Chapter 14
IN THIS CHAPTER
Understanding the differences between the primary and secondary markets
Comparing stock exchanges to the over-the-counter market
Looking at order qualifiers
Meeting a designated market maker and looking over the books
Part of your function as a registered rep will be to understand and explain to customers (and potential customers) how the stock market works. I designed this chapter with that in mind (along with the fact that you need to know this stuff for the Series 7, of course).
In this chapter, I cover the basics of exchanges and the over-the-counter market, along with some of the active participants who help the market run smoothly (at least most of the time). Pay particular attention to the “Talking about order types” and “Factoring in order features” sections, because you’ll definitely use that information every day after you pass the Series 7 exam. As in the other chapters, you will notice some overlap between the material on the Securities Industry Essentials exam and the Series 7 exam.
Depending on whether the securities are new or outstanding, they trade in either the primary or secondary market. This section deals with the differences between the two.
The primary market (new issue market) is broken down into two categories, depending on whether the company has ever issued securities before. A security that has never been offered or sold to the public is considered a new issue. When securities are sold in the primary market, a bulk of the sales proceeds go to the issuer, and the balance goes to the underwriter (who buys the securities from the issuer and sells them to the public). Here are the two types of offerings on the primary market:
When the securities are already trading in the market, the sales proceeds go to another investor instead of to the issuer. The secondary market, also called the aftermarket, consists of four categories (see the following section for info on trading on exchanges versus over-the-counter markets):
After securities are issued publicly, they may trade on an exchange or on the over-the-counter (OTC) market.
Exchanges are auction markets, where bidders and sellers get together to execute trades. I’m sure you’ve seen movies or TV shows featuring the New York Stock Exchange. It definitely looks very chaotic (and like it’s a good place to have a heart attack or develop an ulcer). However, some sort of order is definitely there: All exchanges have a trading floor where all trades are executed. Each security listed on an exchange has its own trading post (location) on the floor where the auction takes place. Brokers looking to purchase shout out and/or make hand signals to indicate the price they’re willing to spend to buy a particular security. Sellers, in turn, shout out the price they’re willing to sell a security for. If buyers and sellers can come to an agreement, a trade is made.
The main exchange that the Series 7 tests you on is the New York Stock Exchange (NYSE, also known as NYSE Euronext), but there are others such as: NASDAQ, NYSE American, NYSE Arca Equities, NYSE National, Chicago Board Options Exchange, Chicago Stock Exchange, ICE and so on. Listed securities are ones that satisfy minimum requirements and are traded on a regional or national exchange like the NYSE. Listed securities may trade on the exchange or in the OTC market.
Although thousands of people may seem to be on the floor of the exchange, you don’t need to be aware of too many titles. Most of the people on the floor of the exchange fall into one of three categories:
Under NYSE rules, only members are permitted to accept offers, make bids, or consummate transactions on the floor of the exchange. These transactions are typically handled by floor brokers or DMMs. However, firms who have a booth on the exchange may have supervised booth clerks process orders sent to the booth.
Unlike exchanges, the OTC market is a negotiated market. Instead of yelling out bid and ask prices, traders buy and sell securities by way of telephone or computer transactions. There’s no central location for trading OTC securities. Thousands of securities — both listed and unlisted — are traded this way. In fact, unlisted securities, which aren’t listed on an exchange, can only trade OTC.
The OTC equities market is divided into NASDAQ issues (issues that meet the NASDAQ listing requirements) and non-NASDAQ issues. Non-NASDAQ issues are unlisted and trade on the Over The Counter Bulletin Board (OTCBB) or in the OTC Pink Market.
The NASD Automated Quotation service (NASDAQ) is the largest U.S. equities trading venue by volume. NASDAQ is an electronic quotation system that displays bid and ask prices of the most actively traded OTC stocks. Additionally, NASDAQ also includes quotes of preferred stock, convertible bonds, and warrants.
To be a market maker on NASDAQ, the dealer must have a minimum net capital requirement, be registered with FINRA, and must provide regular bid and ask prices for a security.
To make trades, people need accurate, current info on bid and ask prices. Not everyone can get the same amount of information, though. Here are the access levels of NASDAQ (the computer displays with NASDAQ information):
Unlike exchanges where they have designated market makers, there are none in the OTC market. However, there are firms (dealers) who will make a market for particular securities and be willing to trade to and from their own inventory. If they wish to make a market in a security, they must receive FINRA's approval. OTC market makers create the inside market by offering to buy and sell securities. The inside market is the highest bid price (the most a market maker is willing to pay) for a security and the lowest ask or offer price (the most a market maker is willing to accept) for a security. In the NASDAQ system, you typically have several market makers for one security. Take a look at what happens when you have several market makers entering quotes for ABCD common stock:
Market Maker |
BID |
ASK |
Vizzion Broker-Dealer |
18.30 |
18.75 |
Silver Stanley |
18.25 |
18.80 |
Utah/New Mexico Securities |
18.35 |
19.05 |
By looking at this chart, you can see that there are three market makers that have entered quotes for ABCD Common stock. To determine the inside market, look at the highest bid price, which was entered by Utah/New Mexico Securities, and the lowest ask price, which was entered by Vizzzion Broker-Dealer. For ABCD, the inside market is currently 18.35–18.75. Looking at a Level I machine, you would only see the name of the security and the inside market price. If you were to give a quote to customers, you would have to let them know it's a subject quote (subject to change) because as buy and sell orders are placed, the inside market will change. Remember, if you were placing an order to buy, you would buy at the lowest ask price. If you were placing an order to sell, you would sell at the highest bid price.
Non-NASDAQ securities are OTC equity securities that don't meet the listing requirements of national securities exchanges such as NYSE or NASDAQ. Non-NASDAQ securities include warrants, ADRs, equity stocks (foreign and domestic), and DPPs. Non-NASDAQ securities can be purchased on the OTCBB or OTC Pink Market. As you can imagine, non-NASDAQ securities are among the riskiest securities available and certainly aren't suitable for all investors.
OTC Markets Group: The OTC Markets Group used to be called Pink Sheets because firms would receive a pink sheet every so often letting them know about these low-priced securities that dealers are selling. There were no financial standards or disclosure requirements for securities listed in the Pink Sheets. However, over the years, the OTC Markets Group has expanded and now has different tiers for trading:
OTC Best Market: The Best Market is for established U.S. and international companies. Companies listed on the Best Market must meet proper disclosure requirements, meet high financial standards, and be able to demonstrate compliance with U.S. securities laws.
OTC Venture Market: The Venture Market is for early stage developing U.S. and international companies. Eligible companies must be current in the reporting and undertake an annual verification and certification process.
OTC Pink: The OTC Pink is the riskiest of all the markets and should only be considered for sophisticated investors with a high risk tolerance. There are no financial standards or disclosure requirements for companies to be listed on the OTC Pink. Companies whose securities trade on the OTC Pink include certain foreign companies with limited disclosure information, companies issuing U.S. penny stocks, distressed companies, delinquent companies, and companies not willing to provide information to investors.
The CQS is a quotation service that includes bid and ask prices of listed securities on all markets. For example, a security that trades on the NYSE may also trade over the counter. The price on the NYSE for that security might be quite different than the price of the security in the OTC market. The CQS allows traders to see the best bid and ask prices for a security across all markets.
Broker: A firm is acting as a broker when it doesn’t use its own inventory to execute a trade. A broker charges a commission (sales charge) for acting as a middleman between a buyer and a seller. If a customer wants to buy a security, the broker will find a seller, and if a customer wants to sell a security, the broker will find a buyer.
If a broker has a customer who wants to sell a security and another who wants to buy the same security, the broker may cross (exchange) the securities without using the services of a dealer. This is known as an agency cross transaction and the trade typically takes place somewhere between the current bid and ask prices.
For Series 7 exam purposes, the term broker and agent may be used interchangeably. A registered representative is sometimes called an agent or stockbroker because she acts as an intermediary between buyers and sellers.
Dealer: A firm is acting as a dealer when it uses its own inventory to execute a trade. When a dealer sells securities to a customer using its own inventory, it charges a markup (sales charge). When a dealer buys securities from a customer for its own inventory, it charges a markdown (reducing the price a customer receives by charging a sales charge). A firm becomes a dealer in the hopes that the securities it has in its own inventory will increase in price so that the dealer can benefit from the appreciation.
The terms dealer, principal, and market maker may be used interchangeably on the Series 7 exam.
Capacity refers to whether a firm is acting as a broker or dealer, and it must always be disclosed on the confirmation (receipt of trade). If a firm is acting as a broker, the commission always needs to be disclosed on the confirmation. However, if a firm is acting as a dealer, the markup or markdown doesn’t always have to be disclosed.
Because market makers are buying and selling securities from their own inventory, they can make firm quotes even though those quotes may only be for a limited period of time. If a market maker enters a quote for a security and then fails to purchase or sell the stated amount of securities at the quoted price, it is a violation known as backing away. Market makers may remove or change their quotes during the course of the trading day based on market conditions. When a price is not firm and is subject to confirmation by the market maker, it is considered a subject (nominal) quote. Subject quotes are for informational purposes only and are subject to change. For example, you could tell a customer that “ABC is trading currently trading at 22.00-22.25 subject.”
A firm's trading department works on positioning (buying and selling securities). Traders handle the brokerage firm's inventory and execute all customers's orders. Traders must have a Series 7 and a Series 57 license.
Here’s where the rubber meets the road. You can receive several types of orders from customers along with numerous order qualifiers. This section explains the types of orders and how to execute them.
It is up to you to look out for your client's best interest. Because OTC equity securities are riskier than many other securities, FINRA requires members to review financial statements and current material business information about the issuer before making a recommendation to purchase or sell short the security. In addition, the recommendation should fit into the client's investment profile and you must have a reasonable basis for making the recommendation.
You can definitely expect a few questions on the Series 7 exam relating to orders. The following sections explore the order types.
A market order is for immediate execution at the best price available. A majority of the orders that you’ll receive will be market orders. Here are the varieties they come in:
Selling short: Selling short occurs when an investor sells securities she doesn’t own. The investor is actually borrowing securities from a lender to sell. Here’s how it works: Say an investor borrows 100 shares of ABC stock and sells them short at $40 per share, thus receiving $4,000. The borrower doesn’t owe the lender $4,000; she owes the lender 100 shares of ABC stock. After a month or two, when ABC is trading at $20 per share, the borrower can purchase the 100 shares for $2,000 and return them to the lender, making a nice $2,000 profit (excluding commission costs). A short seller is bearish (wants the price of the security to decrease). If the price increases instead, the short seller has to buy the stock in the market at a higher price, thus losing money. All short sales must be executed in margin accounts. Short sales are subject to short-sale regulations under Regulation SHO (see the nearby sidebar).
Note: Investors may sell short for speculation (believing the price of the security will decrease), hedging (protecting a security or several securities in the event of a market decline, or arbitrage (taking advantage of a price disparity on the security in different markets).
A stop order is used for protection; it tries to limit how much an investor can lose. Depending on whether an investor has a long or short stock position, she may enter a buy stop order or a sell stop order:
A customer who’s specific about the price she wants to spend or receive for a security places a limit order; this order says the customer doesn’t want to pay more than a certain amount or sell for less. Depending on whether an investor is interested in buying or selling, she can enter a buy limit or a sell limit order:
A stop limit order is a combination of a stop and limit order (see the preceding sections); it’s a buy stop or sell stop order that becomes a limit order after the stop price is reached. For example, an order that reads “sell 1,000 HIJ at 41 stop, 40.75 limit” means that the sell stop order will be triggered as soon as HIJ reaches 41 or below (the stop price). If this were just a stop order, the stock would be sold on the next trade (no matter what the price). But because this is a stop limit order, after the order is triggered, it becomes a limit order to buy at 40.75 or above (the limit price). In other words, this customer is interested in selling her stock if it drops to 41 but wants to receive at least 40.75 per share.
BLiSS (buy limit or sell stop): The BL stands for buy limit, and the SS stands for sell stop. All BLiSS orders are entered at or below the market price of the security. Another thing to remember about BLiSS orders is that they get reduced on the ex-dividend date (the first day a stock trades without a dividend).
The BL in BLiSS helps you remember that the orders are placed BeLow the market price.
SLoBS (sell limit or buy stop): The SL stands for sell limit, and the BS stands for buy stop. All SLoBS orders are entered at or above the market price of the security. Unlike BLiSS orders, SLoBS orders remain the same on the ex-dividend date.
A good way for you to remember that SLoBS orders remain unchanged on the ex-dividend date is to remember the phrase “once a slob, always a slob.”
The following question tests your understanding of trigger and execution prices.
An investor enters an order to sell MNO at 34 stop. The ticker following entry of the order is as follows:
34.75, 34.60, 34.45, 34.20, 34.10, 33.95, 34.25, 34.30, 34, 33.80
At which prices was the order triggered and executed?
(A) Triggered at 33.95 and executed at 33.80
(B) Triggered at 34.10 and executed at 33.95
(C) Triggered at 33.95 and executed at 34.25
(D) Triggered at 34.25 and executed at 33.80
The correct answer is Choice (C). The investor wants to limit losses, so she enters an order to sell if the price dips too low. The order was triggered at 33.95 and executed at 34.25. This is a sell stop order, which is a BLiSS order. BLiSS orders are triggered at or below the order price. In this case, the first transaction that was at or below 34 was 33.95, which is the trigger price. Because this is a stop order, it became a market order for immediate execution and was completed on the next trade (34.25).
The following question tests your ability to answer a stop limit question.
Julia Jingleham purchased 1,000 shares of XYZ Corp. at $45 per share. To limit her losses, a couple of weeks later, Julia places an order to sell 1,000 shares of XYZ at 43 stop 42.90 limit. The ticker following entry of the order is as follows:
43.64, 43.27, 43.30, 43.09, 42.95, 42.87, 42.85, 42.90, 42.94, 43
The order was triggered at
(A) 42.95 and executed at 42.87
(B) 42.95 and executed at 42.90
(C) 42.87 and executed at 42.94
(D) 42.87 and executed at 42.85
The right answer is Choice (B). Julia Jingleham placed this sell stop limit order to sell the stock if it drops to 43 but not sell it at less than 42.90 per share. Take care of the stop portion first, so look for where the sell stop order is triggered. Sell stop orders are BLiSS orders that are triggered at or below the stop price. The first trade that’s at or below 43 is 42.95. Now that the order is triggered, it becomes a sell limit order at 42.90. Sell limit orders are SLoBS orders that are executed at or above the market price. When you move ahead from the point where it was triggered, the first trade that’s at or above 42.90 is 42.90.
Besides knowing the basic types of orders (market, stop, and limit — see “Talking about order types”), you should have a handle on some additional features that may be added to the order to make your customers happy. A lot of them exist, but for the most part, the name of the order feature pretty much explains what it is:
Good-till-canceled (GTC): Good-till-canceled orders are also called open orders because the order is kept open until executed or canceled. For example, say that an investor wants to purchase ABC stock at $30. While the price of ABC is at $35, she enters an open buy limit order for ABC at $30. If the price of ABC ever hits $30 or below, the order will likely be executed; however, if the price of ABC never hits $30 or below, the order stays open until canceled. Regardless of when an open order is placed, a designated market maker clears it out of his book at the end of April or October, and the order has to be reentered.
Note: An investor may specify that she wants the order canceled next week, next month, in two months, and so on. However, the designated market maker only enters the orders as GTC, so it is up to the broker-dealer who accepted the order to cancel the order with the designated market maker on the correct date if not already executed.
Not held (NH): This order gives the broker discretion about when to execute the trade. Typically, investors use not held orders when the broker believes she can get the customer a better price later in the day.
Not held orders deal only with timing. For registered reps to choose the security, number of shares, and/or whether to buy or sell, the customer needs to open a discretionary account, which requires a written power of attorney. See Chapter 16 for details.
All or none (AON): These limit orders have to be executed either in their entirety or not at all. AON orders don’t have to be filled immediately (several attempts to fill the order completely are allowed) and may be day orders or good-till-canceled orders.
As of 2005, the NYSE does not accept AON orders.
A designated market maker (also known as a specialist or DMM) is a member of a stock exchange who’s responsible for maintaining a fair and orderly market on a particular security. A DMM not only maintains an inventory of stock but also posts bid and ask prices and executes trades for other broker-dealers. A DMM acts as both a broker (executing trades for others) and a dealer (buying and selling securities for her own inventory) and tries to keep trading as active as possible.
A designated market maker executes orders by priority, parity, and precedence:
Because DMMs are market makers in a particular security, they may guarantee a price for a floor broker on a trade of securities for a particular period of time (stopping stock). This guarantee allows the floor broker to go to the trading floor to see whether she can get a better price for her customer. In the event that she can’t, she can go back to the designated market maker and do the trade for the guaranteed price. Stopping stock can only be done for public orders.
Super Display Books aren’t written documents like they used to be; now they’ve gone electronic, but they’re still called specialists’ books, order books, market makers’ books, display books, or just books. The book receives and displays orders to DMMs and allows them to execute and then publish orders to the consolidated (ticker) tape.
Take a good look at the book in Table 14-1 to see how it works.
TABLE 14-1 Super Display Book (ABC Stock)
BID |
39 |
ASK (OFFER) |
8 Golden Sec. GTC |
.00 |
7 Livingston Broker-Dealer STOP |
7 Pride Broker-Dealer GTC |
.01 | |
4 VizzionKlempt 14 Orlando Securities |
.02 | |
.03 | ||
.04 | ||
6 Martin Bros. STOP GTC |
.05 |
12 High Profit Securities GTC |
.06 |
6 Brown and White |
When you’re looking at the book, the left-hand side (under “BID”) indicates bid prices that investors (potential buyers) are willing to pay for a security. The right-hand side (under “ASK”) indicates the prices investors (potential sellers) are willing to accept for selling the security.
On each side of the chart are names of broker-dealers looking to buy and sell the security. The numbers to the left of the names represent how many hundreds of shares the investors are looking to buy or sell. For example, the “8” next to Golden Securities on the bid side represents the fact that Golden Securities is looking to buy 800 shares of ABC stock at $39 good till canceled (GTC).
A customer entering a market order would either buy at the best ask price or sell at the best bid price.
As you can imagine, the Series 7 can ask numerous questions about a Super Display book. No matter what the question, you need to ignore the stop orders (pretend they aren’t there) because you can’t be sure what price the order will be executed at, if at all. The following points are examples of information that the Series 7 may ask for. For the data, please refer back to Table 14-1:
Inside market: After ignoring the stop orders, the inside market is the highest bid price and the lowest ask price.
In this case, the highest bid is 39.02 (VizzionKlempt and Orlando Securities) and the lowest ask is 39.05 (High Profit Securities).
Ignoring the Martin Bros. stop, VizzionKlempt and Orlando Securities offer the highest bid at 39.02. VizzionKlempt wants 400 shares and Orlando wants 1,400, for a total of 1,800 shares. Ignoring the Livingston Broker-Dealer stop, High Profit Securities offers the lowest ask price at 39.05; High Profit wants to sell 1,200 shares. The size of the market is therefore 1,800 × 1,200, or 18 × 12 if given in round lots (units of 100 shares).
Spread: The spread is the difference between the highest bid and lowest ask (ignoring the stop orders).
In this case, the spread is $39.05 – 39.02, or $.03.
The narrower the spread, the more actively traded the security. Because investors are buying at the lowest ask price and selling at the highest bid, there’s a built-in loss, which is the difference between those two numbers (the spread). If you have a $2 spread between the highest bid and lowest ask, the price of the stock would have to increase by $2 in order for investors to break even (excluding commissions). As you can imagine, a security like that wouldn’t garner much demand.
Where a designated market maker can enter a bid for her own inventory: Remember that a DMM can’t compete with a public order. A DMM's duty is to keep trading as active as possible, so a specialist can enter a bid (or ask) in between the highest bid and lowest ask.
Using this exhibit, acceptable bids from a specialist would be 39.03 or 39.04.
As you can imagine, certain orders on the DMMs book would have to be adjusted due to dividends or splits. Rules for cash dividends, stock dividends, forward splits, and reverse splits are a little different.
When stocks go ex-dividend, buy limit, sell stop, and sell stop limit orders in the book are reduced to reflect the cash dividend. Remember that buy limit and sell stop (BLiSS) orders are entered below the market value. So if ABC stock was paying a $.30 cash dividend, on the ex-date (the first day a stock trades without the dividend) a buy limit order for ABC common stock at 40 would be reduced to 39.70 ($40 – $.30). In addition, the market price of ABC would be decreased by the amount of the dividend. Investors who want their orders to be reduced by the dividend would have their order marked DNR (Do Not Reduce).
Unlike cash dividends, all orders in the book are adjusted for stock dividends on the ex-dividend date. So, if there's an open order to buy 1,000 shares of ABC at 22 and there's a 10 percent stock dividend, the order will be adjusted to buy 1,100 shares of ABC at 20. If the stock dividend results in the amount of shares being something other than round lots, the odd-lot portion cannot be held in the book because the book only shows round lots. For example, if there's an open order to sell 100 shares of DEF at 60 and there's a 20 percent stock dividend, the new order in the book would be sell 100 shares of DEF at 50. Normally you would think that the order should be sell 120 shares of DEF at 50 (20 percent more shares and the price is decreased to 50 to reflect the stock dividend), but the book only handles round lots (100-share units), so the broker dealer will have to handle the additional 20-share order.
All open orders are adjusted for stock splits. For example, if there's an open order to buy 400 shares of GHI at 60 stop and there's a 2-for-1 split, the order is changed in the book to buy 800 shares of GHI at 30 stop. Remember, for splits, take the shares and multiply them by the first number and divide by the second number. Next, to get the price, multiply it by the second number and divide it by the first number. (For more on splits, see Chapter 6.)
All open orders are canceled for reverse splits (for example, 1-for-2, 2-for-3, 3-for-5, and so on).
In order to help facilitate trading and the dissemination of quotes and trading activity, there are now several systems available. The following are the ones you'll have to recognize when taking the Series 7 exam:
Regulation NMS is an SEC regulation designed to bring trading and reporting consistency to U.S. securities markets. It is designed to help improve U.S. exchanges by setting standards for displaying of quotes and access to market data. It is designed to link trading on different exchanges to make sure customers are getting the best prices.
You should be aware of the sub-penny rule: All equity securities quotes must be in increments of a penny. However, if the security trades for less than a dollar, the quotes may be displayed up to 1/100th of a penny.
To keep investors from panicking when things are going the wrong way, the NYSE has put in place a way to halt trading temporarily if the market drops too quickly. There are different levels put in place to halt trading if the S&P 500 Index drops too much from the previous day's closing price. During that time, the Exchange shall halt trading in all stocks and will not reopen the trading for the time periods specified below:
If a Level 1 or Level 2 decline occurs after 9:30 a.m. EST and up to 3:25 p.m. EST (12:25 p.m. on days the Exchange closes early), the Exchange will halt trading in all stocks for a period of 15 minutes. For a Level 1 or Level 2 market decline, the Exchange will only halt trading once per trading day. If the market decline happens after 3:25 p.m. EST (12:25 p.m. on days the Exchange closes early), the Exchange will not halt trading.
If a Level 3 decline occurs any time during the trading day, the Exchange will halt trading in all stocks until the next trading day.