Lesson 1.3: Placing a Trade - Primary & Secondary Markets
Placing a Trade
Basics of placing a trade and normal order types for secondary markets.
Qualifiers and time limits allowed for most trades.
Discussion of quotes and their components (bid, ask, size).
Acting as a broker vs. dealer.
Settlement of trades in the secondary market.
Quotes
Dynamic and change constantly throughout the trading day in active markets.
Bulls and Bears
Terms describe an investor's attitude toward a market or specific security.
Bull:
Believes a market or stock is likely to increase in value.
Bullish attitude.
Bear:
Believes a market or stock will decrease in value.
Bearish attitude.
Shorting a stock indicates a bearish sentiment.
Quote Components
Usually two-sided: bid and ask (offer).
Includes size: number of shares available at the bid and ask, expressed in round lots (units of 100 shares).
The bid is always less than the ask price.
Bid
Highest amount someone is willing to pay for a security.
Size indicates the number of shares someone is willing to buy at the bid in round lots (100 shares).
Represents a buyer saying, "I will buy this stock at this price."
The bid price is the price a seller receives.
Example:
BCO stock is bid 42, size 10.
A buyer is willing to buy up to 1,000 shares of BCO at $42 per share.
Ask (or Offer)
Lowest amount someone is currently willing to sell the security for.
Size indicates the number of shares someone is willing to sell at the ask.
Represents a seller saying, "I will sell this stock at this price."
The ask price is the price a buyer pays.
Example:
BCO stock is ask 42.5, size 12.
Someone is willing to sell as many as 1,200 shares of BCO at $42.50 per share.
Example Quote
BCO bid 42 ask 42.5 size 10 × 12
Quote Generation
Depends on where the stock trades.
Listed Stocks
On an exchange, the Designated Market Maker (DMM) maintains an order book.
The book contains open limit orders for the assigned stock.
Highest buy limit establishes the bid, and its size establishes the bid size.
Lowest sell limit establishes the ask, and its size establishes the ask size.
Example DMM Book for BCO:
Shares | Sell Limits ($) | Buy Limits ($)
200 shares | 43 | -x-
100 shares | 42.75 | -x-
400 shares | 42.5 | -x-
800 shares | 42.5 | -x-
1,000 shares | -x- | 42
300 shares | -x- | 41.75
1,500 shares | -x- | 41.5
Bid is based on the highest open buy limit.
Ask is based on the lowest sell limits.
A customer placing a market order to buy would pay $42.50.
A market order to sell would execute at $42.
OTC Stocks and Bonds
OTC market consists of Broker-Dealers (BDs) acting as market makers (dealers) and brokers.
Trading occurs between these BDs.
Bid is the highest bid from a market maker.
Ask is the lowest ask from a market maker.
Customers sell to the dealer at the bid or buy from the dealer at the ask.
Example:
Three dealers for MegaGig Storage, Inc. (Ticker MGS).
Market maker quotes are as follows:
Gold Coast Stocks: Bid 15 Ask 15.25 Size 15 x 20
Great Plains Equities: Bid 15.20 Ask 15.27 Size 5 x 8
Seacoast Securities: Bid 15.15 Ask 15.22 Size 10 × 12
The quote for MGS will be Bid 15.2 Ask 15.22 Size 5 x 12
Pricing Increments
Stocks are priced in dollars and cents.
Smallest change (increment) that a bid or ask can be adjusted is (one cent).
Sub-penny pricing is allowed on stocks trading below .
Inside Quote
Highest available BID and lowest available ASK.
Spread
Difference between the bid and ask prices.
The difference between what the security may be bought for and what it sells for.
Market makers buy at the bid and sell at the ask to make money.
Examples
BCO bid 42 ask 42.5—The spread is 50 cents, or .
MGS bid 15.20 ask 15.22-The spread is 2 cents, or .
Order Types
Instruction to a broker to buy or sell a security on behalf of an investor.
Market and Limit Orders
Market order: Buy or sell, executed immediately at the best available market price.
Limit order: Buy or sell, limit price is the maximum purchase price if buying or the minimum selling price if selling.
Buy limit order: executed at the limit price or lower.
Sell limit order: executed at the limit price or higher.
Stop Orders
A trigger price that, when reached, will trigger an order.
No time priority.
Stop order: Buy or sell, does not become a “live” working order until the stock trades at or through a specified price (the stop price).
Once triggered, it becomes a market order and is executed immediately at the best available market price.
Example:
BigCo, Inc., (Ticker BCO) common stock is trading at a CMV = .
Order: Buy 2,000 shares BCO at 15 stop.
As soon as BCO trades at or through the stop price of 15, this order will become a live working market order and will be executed immediately at the next available price.
Stop limit order: Buy or sell, also has a stop price and does not become a "live" working order until the stock trades at or through the stop price, but it also has a limit price.
Once triggered, it becomes a limit order to buy or sell at the specified limit.
May or may not be executed depending on where the price of the stock is.
Example:
BigCo, Inc., common stock is trading at a CMV = .
Order: Buy 2,000 shares BCO at 15 stop limit 16.
As soon as BCO trades at or through the stop price of 15, this order will become a live working limit order, and like all buy limit orders, it will only be executed if the stock can be purchased for (the limit price) or less.
Examples
Buy market order: Buy 1,000 shares XYZ at MKT.
Executed immediately to buy at the best available market price.
Sell market order: Sell 1,000 shares XYZ at MKT.
Executed immediately to sell at the best available market price.
Buy limit order: Buy 1,000 shares of XYZ at 32.
Executed to purchase XYZ at 32 or lower.
Sell limit order: Sell 1,000 shares of XYZ at 32.
Executed to sell XYZ at 32 or higher.
Risks of Limit Orders
The market may never reach the buy limit price or the sell limit price, and the order may never be executed.
Customers risk missing the market because of the limit they've imposed on the buy or sell order.
Order Priority
Market orders always take precedence over limit orders and are executed in time priority (first come, first served).
Limit orders also stand in time priority, but behind market orders.
Order Restrictions
Additional instructions that can be applied to an order.
Time Restrictions
Day order: Valid only until the close of trading on the day it is entered; if not filled, it is canceled at the close of the day's trading (default time limit).
Good-til-canceled (GTC) order: Valid until executed or canceled; automatically canceled if unexecuted on the last business day of April and the last business day of October.
Market-at-open or market-on-close order: Market orders designated to be executed at the opening or close of the day; the customer is not guaranteed the exact opening or closing price but instead a price at or close to the first or last price of the day.
Fill Restrictions
Fill-or-kill (FOK) order: Execute the order immediately in its entirety or cancel the order completely; no partial execution allowed.
Immediate-or-cancel (IOC) order: Partial execution is acceptable; if only a portion of the order can be filled, it is, and the remaining unexecuted portion is canceled.
All-or-none (AON) order: Must be executed in their entirety or not at all; can be day orders or GTC orders; differ from FOK orders in that they do not have to be filled immediately.
Fill restrictions are only for limit orders.
Market orders are always filled at the best available price and immediately.
Buying and Selling
An investor buys a security, he has taken a long position in that security, meaning he now owns the security.
Long Position: Buy to open, sell to close.
Hopes the security will rise in value for profit.
Bullish position.
Risk: the price of the security may fall.
Maximum loss: the security becomes worthless.
Cost Basis: The amount they paid for the position
Sales proceeds: When they close the position, the money they receive
Examples:
Bill Smith: Long 3,000 shares of XYZ
Sarah Mills: Long 30 XYZ warrants
Jill Burns: Long 20 XYZ call options
Owners of shares of stock are considered bullish.
Also bullish are owners of securities convertible into the shares of stock such as rights, warrants, or long call options.
Selling Short
An investor can also sell a security to open a position. Sells a security they do not own.
Short Position: Sell to open, buy to close.
Borrowing stock from a stock lender and selling (shorting) the borrowed shares.
Taking the view that the stock will decline in price, enabling the customer to buy the shares back later at a lower price.
Bearish position.
Risk: the price of the borrowed shares may increase, forcing the seller to buy back at a higher price instead of a lower price as anticipated.
Unlimited loss potential.
Covering the position: Buying back the security to close the position.
Examples:
Bill Smith: Short 3,000 shares of XYZ
Jill Burns: Long 20 XYZ put options
Someone who sold shares of stock they did not own is considered bearish.
Someone who owns put options would also be considered to have a bearish market attitude.
Principal and Agency Capacity in Trading
Two main types of trades: agent and principal.
Agent (Broker)
Customers are trading with another person through an exchange; the broker finds this other person with whom to trade.
Trade on behalf of customers.
Charge commission.
Principal (Dealer/Market Maker)
Customers are making a trade directly with a dealer.
Trade with customers from own inventory.
Maintain inventory.
Profit on spread (markup and markdown).
A BD is both a broker and a dealer but may not act in both capacities on the same transaction.
Settlement of Trades
Ensures that both parties to a transaction receive what they are supposed to receive: money to the seller and securities to the buyer.
Ensures that the trade is completed in a timely manner.
Trades must be completed (settled) by the end of the day on the settlement date.
Regular Way Settlement
Occurs by the end of the business day either one or two business days following the trade date.
Expressed as T+1 (one business day) or T+2 (two business days).
The time frame (one day or two days) depends on the type of security.
Settlement rules are for secondary market trades.
T+1: All Treasury securities (T-bills, T-notes, and T-bonds).
T+2: Corporate issues (stocks and bonds), municipal debt, Agency securities (GNMA), GSE securities (FNMA and FHLMC).
By the end of the settlement day, the BD representing the seller receives the cash due the seller, and the BD representing the buyer receives the securities due the buyer in good order.
Cash Settlement
Requires delivery of securities from the seller and payment from the buyer on the same day a trade is executed.
Stocks or bonds sold for cash settlement must be available on the spot for delivery to the buyer.
Both parties to the transaction would have to agree before the trade takes place for cash settlement to occur.
Rare in practice.
A trade that settles on the trade date.
Do not confuse this with a cash trade, which is simply a trade that does not involve any margin borrowing; the buyer paid for the trade "cash."
Settlement for Options
When an option trades, settlement is the next business day (T+1).
When an equity option is exercised, the transaction must be completed by the second business day (T+2) after the exercise.
When an index option is exercised, the writer pays the owner cash equal to the intrinsic value of the options contract. This payment occurs on the next business day (T+1).
Good Delivery
Rules govern the delivery of physical stock and bond certificates in a trade.
When a certificate is delivered, it must be:
endorsed (signed) by all owners whose name appears on the face of the certificate and signed exactly as the name appears.
The rules do allow deviations such as the "&" symbol in place of the word “and,” “Co.” in place of “Company,”, and “Inc.” in place of “Incorporated.”
Stock Power: A separate document which identifies the specific certificate (issuer, number of shares, certificate number) that the customer could sign instead of signing the back of the certificate. It is common to use a stock power when certificates will be mailed.
Physical Certificates and Electronic Holdings
When securities are issued with physical paper certificates (bonds or shares), it is those certificates that are required for physical delivery.
Most securities are sold without a physical certificate.
Government securities issued by the U.S. Treasury are all issued in book-entry form, meaning that no physical securities (paper certificates) exist.
When a security is held in electronic form by a BD on behalf of a customer, that is called being held in street name.
There is no physical certificate and no requirement for physical signatures for good delivery when a position is held in street name.