Order types, execution, and best execution
About This Lesson
New module, new territory: the trade itself. Every transaction starts as an order, and the exam wants the full taxonomy: what each order type does, when it triggers, what the qualifiers change, and what the rules demand once the order is short. Two skills dominate: reading a stop-limit's two prices correctly, and remembering which GTC orders adjust on ex-date.
What you'll cover
- the order-type toolkit: market, limit, stop, stop-limit, the qualifier vocabulary (AON, FOK, IOC, MOC), and the GTC ex-date adjustment
- best execution under FINRA Rule 5310, payment for order flow, and the three quote types with their two prohibited practices
- short sales under Regulation SHO: locate, close-out, threshold lists, order marking, plus circuit breakers and the DMM
This is the first chapter of the final module, transaction processing and compliance.
Order Types: Market, Limit, Stop & Stop-Limit
Order Types: How Customers and Traders Control Execution
Stop Orders on the Order Book: Long and Short Positions
Understanding where stop orders trigger relative to current market price is a heavily tested concept. The relationship is counterintuitive for sell stops.
If stock drops to $45 → becomes market sell order.
Protects against further decline below $45.
If stock rises to $55 → becomes market buy order.
Limits loss on short if stock rallies.
Stop-Limit Orders: The Two-Step Mechanic
A stop-limit order is two orders welded together: it sleeps as a stop, but when the stop price trades, it wakes as a limit order at a second price instead of a market order.
Step 1 (stop element): The order is dormant until DWQ trades at $140 or higher. At that point the order is elected.
Step 2 (limit element): The elected order becomes a buy limit at $140.25. The firm may execute only at $140.25 or lower.
Risk: If DWQ gaps from $139.50 directly to $140.50 without trading at $140.25 or below, the limit cannot be filled at all — the customer is left without a position despite the trigger having fired.
Stop vs. Stop-Limit Side by Side
A customer has a short position in ABC stock at $60. She wants to limit her loss if the stock rises sharply. Which order should she place?
An investor places a limit order to buy 100 shares of XYZ at $48. The stock opens the next morning at $45 due to positive earnings. At what price will the order be executed?
A customer places a sell limit order for 200 shares at $55. The stock opens the next morning at $58 due to an overnight earnings beat. At what price will the order execute?
A trader wants to buy shares of a stock only if it breaks out above $75, signaling a bullish trend continuation. The stock is currently at $70. What order type should be used?
A customer places a market order to buy 500 shares of a thinly traded small-cap stock. The current bid is $12.00 and the ask is $12.80. What is the primary risk of using a market order in this situation?
A customer enters an order to buy 300 DWQ at 140 stop, but not over 140.25. This order is best classified as
Order Qualifiers & Time Conditions
Order Qualifiers: AON, FOK, IOC, MOC, and Not-Held
Beyond the basic order types, traders can add qualifiers that specify execution conditions.
Time-Sensitive and Special-Instruction Orders
The qualifier vocabulary is small and the exam tests every word of it. Each one names a different constraint on how and when the order may fill:
The BLiSS Rule — Which Orders Are Reduced on Ex-Date?
On the ex-dividend date, the stock price is reduced by the dividend amount. Orders sitting on the book are also adjusted — but only those placed below the market:
Both are placed below the current market price (a buy limit waits for the stock to fall to it; a sell stop is triggered if the stock falls to it).
Sell Limits and Buy Stops are NOT reduced — they are placed above the current market price.
Customers who do not want their BLiSS orders reduced must mark them DNR.
Open GTC orders get automatically adjusted on the ex-dividend date so the bookkeeping price drop does not trigger them by accident, and FINRA Rule 5330 sorts the orders by where they sit relative to the market, not by type:
Reduced (unless marked DNR): orders placed below the market, GTC buy limits and sell stops (including sell stop-limits). A GTC buy limit at $50.00 against a $0.50 dividend becomes $49.50 on ex-date.
Not adjusted: orders placed above the market, sell limits and buy stops. The dividend drop moves the stock away from these, so there is nothing to protect.
The trap: candidates sort by order type, limits versus stops. The rule sorts by position: below-the-market orders (BLiSS, buy limits and sell stops) reduce; above-the-market orders do not. A customer who wants no adjustment marks the order Do Not Reduce.
Which of the following time-sensitive orders demands immediate complete execution or immediate cancellation?
An investor places a GTC (Good Till Cancelled) stop order to sell 100 shares at $40. The stock pays a $2 cash dividend. Under exchange rules, what typically happens to the stop price after the ex-dividend date?
Best Execution & Quotations
FINRA Rule 5310 obligates a broker-dealer to use reasonable diligence to get customers the most favorable terms reasonably available. Three tested angles:
The factors: price, execution speed, likelihood of execution, order size, and the character of the market for the security.
Payment for order flow: market makers may pay broker-dealers for routing orders to them. Legal, but it must be disclosed to customers, and it can never outrank best execution; the customer still gets the best reasonably available price.
Internalization: a firm may fill customer orders from its own inventory, as principal, when its price matches or beats the prevailing market. The structure is allowed; disadvantaging the customer with it is not.
Quotations: Firm, Subject, Workout, and the Rules Around Them
A market maker who publishes a quote takes on an obligation to honor it, and the exam tests three quote types plus the two ways firms get in trouble around them:
Backing Away
Backing away is the failure to honor a firm quote at the quoted price and size. It is a FINRA rule violation and exposes the firm to disciplinary action. A quote is firm at minimum for one round lot if size is not specified; backing away on even a 100-share trade is enforced.
Interpositioning
Interpositioning is the practice of inserting an additional broker-dealer between the customer and the best available market — typically because the inserted firm rebates business or commissions. Generally prohibited because it harms execution quality.
Markup, Markdown, Commission — Never Both
A broker-dealer either acts as a principal (dealing from inventory, charging a markup or markdown built into the price) or as an agent (executing the customer’s order at the inside market and charging a separate commission). On any single trade, the firm cannot charge both a markup and a commission — the role is exclusive.
To fill a customer buy order for 800 WXYZ shares, a firm requests a quote from a market maker. The market maker responds "bid 15, ask 15.25" without specifying size. If the order is placed at the ask, the market maker is obligated to sell
Failure by a market maker to honor its published firm quote is best described as the prohibited practice of
Short Sales, Reg SHO & Market Structure
Short Sales and Regulation SHO
Short selling is the only trade where you sell what you do not own, and both the mechanics and the rulebook get tested. The mechanics first; the next block takes the rule in depth.
Short Sale Mechanics
To sell short, the firm borrows the shares: from another customer's account (with consent), from its own inventory, or from another broker-dealer. The proceeds land in the seller's account, and the borrowed shares are owed back.
The position profits when the price falls, buy back cheaper, return the shares, keep the difference, and it carries theoretically unlimited risk, because there is no ceiling on a stock price.
Regulation SHO Requirements
- Locate requirement: Before executing a short sale, the broker-dealer must have reasonable grounds to believe the security can be located and borrowed. This is the "locate" or "pre-borrow" requirement. Selling short without locating is called a naked short sale and is generally prohibited.
- Close-out requirement: If a firm fails to deliver shares on settlement date (a "fail to deliver"), it must close out the position by purchasing the shares in the open market within a specified time period.
- Threshold securities: Securities with large and persistent fails-to-deliver are placed on the Reg SHO threshold list. Special close-out requirements apply to positions in threshold securities.
Prohibited Short Sale Practices
Naked short selling, shorting without a locate, is prohibited for most securities. Short-and-distort, shorting and then spreading false negatives to push the price down, violates both Reg SHO and the antifraud provisions of the Exchange Act.
Regulation SHO: Short Sale Rules
The previous block gave the headlines; this one draws Regulation SHO's exact lines. The SEC adopted it in 2005, and its core is the locate rule and the naked-shorting ban.
The Locate Requirement
Before accepting a short sale order, the firm must reasonably believe the shares can be borrowed and delivered on settlement date. The locate satisfies that: a specific identified source, the firm's inventory, a stock loan desk, a borrowable list.
What Regulation SHO Does NOT Govern
- Short sales in cash accounts. The prohibition on shorting from a cash account is in Regulation T, not SHO. All short sales must clear through a margin account.
- Suitability of short sales. The general suitability standard applies, but it is a FINRA rule, not a SHO requirement.
- The uptick rule. The original 1938 uptick rule was eliminated in 2007. The current alternative uptick rule (Rule 201) only triggers after a stock falls 10% in a single day, and it limits short sales to prices above the national best bid — not strictly an "uptick."
Order Marking and Mark to Market
Every sell order ticket must be marked as one of three categories at order entry: long, short, or short exempt. A customer is "long" the security only if they own it, are entitled to receive it, or have a contractual right to it (such as exercising a long call).
Short positions are marked to market daily. As the stock price moves, the credit balance and equity in the short margin account adjust accordingly. The firm has the right to require additional deposits if the short moves against the customer.
Bonds and Short Selling
Short selling is almost never done on municipal bonds. The market is fragmented, locates are difficult, and the practice is impractical. Treasury bonds and corporate bonds can be shorted but it is uncommon outside of institutional desks.
Circuit Breakers and the Designated Market Maker
Market-Wide Circuit Breakers (S&P 500-Based)
When the whole market falls fast, the exchanges pull a documented set of brakes. Three trigger levels, keyed to the S&P 500's decline from the prior close:
The Designated Market Maker (DMM)
Each NYSE-listed security has a single Designated Market Maker (formerly the "specialist") responsible for maintaining a fair and orderly market in the stock. DMM functions:
- Sets the opening quote based on the level of opening orders held overnight.
- Buys and sells for a proprietary account to dampen volatility — absorbing imbalances when natural buyers or sellers are scarce.
- Accepts limit orders for execution if the stock reaches the limit price during the trading day.
- Maintains a two-sided market — required to publish both a bid and an offer simultaneously.
The practice of naked short selling — selling a security short without first locating shares available to borrow — is prohibited by
Regulation SHO specifically prohibits which of the following practices?
A designated market maker on the NYSE is permitted to do all of the following EXCEPT
Chapter Summary
- Limit orders execute at limit price or BETTER: Buy limit = at or below the limit. Sell limit = at or above the limit. If the market gaps through the limit in a favorable direction, the order executes at the better (market) price.
- Stop orders trigger, then become market orders: Sell stop = below current price (protect long position). Buy stop = above current price (cover short position or buy on breakout). Execution price may differ from the stop price.
- Stop-limit orders: Have two prices — the trigger (stop) and the execution floor/ceiling (limit). Advantage: price control. Disadvantage: may not execute if market gaps through the limit price.
- GTC order adjustments: GTC limit and stop orders are adjusted downward by the dividend amount on the ex-dividend date to prevent inadvertent triggering from the expected price drop.
- Best execution (FINRA Rule 5310): Firms must use reasonable diligence to obtain the most favorable terms reasonably available. Payment for order flow must be disclosed and cannot compromise best execution.
The Series 7 returns to a small set of distinctions in this content area. If a question feels familiar, it is probably testing one of these:
1. Stop-limit has TWO prices. "At X stop, but not over Y" or "X stop, Y limit" — always a stop-limit. Single price = plain stop or plain limit.
2. FOK vs. IOC vs. AON. FOK demands immediate full execution or kill all. IOC accepts partial immediate fills, cancels rest. AON requires full fill but no time pressure.
3. BLiSS rule for ex-dividend reductions. Buy Limits and Sell Stops are reduced on ex-date. Sell Limits and Buy Stops are not. DNR overrides the reduction.
4. Firm quote default size = 100 shares. If a market maker doesn’t specify size, the firm quote is good for one round lot. Failing to honor it is "backing away."
5. Markup OR commission, never both. Principal trades have markups/markdowns; agency trades have commissions. The capacity is exclusive on any single trade.
6. Interpositioning is OK only if execution improves. Adding a broker-dealer between customer and best market is permitted only when it produces a better price than going direct. Reciprocity, convenience, or staffing problems are never valid justifications.
7. Naked short selling = locate failure. Regulation SHO requires the short to locate borrowable shares before entering the order. Not at settlement.
8. The uptick rule was eliminated in 2007. The current alternative uptick (Rule 201) only triggers after a 10% intraday decline and limits to prices above the NBB — not "shorting only on an uptick" as in the old rule.
9. Reg SHO governs locates; Reg T prohibits cash-account shorts. Two different rules. The exam tries to assign the cash-account ban to SHO.
10. Circuit breakers: 7% / 13% / 20%. Levels 1 and 2 cause 15-minute halts before 3:25 PM. Level 3 (20%) halts trading for the remainder of the day at any time.
11. DMM accepts limit, not not-held. The DMM’s obligation to maintain a fair market is incompatible with the discretion granted by a not held order. Not held goes to a floor broker.
12. During halts, cancellations and option exercises continue. Trading in the halted security stops, but customers can cancel pre-halt orders and exercise options on the halted underlying.
Test yourself with exam-style questions on this topic.