Trading Securities

Trading Securities

Trading mechanics are heavily tested on the Series 66 because they touch suitability, supervision, and disclosure obligations. Five sections: order types and conditions (market, limit, stop, stop-limit, FOK/AON/IOC, day/GTC); trade execution including best execution, payment for order flow (PFOF), and market roles; trade settlement under the new T+1 standard effective May 28, 2024; margin accounts under Regulation T (50% initial, 25% maintenance) with a hands-on margin-call calculator; and short selling mechanics under Reg SHO plus pattern day trader (PDT) rules. The chapter equips you to answer trade-mechanics questions confidently and to recognize where supervisory issues commonly arise.

Trading Terminology

• Bid: The highest price a buyer will pay
• Ask (offer): The lowest price a seller will accept
• Spread: Difference between bid and ask
• Market order: Execute immediately at the best available price
• Limit order: Execute only at a specified price or better
• Stop order: Becomes a market order when the stop price is reached
• Short sale: Selling borrowed securities with the expectation of buying them back at a lower price

Market and limit orders — the two fundamentals

The two foundational order types differ in what they guarantee:

• MARKET ORDER. Buy or sell at the BEST CURRENTLY AVAILABLE price. Guarantees EXECUTION (will fill almost instantly in liquid markets) but does NOT guarantee a specific price. In fast-moving or illiquid markets, the execution price can differ materially from the displayed quote — called “slippage.” Use when getting in or out matters more than the exact price.
• LIMIT ORDER. Buy at a specified MAXIMUM price or sell at a specified MINIMUM price. Guarantees the PRICE (or better) but does NOT guarantee execution — a limit order may never fill if the market doesn't reach the limit price. Use when controlling the entry/exit price matters more than guaranteed execution.

Critical exam distinction: market orders guarantee EXECUTION but not price; limit orders guarantee PRICE (or better) but not execution. These are mutually exclusive guarantees — you can't have both. Stop and stop-limit orders combine elements of these to create conditional execution.

Marketable limit order. A limit BUY order with a limit price AT OR ABOVE the current ask is “marketable” — behaves like a market order but with a price cap that prevents extreme slippage. A common best-practice substitute for pure market orders in less-liquid stocks.

Stop and stop-limit orders — conditional triggers

STOP orders are CONDITIONAL — they only become active when a TRIGGER PRICE (the “stop” price) is hit. Used to limit losses or lock in gains.

• Stop (Stop-Loss) Order. Once the trigger price is hit, BECOMES A MARKET ORDER. SELL STOP: triggered when price falls TO OR BELOW the stop price (used to limit losses on long positions). BUY STOP: triggered when price rises TO OR ABOVE the stop price (used to limit losses on short positions or trigger entry on momentum).
• Stop-Limit Order. Once the trigger price is hit, becomes a LIMIT ORDER at a SPECIFIED LIMIT PRICE. Adds price control to the stop trigger. Risk: if the market moves past both the stop AND limit prices, the order may never execute — potential for unlimited losses.
• Trailing Stop. A stop order with a trigger price that ADJUSTS as the security moves favorably. E.g., trailing 10% stop on a stock at $100 starts at $90; if stock rises to $120, trailing stop moves to $108. Locks in gains while limiting downside.

Common test confusion: a STOP-LOSS for a long position uses a SELL STOP (sells when price drops). A STOP for a short position uses a BUY STOP (buys to cover when price rises). The direction of the stop matches the direction needed to CLOSE the position.

Practical use of stop orders. Stop orders provide AUTOMATED DOWNSIDE PROTECTION without requiring the investor to watch the market. Risk: in fast-moving markets (e.g., earnings gaps, flash crashes), the execution price after stop trigger can be substantially worse than the stop price.

Time-in-force conditions — how long does the order remain active?

Order DURATION and EXECUTION conditions specify how long the order stays alive and whether partial fills are acceptable. Standard time-in-force conditions:

• DAY ORDER. Active only for the current trading day. Cancels automatically at market close if unfilled. The DEFAULT time-in-force for most retail orders.
• GTC (Good Til Canceled). Remains active until executed or canceled by the customer. Many broker-dealers limit GTC orders to 60-180 days before automatically canceling them.
• IOC (Immediate-or-Cancel). Fill whatever portion can be filled IMMEDIATELY; cancel the rest. Allows partial fills. Used for fast execution where the trader doesn't want a working order left in the market.
• FOK (Fill-or-Kill). Fill the ENTIRE order IMMEDIATELY or cancel completely. No partial fills allowed. Often used for large block orders where partial execution is undesirable.
• AON (All-or-None). Fill the ENTIRE order or none of it — but doesn't require IMMEDIATE execution like FOK. The order stays alive waiting for a fill of the entire size. Allows partial-fill prevention without time pressure.
• MOC (Market-on-Close). Becomes a market order at the closing auction. Used to get the closing price.
• MOO (Market-on-Open). Becomes a market order at the opening auction. Used to get the opening price.

Distinguishing FOK vs. AON: both require complete fill. FOK = immediate; AON = patient. AON without time qualifier on day order will cancel at market close if unfilled.

Best execution — the broker-dealer's ongoing obligation

BEST EXECUTION is the broker-dealer's duty to use REASONABLE DILIGENCE to obtain the most favorable terms reasonably available for the customer's order. NOT a guarantee of the best price — it's a process obligation. FINRA Rule 5310 governs the duty.

• Factors considered. Price, transaction costs, speed of execution, likelihood of execution and settlement, order size relative to available liquidity, character of the market for the security. The relative weight of factors varies by the type of security and the customer's instructions.
• Regular and rigorous review. Broker-dealers must REGULARLY AND RIGOROUSLY review the execution quality they obtain from various venues. SEC Rule 605 requires market centers to publish monthly execution-quality statistics; Rule 606 requires broker-dealers to disclose routing practices.
• Best execution applies to ALL orders — market and limit, retail and institutional, equities and other securities. The obligation is to the CUSTOMER, not to any particular venue or counterparty.
• Common best-execution failures. Routing orders to venues that pay PFOF without verifying execution quality; failing to consider multiple venues; not reviewing execution against benchmarks; treating “reasonable diligence” as a formality rather than a substantive obligation.
• Documentation. Broker-dealers must DOCUMENT their best-execution analysis. Without documentation, the obligation is presumed unmet — even if actual execution was favorable.

Payment for Order Flow — mechanics and tension with best execution

PAYMENT FOR ORDER FLOW (PFOF) is compensation a broker-dealer receives from a MARKET MAKER or wholesaler for ROUTING customer orders to that wholesaler for execution. PFOF enabled the “zero-commission” retail brokerage model that became dominant in the late 2010s.

• How PFOF works. Retail broker (e.g., Robinhood, Schwab) routes customer orders to a wholesale market maker (e.g., Citadel Securities, Virtu). Wholesaler executes the order, typically at or near the National Best Bid and Offer (NBBO), and pays the broker a small per-share fee or percentage of order value (often $0.001-$0.003 per share for equities; substantially higher for options).
• Tension with best execution. The broker has a FINANCIAL INCENTIVE to route to the wholesaler that pays the most — not necessarily the one providing the best execution. Best-execution obligation requires the broker to evaluate execution quality at multiple venues, not just route based on payment.
• Required disclosure. SEC Rule 606 requires broker-dealers to publish QUARTERLY REPORTS on order routing practices and payments received. SEC Rule 605 requires market centers to publish execution-quality statistics. Customers can request specific order-routing information.
• Regulatory scrutiny. PFOF is legal in the US but BANNED in the UK, Canada, and Australia for retail equity orders. The SEC has periodically considered restrictions. Critics argue it creates conflicts of interest; defenders argue it enables zero commissions and that competition among wholesalers maintains execution quality.
• Disclosure on customer statements. Confirmation statements must indicate whether PFOF was received; broker must disclose source and approximate amount in their public 606 reports.

Market roles — broker, dealer, market maker, and ECN

Different participants in the trading ecosystem play different roles. The Series 66 tests recognition and the compensation distinctions:

• BROKER. An AGENT representing the customer's interest in a transaction. Charges COMMISSION (fee paid by the customer for facilitating the trade). Has FIDUCIARY-LIKE obligations to seek best execution. Doesn't take principal risk — just connects buyer and seller.
• DEALER (Principal Capacity). Trades from its OWN INVENTORY. Charges a MARKUP (when selling to customer at above-market price) or MARKDOWN (when buying from customer at below-market price). Takes principal risk — profits or loses based on inventory price movements.
• MARKET MAKER. A dealer that QUOTES TWO-SIDED MARKETS (bid and ask) continuously, providing LIQUIDITY. Standard for OTC stocks and the foundation of dealer markets like NASDAQ. Earns the BID-ASK SPREAD plus any PFOF rebates.
• DESIGNATED MARKET MAKER (DMM). Formerly “Specialist.” The exchange-floor designee for a specific listed stock on NYSE. Maintains an orderly market with affirmative obligations to provide liquidity during stress periods.
• ECN (Electronic Communications Network). Computerized matching systems that pair buyers and sellers directly without a market maker intermediary. Lower transaction costs but no liquidity provider for one-sided markets. Examples: Direct Edge, Instinet.
• DARK POOL. Private Alternative Trading System (ATS) where INSTITUTIONAL orders are matched without pre-trade transparency. Used to minimize market impact when trading large blocks. Operates outside the visible exchange order book.

Test framings: broker = commission; dealer/market maker = markup/markdown. A broker-dealer firm acts in EITHER capacity for a given trade — the customer confirmation indicates which.

T+1 settlement — the May 2024 transition

SETTLEMENT is the formal transfer of securities and cash between buyer and seller. Settlement timing determines when ownership formally changes and when cash must be available. On MAY 28, 2024, the US securities markets transitioned from T+2 to T+1 settlement for most securities — a major operational change requiring substantial firm preparation.

• T+1 RULE (current). Trade date plus 1 BUSINESS DAY. A trade executed Monday settles Tuesday. Applies to MOST EQUITIES, CORPORATE AND MUNICIPAL BONDS, ETFs, and many other listed securities.
• SAME-DAY SETTLEMENT (T+0). Treasury bills, notes, bonds, and options on US government securities settle same day. Also called “cash settlement.”
• OPTIONS settle T+1 as well (same as the new equity settlement cycle).
• Why T+1? Reduces counterparty risk during the settlement window; aligns US with global trends; reduces capital and margin tied up in unsettled trades; reduces clearinghouse risk during volatile periods.
• Implications for investors. Cash from a sale is available 1 business day after trade (vs. 2 previously). Wire transfers, options exercises, and corporate actions must be tracked more carefully. International investors must adjust for time-zone friction (Asian markets have less time to fund).
• SEC Rule 15c6-1 governs settlement cycles for broker-dealers. Failure to deliver securities by settlement creates a “fail” that may require buy-in.

Regular way vs. cash settlement. “Regular way” means standard T+1 settlement. “Cash trade” means SAME-DAY SETTLEMENT and is rarely used in retail markets. Trades can also be marked “when issued” (for securities not yet officially issued) or “seller's option” (negotiated settlement date).

Ex-dividend date and the consequence of settlement timing

Settlement timing has practical consequences for DIVIDENDS and other corporate actions. The Series 66 frequently tests the relationship between trade date, settlement date, ex-dividend date, and record date.

• Declaration date. Board of directors announces the dividend, the amount, the record date, and the payment date.
• Record date. The date the company looks at the shareholder ROSTER to determine who's entitled to the dividend. Whoever owns shares OF RECORD on this date receives the dividend.
• Ex-dividend date (X-date). Under T+1 settlement, the ex-date is the SAME DAY as the record date. (Under the old T+2 settlement, it was one business day before the record date.) Buying on or after the ex-date does NOT entitle the buyer to the upcoming dividend — the seller keeps it.
• Payment date. When the company actually distributes the dividend to record-date holders.
• Practical sequence under T+1. Buy on Monday: settles Tuesday. If Tuesday is the record date, the buyer is the holder of record and gets the dividend. The ex-date in this scenario is Tuesday too — meaning Monday was the last day to buy “cum-dividend.”

Reg SHO (short selling) preview. Settlement failures from short selling are governed by Regulation SHO. Short sellers must LOCATE shares before short-selling (Rule 203) and CLOSE OUT failed-to-deliver positions promptly (Rule 204). T+1 settlement made these timelines tighter.

Regulation T — initial margin requirements

The Federal Reserve's Regulation T (Reg T) sets INITIAL MARGIN REQUIREMENTS for purchasing securities on margin (with borrowed funds). The current standard:

• Reg T initial margin = 50% for equity securities. Investor must deposit at least HALF the purchase price; broker-dealer lends the other half (called the DEBIT BALANCE). To buy $20,000 of stock, investor needs at least $10,000 in equity.
• Broker-dealer can require MORE than 50% (called “house margin”) for individual securities, particularly volatile or low-priced ones. Some stocks may have 100% margin requirements (effectively cash-only) at the broker's discretion.
• Day 1 of the trade: investor deposits $10K, broker lends $10K, total purchase $20K. Equity = $10K, debit balance = $10K, market value = $20K. Equity ratio = 50%.
• Reg T applies to most equity securities. Some securities are NOT MARGINABLE: securities priced under $5/share (some exceptions); newly issued securities for 30 days; mutual funds for 30 days after purchase. Always check the specific marginability of the security.
• Marginable bonds. Government bonds: typically 1% or higher; municipal bonds: 7% or higher; corporate bonds: 20-30% or higher depending on maturity and credit. Much lower than equity 50%.
• Cash account vs margin account. Cash accounts: 100% paid in full; no borrowing. Margin accounts: investor can leverage with broker loans; margin agreement required at account opening (hypothecation agreement permits broker to use customer securities as collateral; consent to credit terms).

Maintenance margin and the margin call

After initial purchase, FINRA imposes a MINIMUM MAINTENANCE MARGIN of 25% of the market value of the securities. If the account's equity falls below this minimum due to a price decline, the broker issues a MARGIN CALL.

Margin call formula:

Worked example. Investor buys $20,000 of stock on 50% margin (Reg T). Deposits $10,000; borrows $10,000 from broker (debit balance). Equity at trade = $10,000.

• Margin call triggers when EQUITY = 25% of MARKET VALUE
• Margin call price = $10,000 ÷ (1 − 0.25) = $10,000 ÷ 0.75 = $13,333
• If the stock falls to $13,333 total value: equity = $13,333 − $10,000 (debit) = $3,333. Equity ratio = $3,333 / $13,333 = 25% — margin call triggered.

Response to margin call:

• Deposit cash to restore equity above the maintenance level.
• Deposit additional marginable securities to increase total equity.
• Allow the broker to liquidate a portion of the position. Broker may liquidate WITHOUT customer consent if call not met within the firm's deadline (often 1-3 business days). Forced liquidation occurs at potentially unfavorable prices and can cause losses beyond the initial deposit.

SMA (Special Memorandum Account). A line of credit that accumulates as the account's equity grows. Functions like a margin loan available without further deposits. Used by sophisticated investors to leverage gains. The SMA is governed by Reg T and is not actual cash — it's borrowing capacity.

Short selling mechanics and Regulation SHO

SHORT SELLING is selling securities the seller doesn't own — borrowed from a broker-dealer or another customer. Profits if the price FALLS; loses if the price RISES (unlimited theoretical loss since the price can rise indefinitely).

• Mechanics. (1) Investor BORROWS shares from broker (or broker borrows from another customer or institution); (2) sells the borrowed shares in the market at current price; (3) later BUYS BACK (“covers”) the same shares to return to the lender; (4) keeps the difference if the buy-back price is lower than the sell price.
• Locate requirement (Reg SHO Rule 203). Before executing a short sale, the broker-dealer must have reasonable grounds to believe shares can be DELIVERED at settlement. The broker must “locate” available shares from a lending source. Naked short selling (selling without locating shares) is prohibited.
• Hard-to-borrow. Securities for which only limited shares are available to short are “hard-to-borrow.” Brokers charge a borrow fee (sometimes 10-100%+ annualized for the most-shorted stocks), making short selling expensive.
• Buy-in (Rule 204). If a short seller fails to deliver shares by settlement (T+1), the broker must close out the failed-to-deliver position by buying replacement shares promptly (typically by the morning of T+2).
• Short interest reporting. Broker-dealers report short positions to FINRA twice monthly. Aggregate short interest is publicly disclosed and used by traders to identify potential SHORT SQUEEZES (when rapid buying forces shorts to cover, driving the price up further).
• Short selling on margin. Short sales must occur in a margin account. Reg T requires 50% margin (initial); FINRA requires 150% maintenance margin equity (because losses are theoretically unlimited).

Risks. Unlimited theoretical loss; carry costs (borrow fee, dividend pass-through to lender); short squeezes; recall risk (lender can demand return of shares, forcing buy-in at unfavorable prices).

Pattern Day Trader (PDT) rules — $25K minimum

The FINRA-defined PATTERN DAY TRADER (PDT) rules govern margin accounts that engage in frequent day trading. Designed to ensure adequate capital for the increased risks of intraday leveraged trading.

• PDT definition. A customer who executes FOUR OR MORE DAY TRADES within a rolling 5-business-day period in a margin account — AND those day trades represent MORE THAN 6% of total trading activity in that period.
• Day trade defined. Buying and selling (or selling and buying) the same security on the SAME TRADING DAY in a margin account.
• $25K minimum equity. A PDT must maintain MINIMUM EQUITY of $25,000 in the margin account at the start of any day on which they day-trade. If equity falls below $25K, the customer cannot day-trade until equity is restored.
• Day trading buying power. PDTs receive 4-to-1 LEVERAGE (4x maintenance margin excess) for day trades intraday — vs. 2-to-1 for non-day-trades or positions held overnight. This is the practical benefit of PDT designation.
• Day-trade margin call. If a PDT exceeds buying power, a day-trade call is issued, requiring deposit within 5 business days. Failure to meet a call restricts the account to cash-trading only for 90 days.
• Cash account workaround. Day trading in a CASH ACCOUNT avoids PDT designation entirely but limits trades to settled funds — meaning settlement timing matters more.

Suitability implications. Day trading involves substantial risk; many retail traders lose money. Brokers must disclose risks and ensure customer understanding. PDT rules add a STRUCTURAL barrier to undercapitalized day trading — without $25K minimum, an account cannot day-trade frequently.

Account types and market participants

Cash vs. margin accounts

• Cash account: Securities paid in full. No borrowing.
• Margin account: Borrow from the broker-dealer to purchase securities. Reg T requires 50% initial margin. Subject to maintenance margin requirements and margin calls.

Market roles

• Broker: Acts as agent in transactions. Charges commission.
• Dealer: Acts as principal — buys and sells from own inventory. Charges markup or markdown.
• Market maker: Dealer that quotes both bid and offer prices continuously, providing liquidity.
• Designated Market Maker (DMM): Exchange-floor designee for a specific listed stock with affirmative obligations.

Order types — when to use each

Margin accounts — Regulation T and maintenance

• Regulation T (Federal Reserve): Sets the initial margin requirement at 50%. To buy $10,000 of stock on margin, the investor must deposit at least $5,000.
• Maintenance margin (FINRA): Minimum equity of 25% of the market value of the securities. If equity falls below this minimum, a margin call is issued.
• Margin call formula: Margin call price = Debit balance ÷ (1 − Maintenance margin %)
• Brokerage may require more than the federal/FINRA minimum (house margin) for specific stocks or accounts.
• Hypothecation agreement: Required to open a margin account; permits the broker-dealer to use customer securities as collateral.