Chapter 3: Trading - Secondary Market

Question 1

Broker/Dealer

Answer 1

When acting as a broker, the firm is acting in an agent capacity, and receives commissions.

-“ABC - Agent, Broker, Commissions”

When acting as a dealer, the firm is acting as a principal and charges a Mark up.

• “DIPP - DEALERS sell out of their INVENTORY and act as PRINCIPAL for PROFIT”

Question 2

Elements of an order ticket

Answer 2

1) name of security
2) symbol
3) account
4) price
5) quantity
6) Was the the trade solicited, unsolicited, or discretiona
7) if the ticket is a sell, must be marked long or short
8) must have three timestamps – when the order is received, when the ticket hits the trading desk, and when it is executed. 

Question 3

Regulation SHO

Answer 3

Applies to short sales. If a broker/dealer misses 13 consecutive settlement dates on a threshold security, the broker/deal is required to perform a mandatory buy-in

A threshold Security is one with a large short position where the broker/dealer might be at risk of covering the short..

Question 4

Long position

Answer 4

When the stock is owned and investor is bullish.

Question 5

Short position

Answer 5

Does not own the stock, sells the stock first, and then buys it second. Bearish on the security. Wants it to go down in value.

Question 6

Trade confirmations and statements

Answer 6

Confirmations must be sent to customers no later than the completion date of the transaction or settlement of the trade. Is when money and securities change hands.

Must include:
-broker/dealer’s name, address (+ phone number for munis)
-Purchase versus sale?
-Security description
– quantity.
– trade date and settlement date
– delivery and payment instructions.
– is broker/dealer the agent or principal?
– Commission, if firm was the agent
– Markup/markdown, if firm was principal in NASDAQ or riskless principal trade.

-if firm acts as an agent, contra broker must also be disclosed.

Question 7

Confirmation of Municipal Security Transactions

Answer 7

Broker/dealer must provide written confirmation at or before settlement

• Name of customer
• name of broker/deal or muni dealer, and capacity on behalf of customer
• Name of issuer
• Buy or sell?
• Trade date
• Settlement data total dollar amount, accrued interest, principal, compensation/other fees
• Description of the security
• Delivery info
  -Interest rate
• Par value
• Maturity date
  -Yield (unless sold at par)
• CUSIP number
• Any control relationship must be disclosed

Question 8

Statements

Answer 8

Must be sent at least quarterly, and monthly for penny stocks. Must include list of all transactions, list of all securities (which maybe summarized by asset class) and realized/unrealized gains

Question 9

Market order

Answer 9

-Is executed immediately upon delivery of the order. Execution is guaranteed, price is not guaranteed.

Priority of execution:
1. Priority - which got there first
2. Precedence - size, bigger first
3. Parity - coin toss

Question 10

Limit order

Answer 10

Order for purchase at a certain price or better. “Buy 100 shares of ABC at $10 or less.” Are not guaranteed, market orders have priority.

Buy limit is executed at or below the current market price. Sell limit is executed at or above the current market price.

Are day orders unless entered as GTC (good tile cancelled)

Question 11

FINRA 5% rule

Answer 11

Generally, keep commissions under 5%. Applies to nonexempt/corporate securities traded in the OTC secondary market, and Securitieslisted on an exchange. Also applies to find wire services, proceeds trades, agency, Crestridge, request and simultaneous, peaceful transactions, and other non-exempt stock and bond trades. Applies to the third market.

• Applies to nonexempt (corporate) securities traded in the OTC secondary market, and securities listed on an exchange, such as the NYSE.
• For OTC securities, this includes the securities listed on the Pink Sheets, Yellow Sheets (lists corporate bonds), NASDAQ, and all nonexempt registered securities which trade OTC, including ADRs (foreign equities traded in the U.S.).
• The Five Percent Policy does NOT apply to exempt securities, such as Treasuries and municipals, nor to prospectus offerings, for which FINRA has different rules that apply to the prospectus offerings.

Question 12

Exchange

Answer 12

A stock exchange is a physical location where broker/dealers execute investor orders to buy and sell securities

Question 13

NYSE

Answer 13

Has seven liquid markets, with access to Stocks, bonds, ETFs, and options. 

Listing requirements for companies:
-have at least 1.1 million shares outstanding
-market value of at least $140,000,000
-aggregate pre-tax earnings over the last three years of $10 million.
-Share must be at least four dollars at time of listing.

Requirements for issuers:
-must have at least $500 million in global market cap.
-must have $100 million in revenues over most recent 12 months.

Question 14

Designated market maker (DMM)

Answer 14

Maintains a fair and orderly market. DMMs must buy when no buyers exist and sell when no sellers exist and hold these orders in their own account.

A designated market maker may also act as an agent for a trading floor broker. A trading floor broker who cannot execute a client’s order due to price or timing gives the order to the DMM, who records it in their own book. The order is held until it can be executed. If the order is executed, the DMM charges a commission.

The DMM is also permitted to stop the stock for public orders. By stopping the stock, the trader guarantees an order fill at a specified price for a period of time. Then there’s one opportunity to better that price.

Question 15

Trading floor Broker

Answer 15

Execute orders for their firm’s own accounts and for clients of their firm. The member firm charges a commission to the clients.

Question 16

Supplemental liquidity providers (SLP)

Answer 16

– High-volume traders, increasing liquidity on NYSE.
- Trade only for their own accounts, not agencies or customers.
– Must maintain a bid or offer at the NBBO in each of their securities at least 10% of the trading day.

Question 17

Components of stock ticker 

Answer 17

-Symbol – The unique character that is used to identify the company.
-Shares traded – The volume of the trade being quoted expressed in round lots.
-Price traded – The price per share in a particular trade.
-Change direction – A symbol that indicates whether the price is higher or lower than the previous day’s closing price.
-Change amount – The difference in price from the previous day’s close.

Question 18

Market arbitrage

Answer 18

Occurs when an investor buys a security on one exchange and simultaneously sells the same security on another exchange.

This enables the investor to take advantage of small price deviations between the exchanges.

Question 19

Risk arbitrage

Answer 19

The risk arbitrageur buys the stock of the company that is being acquired and sells short the stock of the purchasing company that is doing the acquisition.

Question 20

Arbitrage - Convertible securities

Answer 20

Arbitrageur purchases convertible bond or preferred stock, converts them to to common stock, then sells for a profit on the open market.

Question 21

Order Flow

Answer 21

Pneumonic: “Other People’s Money Counts”

1. Order/Wire department
2. Purchase and sale department
3. Margin department
4. Cashier

Question 22

Order flow - Order/Wire department

Answer 22

-aka The Wire Room
-Where the order is sent for execution. Once executed, it goes to Purchase and Sale

Question 23

Order Flow - Purchase and Sale department

Answer 23

-Where confirmations are created and sent out to the customer.

-Before it is sent to the customer, the RR is responsible for reconciling the confirmation with the execution report for accuracy.

Question 24

Order Flow - Margin department

Answer 24

Ensures that margin account balance is high enough to cover transactions.

Margin = the amount of equity an investor has in their brokerage account.

Question 25

Order flow - Cashier

Answer 25

-aka The Cage
-Where the receipt/delivery of cash/securities takes place.
-Responsible for rejection or reclamation

Rejection is refusal from the transfer agent to accept the security; Reclamation is correcting the issue.

Question 26

Don’t Know (DK) notice form

Answer 26

If, when transmitted, a transaction is not recognized by the contra party. Amount or price may be wrong on the order.

• Executing broker/dealer has four days to respond to a DK notice.

Question 27

Errors in securities transaction

Answer 27

1. In an error in the reporting transaction, the customer is obligated to pay the actual amount, even if erroneous
2. In an error in executing the transaction, the broker/dealer is responsible, not the customer

Question 28

Block trade

Answer 28

10,000+ shares (not penny stocks) or $200,000

Question 29

Crossing the market (aka cross transaction)

Answer 29

When a firm receives buy and sell orders on the same stock at the same time. Order must first be offered on the exchange for $0.01 higher than the current bid for at least 16 seconds before the broker/dealer May cross the transaction within its own client base.

Question 30

Stop orders

Answer 30

Stop and stop limit orders are instructions that indicate if a stock goes up/down to a specified price, then an order is entered.

Note that a sell stop order is the same thing as a stop loss order

Question 31

Sell stop orders

Answer 31

Are placed below the market, if stock goes down to the stock price, the stop is elected or triggered. Then, the order becomes a market order for immediate execution.

Note: Once triggered, it does not matter if the next trade is higher, lower, or the same.

Question 32

Buy stop orders

Answer 32

Are placed above the market, and are executed at or above the stop price. Once the market hits the order price, execution is at the very next trade.

Note: it does not matter if the next trade is higher, lower, or the same.

Primarily used as protection for short sales where the position has unlimited risk from market appreciation.

Question 33

Sell stop limit orders

Answer 33

Triggered when the stock price trades at or below the stock price, then becomes a live limit order. Like any limit order, will only be executed at a designated price or better.

So it is triggered at a certain price, but then it’s only executed if the price subsequently is the same or better. This makes it different than a sell stop order.

Example: “Sell $55.50 stop $56.” At $55.50 or below, the order is triggered and becomes a live limit order. This limit order will only be executed at 56 or higher.

Question 34

Buy stop limit order

Answer 34

Entered above current market value. Is triggered at or above the stock price, then becomes a live a limit order, to be executed at or below the limit price.

Example: “Buy 66 stop 65.” the order is elected when the stock trades at 66 or above, becomes a live limit order to buy at 65 or below.

Question 35

Impact of dividends on orders

Answer 35

When are dividends paid, stocks, price is adjusted downward to reflect the payment. This downward price adjustment might result in unintentional execution of special orders. Therefore, orders that are placed below market value are also adjusted downward along with the stocks price to reflect the dividend payment (unless there is a “do not reduce” order). Prevent accidental execution of by limits, sell stops and sell stop limits.

Question 36

All or none order

Answer 36

Top priority is quantity, time is secondary. Executed in their entirety or not at all. Day order unless entered as good till canceled.

Question 37

Not held order

Answer 37

A not-held order gives a broker the time and price discretion to seek the best price available. The broker is not held responsible for any potential losses or missed opportunities that result from their best efforts. A held order, in contrast, requires immediate execution

Day order, unless entered as good till canceled

Question 38

Good till canceled order (GTC)

Answer 38

Remain in the designated marketmakers book until executed or canceled.

Twice per year existing GTC orders must be re-entered or they are canceled, occurs on the last trading date of April and October.

Question 39

Fill or kill order (FOK)

Answer 39

Must be executed in its entirety at the time of order entry. For example, order to buy 500 shares, fill or kill, must be immediately executed in its entirety, or it is canceled. Thus, they do not go in the designated market makers book. Killed if not executed immediately.

Question 40

Immediate or cancel order (IOC)

Answer 40

Time is top priority. Filled immediately with as many shares as available. If only partially filled, unfilled amount is canceled.

Example IOC order for 500 shares, 300 available. 300 purchased, 200 are canceled.

Question 41

Market on close order (MOC)

Answer 41

To be filled at close of trading day. No later than 3:45 EST unless there’s order imbalance, then 3:50 PM.

In the event of a trading halt and order cannot be filled at the close, it is canceled.

Question 42

Block orders

Answer 42

Occur off the floor and off tape. Attempt to maintain an orderly market. Usually involves block trade of low priced, thinly traded stock in the third market. Order is slowly tripled in throughout the trading day, rather than all at once, to protect price of the stock.

From Investopedia: A block trade is a large, privately negotiated securities transaction.

Block trades are arranged away from public markets to lessen the effect on the security’s price.

They are usually carried out by hedge funds and institutional investors via investment banks and other intermediaries, though high-net-worth accredited investors may also be eligible to participate.

The New York Stock Exchange and the Nasdaq define a block trade as one involving at least 10,000 shares of stock, or one worth more than $200,000.

Most block trades far exceed these minimums.

Question 43

OTC market

Answer 43

No physical location. 24 hour market your phone and Internet. World’s largest market. There are no auctions, all transactions are negotiated between parties. Listed trades report within 10 seconds of execution.

Question 44

NASDAQ

Answer 44

Is it in electronic quotation system.  Stocks must meet listing requirements for size and outstanding shares. Are biggest and most actively traded OTC securities. Listed trades report within 10 seconds of execution.

Question 45

Seller’s option

Answer 45

A negotiated settlement, which gives the seller the option to deliver the security during any time Ranging from 6 to 60 business days.

Locks in the right to buy/sell the security at a specific price

Question 46

NASDAQ level one

Answer 46

Shows the inside market, which is highest bid and lowest offer for security. This info is needed for RRs to report to customers. Requires 2+ marketmakers to enter quotes for system to show it.

Question 47

NASDAQ level two

Answer 47

Shows bid and ask for all market makers for a given security. All are firm for 100 shares.

Used by traders, who need to see depth of market and identity of market makers

Question 48

NASDAQ level three

Answer 48

Same info as level two, but allows market makers to enter/change their own quotes. Market makers cannot withdraw quotes without penalty, which is usually a 20 day restriction on entering quotes.

Question 49

NASDAQ ticker

Answer 49

From left to right:
-name of the Security
– last trade
– bid price designated by the B
– ask price designated by the A

Example: XYZ 25.25 +.25; B 25; A 25.12

Question 50

Pink sheets

Answer 50

Publication listing quotes for non-NASDAQ, OTC stocks, generally too small to be listed on NASDAQ. Often penny stocks.

Not necessarily SEC reporting companies.

Include stock, market makers, sometimes market makers phone number, and their quotes.

Question 51

The third market

Answer 51

The trading of exchange listed securities in the OTC market, where prices are negotiated rather than dictated by the market. There is no physical location.

Exchange listed stocks can trade on the third market because if it is purchased through a regular exchange, a trade could be large enough to create an order imbalance in a market. i.e. Large, institutional investor purchases may be done OTC to maintain market stability for security.

Example: an institutional investor came to a broker/dealer and wanted to buy shares of IBM. The first place the broker/dealer looks is in their own inventory. If they have it and wish to sell to the customer out of their own inventory, then IBM, which is listed on the New York Stock Exchange, trades in an over the counter transaction. This is a third-market trade.

Question 52

Designated reporting members (DRM)

Answer 52

Market makers in the third market designated by FINRA are required to register as designated reporting members (DRM).

If both the buyer and seller firms are DRMs in a security, the sell side is required to report within 10 seconds. If neither side is a DRM, the sell side reports in 10 seconds. If just one side is a DRM, the DRM reports.

Question 53

Fourth market - Electronic Communications Network (ECN)

Answer 53

The Fourth Market consists of institutional investors, such as mutual funds and pension funds, electronically trading big blocks of securities with one another. Use ECNs, or Electronic Communications Networks. ECNs facilitate agency cross services, taking the shares from the seller and delivering and confirming them to the buyer electronically. Less costly way of trading, there are no commissions.

Ex: massive sale of stocks from a mutual fund to a hedge fund.

ECNs eliminate the need for a (costly) third party, such as an investment bank.

ECNs are SEC registered and charge fees. NASDAQ is an ECN.

Question 54

Order Routing and Best Execution

Answer 54

SEC requires NBBO be published. FINRA requires members and their associated persons to use reasonable diligence to determine the best market for executing a customer order so the customer receives the best possible price. The following factors are taken into consideration:

-The market’s characteristics: price, volatility, liquidity, pressure on communications;
-The size and type of transaction;
-The number of markets the member firm checked before entering the order;
-The accessibility of a quotation; and
-The terms and conditions of the order (whether it is a market order, not held order, or a stop loss order.)

NOT A CONSIDERATION. - what the broker/dealer paid for the security. Must be influenced by market price, not what the broker/dealer paid.

Question 55

Interpositioning

Answer 55

When the broker/dealer places another firm between itself and the customer. Only allowable if it provides a better price to the end customer.

Ex of interpositioning: Broker/Dealer B goes to Broker/Dealer C and asks C to purchase the shares from Broker/Dealer A, the market maker.

Question 56

Trade Reporting and Audit Systems - Stocks

Answer 56

• Linked electronic communications networks (ECNs) use Trade Reporting Facilities (TRFs) to report their trades.

-If firm uses an alternative display facility (ADF) and on an unlinked ECN, the system for trade reporting is TRACS (Trade Reporting and Comparison Service)

• OTC Reporting Facility (ORF) is used to report OTC non-NASDAQ.

Question 57

Trade Reporting and Audit Systems - Bonds

Answer 57

• TRACE (Trade Reporting and Compliance Engine) reports trades in U.S. Treasury and corporate bonds. TRACE requires that both the buy and sell side report within 15 minutes of the transaction.

Once both sides of the trade reports through TRACE, FINRA will release the information to the public immediately.

-The Real-Time Transaction Reporting System (RTRS) is the MSRB system which tracks municipal bonds.

Question 58

Consolidated Audit Trail (CAT)

Answer 58

CAT tracks orders and identifies the broker/dealers handling the orders. This allows regulators to track activity in eligible securities in the U.S. markets. CAT gives the SEC, FINRA, and other regulators the ability to identify order and trade activity in detail without contacting the broker/dealers directly via electronic blue sheet requests.

Question 59

Special order

Answer 59

A stabilizing bid reported on the tape prior to execution to support a falling stock

Question 60

Consolidated reporting system (CRS)

Answer 60

The consolidated quote system is the electronic system that provides pricing to the NYSE and the third market.

Question 61

National Market System

Answer 61

Primary focus is ensuring transparency and disclosure regarding stock price quotations and trade executions.

Last sale information is available for OTC transactions in NASDAQ national security system, not on NASDAQ small caps or emerging companies

Question 62

Exchange distribution

Answer 62

Block order or stock cross order with one or two designated market makers involved.

For example – a large sell order is crossed or matched with a large buy order. This block is handled off the floor of the exchange and recorded on the tape.

Question 63

Proceeds transaction

Answer 63

A transaction in which the proceeds of the sale are used to make an immediate purchase. FINRA states that the fairness of the markup is based on the combined proceeds to the Broker/dealer divided by the inside to ask on the buy side. The Broker/Dealer should not consider these as separate trades, but as one combined trade.