Orders and Trading Strategies

Every trade starts with an order ticket, and the ticket answers a short list of questions. What price? How long does the order stand? Who chose the trade, and which side did your firm take? Section 3 is 31% of your exam, and this vocabulary runs through it.

Bid, ask, and the spread

Every quote carries two prices, and you get the worse one. The bid is the highest price a buyer will pay. The ask, also called the offer, is the lowest price a seller will accept. You sell at the bid and you buy at the ask.

The spread is the ask minus the bid. Quote XYZ at $20.10 bid and $20.15 ask, and the spread is 5 cents. That nickel is a cost to you and income to the market maker.

The four order types

An order type answers one question: at what price will this trade?

• A market order trades right away at the best available price. It guarantees execution and never guarantees price.
• A limit order names the worst price you will take. A buy limit fills at the limit or lower, a sell limit at the limit or higher. It guarantees price and never guarantees execution.
• A stop order waits until the stock trades at or through the stop price. That trigger turns it into a market order.
• A stop-limit order waits the same way, except the trigger turns it into a limit order. It guarantees neither price nor execution.

Placement follows from the job. A buy limit and a sell stop go below the current market price. A sell limit and a buy stop go above it.

DEF trades at $47 and you enter a buy limit at $45. Nothing fills until DEF reaches $45 or lower. You own 500 shares of ABC at $50 and you enter a sell stop at $45. If ABC trades at $45, your order becomes a market order and sells at the next available price, which may be below $45.

Short sellers use the mirror image: a buy stop above the market closes the position.

How long the order lives

A day order expires at the close of the trading day if it does not fill. Unless the ticket says otherwise, an order is a day order.

A good-til-canceled (GTC) order stays open across trading days until it fills or the customer cancels it.

An all-or-none (AON) order must fill in full, and it may stay open while it waits.

Who chose the trade, and who raised the idea

Discretion is about who chose the trade. In a discretionary account, the representative chooses the security, the action, and the amount: what to buy or sell, whether to buy or sell, and how many shares. The representative decides all three without asking first. That authority requires the customer's prior written authorization. In a non-discretionary account, the customer makes all three choices.

Choosing only the time or the price of an order the customer already defined is not discretion. That leeway lasts only for the day the customer gives it.

Solicitation is about who raised the idea. A solicited order is one the representative recommended. An unsolicited order is the customer's own idea, placed with no recommendation behind it. The order ticket records which one it was, because a recommendation carries duties an unsolicited order does not.

The capacity your firm trades in

Capacity is the side your firm took on the trade.

In agency capacity, also called acting as a broker, the firm arranges the trade between a buyer and a seller and charges a commission. It never owns the security.

In principal capacity, also called acting as a dealer, the firm trades from its own inventory. It sells you a security it owns and adds a markup, or it buys a security from you and takes a markdown.

A broker-dealer may do both jobs, called dual capacity, but it uses one capacity per trade.

A firm buys a municipal bond from one customer at $98 and sells it to another at $100. Both trades are principal trades, and the $2 is the firm's spread.

Every trade confirmation states the capacity the firm used, under SEC Rule 10b-10.

Long, short, covered, and naked

Long means you own it. Buy 100 shares and you are long 100 shares. You profit when the price rises, and the most you can lose is what you paid.

Short means you sold a security you do not own. The short seller borrows the shares through the firm, sells them, and owes them back. Sell short 100 shares at $60 and buy them back at $40, and you keep $2,000 before costs. Buying the shares back is called covering.

Before you sell short, price the downside. A stock has no ceiling, so a short position's maximum loss is unlimited.

Covered and naked describe whether a short option position has an offsetting position behind it. Write a call against 100 shares you already own and the call is covered: assignment delivers shares you hold. A naked, or uncovered, call has nothing behind it. Assignment forces the writer to buy the stock at any price the market asks. That loss is unlimited too.

Bullish and bearish

Bullish means you expect the price to rise. Bearish means you expect it to fall. Sort the strategies by direction:

• Bullish: buy stock, buy calls, write puts.
• Bearish: sell short, buy puts, write calls.

How this gets tested

Most items describe a situation and ask for the order. A customer holds stock and wants protection against a drop: sell stop. A customer wants in only above a price: buy stop. A customer will pay no more than a set price: buy limit.

One trap uses the word covered. A covered call writer already holds the stock, which caps the gain and rules out an unlimited loss. A naked call writer and a short seller both face unlimited loss. The exam puts those three side by side.