin Board (OTCBB)

A FINRA-operated quotation system displaying quotes for OTC securities that do file reports with the SEC.

OTC Markets (OTC Pink)

An OTC quotation system with no listing standards and no SEC reporting requirement, often featuring thinly traded securities.

Third Market

Trading of exchange-listed securities in the OTC market, often to achieve best execution.

Fourth Market

Trading through Electronic Communications Networks (ECNs) where institutions trade directly without intermediaries.

Electronic Communications Network (ECN)

A passive, automated system that matches buy and sell orders electronically, often at lower cost.

Market Order

An order that guarantees immediate execution at the best available price. Price is not guaranteed.

Limit Order

An order to buy or sell at a specified price or better. Guarantees price, not execution.

Day Order

An order that expires at the end of the trading day if not executed.

Good ’Til Cancelled (GTC) Order

An order that remains active until executed or canceled.

Market-on-Close Order

An order executed near the close of trading at the closing price.

Stop Order (Stop-Loss Order)

An order that becomes a market order once a specified price is reached, used to protect profits or limit losses.

Sell Stop Order

Placed below market price to protect profits on a long position.

Buy Stop Order

Placed above market price to limit losses on a short position.

Gap Risk

Risk that a stop order executes at a price worse than the stop price due to rapid price movement.

BLiSS Orders

Buy Limit and Sell Stop orders — entered below the market and adjusted for dividends.

SLoBS Orders

Sell Limit and Buy Stop orders — entered above the market and not adjusted for dividends.

Do Not Reduce (DNR)

Instruction preventing automatic dividend-related price adjustments to limit or stop orders.

Order Ticket

A required record documenting customer instructions, order type, account number, time received, and solicitation status.

Best Execution

A firm’s obligation to route customer orders to the venue offering the most favorable terms, considering price, speed, and liquidity.

Interpositioning

A best-execution violation where a firm inserts an unnecessary intermediary to increase fees.

Order-Splitting (Trade-Shredding)

Illegally dividing an order solely to increase commissions.

Front-Running

Trading ahead of a customer’s large (block) order using material, nonpublic information.

Block Trade

A large transaction, typically 10,000 shares or more.

Trading Ahead of Customer Orders

Prohibited practice where a firm trades for its own account before executing a customer’s limit order.

Trading Ahead of Research Reports

Prohibited trading based on nonpublic research information prior to public release.

Information Barriers (Firewalls)

Internal controls preventing the flow of nonpublic information between research and trading departments.

Marking the Open / Marking the Close

Manipulating prices by placing trades near market open or close to influence reported prices.

Spoofing

Placing orders with no intent to execute to manipulate prices.

Pump and Dump

Artificially inflating a stock’s price through misleading information, then selling at the higher price.

Circulation of Rumors

Spreading false or misleading information about a security to influence its price.

Arbitrage

A legal strategy exploiting temporary price differences between markets.