Trading and Settlement

Order Types

Understanding order types is one of the most critical skills for any registered representative and is heavily tested on the Series 7 exam. Each order type serves a specific purpose and carries different implications for execution price, speed, and risk. You must know not only what each order type does, but when and why a customer would use it.

Market Orders

A market order is an instruction to buy or sell a security immediately at the best available price. Market orders guarantee execution but do not guarantee a specific price. They are the most common order type and provide the fastest execution. In liquid markets, the execution price is typically close to the quoted price, but in volatile or illiquid markets, the fill price may differ significantly from the last quoted price — a phenomenon known as slippage.

Limit Orders

A limit order specifies the maximum price a buyer is willing to pay (buy limit) or the minimum price a seller is willing to accept (sell limit). Limit orders guarantee price but do not guarantee execution — the order will only execute if the market reaches the specified price or better.

• Buy limit order: Placed below the current market price. Executes at the limit price or lower. Used by investors who believe the stock will decline before rising.
• Sell limit order: Placed above the current market price. Executes at the limit price or higher. Used to lock in profits at a target price.

Stop Orders (Stop-Loss Orders)

A stop order becomes a market order once a specified price (the stop price) is reached. Stop orders are primarily used to limit losses or protect profits.

• Sell stop order: Placed below the current market price. When the stock drops to the stop price, the order becomes a market order to sell. Used to limit losses on a long position. Example: You own stock at $50 and place a sell stop at $45. If the stock falls to $45, your stop triggers and becomes a market sell order.
• Buy stop order: Placed above the current market price. When the stock rises to the stop price, the order becomes a market order to buy. Used to limit losses on a short position or to buy on an upward breakout.

Stop-Limit Orders

A stop-limit order combines features of both stop and limit orders. When the stop price is reached, the order becomes a limit order (not a market order). This gives the investor price control once the stop is triggered, but introduces the risk that the order may not execute if the market moves past the limit price too quickly.

Example: A stop-limit order to sell at $45 stop, $44 limit means that if the stock falls to $45, a limit order to sell at $44 or better is activated. If the stock gaps down below $44 without trading at $44, the order may not execute.

Time-in-Force Qualifiers

• Day order: Valid only for the trading day on which it is entered. If not executed by market close, it expires. All orders are day orders by default unless otherwise specified.
• Good-Till-Cancelled (GTC): Remains active until executed or cancelled by the customer. FINRA member firms typically impose a maximum duration (e.g., 90 days) and notify the customer when a GTC order is about to expire.
• Immediate or Cancel (IOC): Must be executed immediately. Any portion not immediately filled is cancelled.
• Fill or Kill (FOK): Must be executed in its entirety immediately or cancelled entirely. No partial fills allowed.
• All or None (AON): Must be executed in its entirety but does not need to be filled immediately. The order remains active until it can be filled completely.
• Not Held (NH): Gives the floor broker or market maker discretion over the time and price of execution. The customer cannot hold the broker liable for the execution quality. This is NOT considered a discretionary order because the customer has already specified the asset, action, and amount.

Trade Execution

Auction Market vs. Dealer Market

Securities are traded in two primary market structures:

Auction market (exchange-based): Buyers and sellers compete against each other through a centralized order book. The NYSE is the best example. A Designated Market Maker (DMM) facilitates trading by maintaining an orderly market, providing liquidity, and narrowing the bid-ask spread. The highest bid and lowest ask determine the current market price. Trades occur when a buyer's price matches a seller's price.

Dealer market (OTC/Nasdaq): Multiple dealers (market makers) compete for order flow by posting bid and ask prices. Each market maker quotes its own two-sided market. Trades occur when a customer's order matches a market maker's quote. Market makers profit from the bid-ask spread. Nasdaq operates as a dealer market, though it has increasingly adopted auction-like features.

National Best Bid and Offer (NBBO)

The NBBO represents the best available bid (highest) and best available ask (lowest) across all venues where a security trades. Broker-dealers have an obligation to execute customer orders at prices equal to or better than the NBBO. The NBBO is continuously updated as quotes change across all exchanges and market makers.

Regulation NMS (National Market System)

Regulation NMS, adopted by the SEC in 2005, modernized the U.S. equity market structure. Its key provisions include:

• Order Protection Rule (Rule 611): Prohibits trade-throughs — executing orders at prices inferior to displayed quotes on other venues. Ensures customers get the NBBO.
• Access Rule (Rule 610): Requires fair access to quotations and limits fees that trading centers can charge.
• Sub-Penny Rule (Rule 612): Prohibits quoting stocks in increments smaller than one cent for stocks priced at $1.00 or above.
• Market Data Rules: Requires the distribution of consolidated market data to all investors.

Best Execution Obligation

Under FINRA Rule 5310, broker-dealers have a duty of best execution — they must use reasonable diligence to find the best market for a customer's order, considering factors such as price, speed, likelihood of execution, size, and the character of the order. Best execution does not mean the best possible price on every trade; rather, it means the firm must have a process to regularly review execution quality and seek favorable terms for customers.

Settlement

Settlement is the process by which the buyer receives the securities and the seller receives payment. The settlement date is when the legal transfer of ownership occurs. Different types of securities have different settlement cycles.

Settlement Dates

• Corporate stocks and bonds: T+1 (regular-way settlement — trade date plus one business day). This was shortened from T+2 in May 2024 under SEC Rule 15c6-1(a).
• Government securities and options: T+1 (next business day). Options previously settled same day for exercise; listed options settle T+1 for the premium.
• Cash settlement: Same day (T+0). Used in special circumstances; requires agreement between parties.
• When-issued securities: Settlement date is determined when the security is actually issued. No settlement until issuance.

Ex-Dividend Date and Record Date

When a company declares a dividend, several important dates determine who receives the payment:

1. Declaration date: The board of directors announces the dividend amount, record date, and payment date.
2. Ex-dividend date: The first date on which a buyer of the stock is NOT entitled to the declared dividend. Under the T+1 settlement cycle, the ex-dividend date is typically one business day before the record date. The stock price typically drops by approximately the dividend amount on the ex-date.
3. Record date: The date on which the company checks its records to determine which shareholders are entitled to receive the dividend. You must be a shareholder of record by this date.
4. Payment date (payable date): The date the dividend is actually paid to shareholders of record.

Due bills: If a trade occurs near the ex-dividend date and settlement occurs after the record date, a due bill may be used to ensure the proper party receives the dividend. The due bill is a document attached to the security requiring the seller to forward the dividend to the buyer.

Clearing Process — DTCC and NSCC

The Depository Trust & Clearing Corporation (DTCC) and its subsidiary, the National Securities Clearing Corporation (NSCC), provide clearing, settlement, and information services for the U.S. securities industry.

The NSCC uses a process called Continuous Net Settlement (CNS), which nets all of a firm's buy and sell transactions in each security to a single net long or short position. This dramatically reduces the number of securities and cash deliveries that must occur, increasing efficiency and reducing risk. For example, if a firm bought 10,000 shares of XYZ and sold 8,000 shares of XYZ on the same day, it only needs to receive (and pay for) the net 2,000 shares.

The Depository Trust Company (DTC), another DTCC subsidiary, holds securities in electronic (book-entry) form. Most securities are held in "street name" (the name of the broker-dealer) at the DTC, which facilitates rapid electronic transfer of ownership during settlement.

Corporate Actions

Corporate actions are events initiated by a publicly traded company that affect its securities. Understanding how corporate actions impact shares, prices, and outstanding orders is critical for the Series 7 exam.

Stock Splits

A stock split increases the number of shares outstanding while proportionally reducing the price per share. The total market capitalization remains the same.

• Forward split (e.g., 2-for-1): An investor who owns 100 shares at $80 would own 200 shares at $40 after a 2:1 split. The value remains $8,000.
• Reverse split (e.g., 1-for-4): An investor who owns 400 shares at $5 would own 100 shares at $20 after a 1:4 reverse split. Companies use reverse splits to increase their share price, often to maintain exchange listing requirements.

Effect on open orders: For forward splits, open orders below the market (buy limits and sell stops) are adjusted — the number of shares increases and the price decreases proportionally. For GTC orders, the order quantity is multiplied by the split ratio and the price is divided by the split ratio. Day orders are not adjusted because they expire at the end of the trading day.

Stock Dividends

A stock dividend distributes additional shares to existing shareholders instead of cash. For example, a 10% stock dividend gives shareholders 1 additional share for every 10 they own. Like stock splits, stock dividends increase the number of shares outstanding and reduce the price per share, with no change in total market value.

Tender Offers

A tender offer is a public offer to purchase shares from existing shareholders at a specified price, usually at a premium to the current market price. Tender offers are commonly made by companies seeking to acquire another company or by companies seeking to repurchase their own shares. Under SEC rules, tender offers must remain open for a minimum of 20 business days, and shareholders who tender their shares can withdraw them at any time before the offer expires.

Rights Offerings

A rights offering (preemptive right) allows existing shareholders to purchase additional shares at a subscription price below the current market price, in proportion to their existing holdings. Rights protect shareholders from dilution when the company issues new shares. Rights are typically short-lived (30-45 days) and can be exercised, sold in the secondary market, or allowed to expire.