How Broker-Dealers Function

• Broker
  • Remember, A-B-C
  • Agency trades are executed by Brokers and they charge Commissions
  • Brokers don’t assume risk
• Dealers
  • Remember, P-D-M
  • Principal trades are executed by Dealers and they charge Markups and/or Markdowns
  • Dealers assume risk

Markups and Markdowns

• Market maker quotes are inter-dealer, but are adjusted when trading with retail customers
  • Allows dealers to profit on trade with customers
  • Price adjustments are built into the trade, but are generally disclosed on the confirmation 

This quote shows the prices at which the market maker will buy from and sell to other dealers

Factoring in a $.05 markdown or markup, the prices to retail clients will be as follows:

Fair Prices and Commissions

• The Policy
  • FINRA has established a 5% policy
    • The policy is not a rule, but rather a guideline for commissions, markups, and markdowns
      • Certain transactions may justify a higher markup/markdown
      • Other transactions may justify a lower markup/markdown
• The Factors that Influence the Charge
  • Type of security involved (equity or debt)
  • Availability of the security
  • Price
  • Amount of money involved
  • Pattern of markups
    • What is the firm’s policy on what it charges clients
  • However, the type of client or whether the firm will profit is NOT relevant

Markup higher than 5% can be justified under certain conditions. A markup of less than 5% is not a safe harbor. If you charge 5% of every trade, that might be breaking a guideline.

The 5% Policy

• The policy applies to proceeds transactions
  • When a client directs a B/D to liquidate securities and use the proceeds to buy other securities
    • Markup is calculated based on one trade (as if done for cash)
  • Use the dollar value of the trade
• The policy excludes:
  • Trades involving securities sold by prospectus or offering circular (e.g., new issues, mutual funds, variable annuities)
  • Exempt securities (e.g., US government and municipal securities)

Determine which is true/false

• A markup is applied to the ask price when a market maker sells to a customer
  • True
• Total price paid by the customer is the ask price
  • False
  • Ask + commission/markup
• FINRA’s 5% policy allows a broker-dealer to charge enough to make a profit
  • False
• The 5% policy applies when a customer sells a security and uses the proceeds to purchase another security
  • true

Discretionary Orders

• For Discretionary Accounts
  • When discretion is granted to a registered representative, must be documented when used
    • If the trading decision was made by the representative without consent to the specific trade, the order ticket must state that it was discretionary
    • If the trade was executed with the client’s consent, the order ticket will state discretion not exercised
• For Non-Discretionary Accounts
  • Any order ticket must indicate solicited or unsolicited
    • If a trade was recommended by the agent and accepted by the customer, the order ticket is marked solicited
    • If a trade is placed by a customer without the representative’s recommendation, the order ticket is marked unsolicited

Types of Transactions

• When an order is placed, it must be identified as either a:
• Purchase
  • Trade may be paid in full or purchased on margin
• Long Sale
  • Sale of securities that are owned by the customer
• Short Position Created by:
  • Sale of securities that are not owned by the customer
    • Customer borrows from the firm and sells
    • Must deposit the appropriate amount of margin to borrow securities
    • Risk is on the upside and unlimited
  • Covered and uncovered options (the sale of call or put options)
    • If covered, no margin is required and risk is generally limited
      • If you own the stock
    • If uncovered, margin is required and risk may be significant 

Types of Orders

• Market Order
  • Customer wants to buy or sell
  • Customer specifies the security and size of the order only
  • Order is immediately executed at the best price available
    • Not guaranteed time and price
• Limit Order
  • Customer only wants to buy or sell at a set price or better
  • Customer specifies the security, size, and price
  • Order is only executed if the limit price is able to be met
    • Buy limit: at preset price or lower
    • Sell limit: at preset price or higher

Buy Limit Order

• An investor is interested in ABC stock, which is trading at $30.75. Rather than placing a market order, she enters a buy limit order, Buy 1,000 ABC at $30

Sell Limit Order

• ABC is currently trading at $29.40, and an investor who is long the stock is willing to sell her shares, rather than placing a market order,s he enters a sell limit order, Sell 1,000 ABC at $30

• Remember, these do not guarantee you a profit

Matching

• Market
  • A buy or sell order that will be immediately executed
• Sell limit
  • An order that will only be executed at a specific price or higher
• Limit
  • A buy or sell order that may not be executed
• Buy limit
  • An order that will only be executed at a specific price or lower

Stop Orders

• May be used to limit a loss or protect a gain
• Does NOT guarantee a specific price when buying or selling
• If Long Stock (Bullish)
  • Hope
    • Stock rises in value
  • Fear
    • Stock falls in value
  • Need
    • Limit downside risk (enter sell stop order below the current market value)
• If Short Stock (Bearish)
  • Hope
    • Stock falls in value
  • Fear
    • Stock rises in value
  • Need
    • Limit upside risk (enter buy stop order above the current market value)

Stop and Stop Limit Orders

• Both stop and stop limit orders are “triggered” (activated) when a trade occurs at, or through the stop price
  • Sell stop orders will activate at the stop price or lower
  • Buy stop orders will activate at the stop price or higher

• Limit & stop limit orders may not provide protection since it’s possible that they may not have been executed

Fill in blank

• Can be used to hedge a long position
  • Sell stop order
• Once activated, it may not be executed
  • Stop limit order 
• Once activated, it will be immediately executed
  • Stop order
• Can be used to hedge a short position
  • Buy stop order

Sell Stop Order

• An investor’s long position in RST has risen in value; however, he’s afraid of a potential decline. To limit downside risk, he enters a sell stop order
• Sell 1,000 RST at $30 stop

Sell Stop Order Example

• An investor bought 1,000 shares of DEF at $34
  • The stock starts trading at lower prices
  • Afraid of a large loss, she enters an order: Sell 1,000 DEF at $30 stop
  • Today’s transactions: $30.35 | $30.70 | $30.38 | $29.87 | $29.85
    • Trigger price?
      • $29.87 (as soon as it goes at or below $30)
    • Execution price?
      • $29.85 (in this example)
• A stop order (which becomes a market order once triggered) can be executed at a price that’s above or below the stop price

Buy Stop Order

• An investor’s short position in ABC has fallen in value; however, he’s afraid of a potential increase. To limit upside risk, he enters a buy stop order
• Buy 1,000 ABC at $30 stop 

Buy Stop Order Example

• An investor is short 1,000 shares of DEF at $26
  • The stock starts trading at higher prices
  • Afraid of a large loss, he enters an order: Buy 1,000 DEF at $30 stop
  • Today’s transaction: $29.75 | $29.60 | $29.70 | $30.12 | $30.15
    • Trigger price: $30.12
    • Execution price: $30.15 
  • A stop order (which becomes a market order once triggered) can be executed at a price that’s above or below the stop price

Order Qualifiers

• Different qualifiers can be used to influence when and if an order is executed
• Two of the more popular are:
  • Day order – unless otherwise indicated, all orders are day orders and are canceled at the day’s end if not executed
  • Good-’til-canceled (GTC) or Open Order – stays on the book until it expires, is executed, or is canceled
    • May be placed for one week, one month, or other specified period
    • Entering firm should periodically check with the exchange on which the order was entered
    • May be adjusted for distribution on the security or partial execution