Buying new in the primary market

The primary market (new issue market) is broken down into two categories, depending on whether the company has ever issued securities before. A security that has never been offered or sold to the public is considered a new issue. When securities are sold in the primary market, a bulk of the sales proceeds go to the issuer, and the balance goes to the underwriter (who buys the securities from the issuer and sells them to the public). Here are the two types of offerings on the primary market:

• Initial public offering (IPO): An IPO is the first time a company ever sells stock to the public to raise money. When a company is in the process of issuing securities for the first time, it’s said to be going public.
• Primary offering: When a company initially offers securities, it usually holds some back for future use; it later pulls those securities out of storage and sells them in a primary offering. For example, a company may be authorized to sell 2 million shares of common stock, but in its initial public offering, it may sell only 800,000. At this point, 1,200,000 new shares remain that have never been offered to the public. One year later, when the company needs to raise additional capital to build a new warehouse, it can sell some of the remaining 1,200,000 shares in a primary offering.

Buying used in the secondary market

When the securities are already trading in the market, the sales proceeds go to another investor instead of to the issuer. The secondary market, also called the aftermarket, consists of four categories (see the following section for info on trading on exchanges versus over-the-counter markets):

• First market (auction market): The first market is the trading of listed securities on the exchange floor, such as the New York Stock Exchange (NYSE).
• Second market (over-the-counter market): This market is the trading of unlisted securities over-the-counter (by phone or computer).
• Third market: The third market is comprised of exchange-listed securities trading over-the-counter (OTC) — traders are calling in their orders or ordering online. All NYSE Amex Equities and NYSE securities and most of the securities listed on other exchanges can be traded OTC.
• Fourth market: The fourth market is the trading of securities between institutions without the use of a brokerage firm. Fourth-market trades are reported on Institutional Networks, or Instinet, a computerized system for institutional traders.

You’re more likely to get a question on the third or fourth market than the first or second.

Auctioning securities at securities exchanges

Exchanges are auction markets, where bidders and sellers get together to execute trades. I’m sure you’ve seen movies or TV shows featuring the New York Stock Exchange. It definitely looks very chaotic (and like it’s a good place to have a heart attack or develop an ulcer). However, some sort of order is definitely there: All exchanges have a trading floor where all trades are executed. Each security listed on an exchange has its own trading post (location) on the floor where the auction takes place. Brokers looking to purchase shout out and/or make hand signals to indicate the price they’re willing to spend to buy a particular security. Sellers, in turn, shout out the price they’re willing to sell a security for. If buyers and sellers can come to an agreement, a trade is made.

The main exchange that the Series 7 tests you on is the New York Stock Exchange (NYSE, also known as NYSE Euronext), but there are others such as: NASDAQ, NYSE American, NYSE Arca Equities, NYSE National, Chicago Board Options Exchange, Chicago Stock Exchange, ICE and so on. Listed securities are ones that satisfy minimum requirements and are traded on a regional or national exchange like the NYSE. Listed securities may trade on the exchange or in the OTC market.

All securities exchanges have listing requirements for companies that want to have their shares sold on the exchange, which include a minimum number of outstanding shares, a minimum stock price, a minimum net worth, a certain trading volume, and so on.

Although thousands of people may seem to be on the floor of the exchange, you don’t need to be aware of too many titles. Most of the people on the floor of the exchange fall into one of three categories:

• Floor brokers: These individuals act as agents in executing buy or sell orders on behalf of their firm’s customers. A floor broker may also facilitate buying and selling for her firm. Floor brokers receive buy or sell orders from their firms and either transfer the orders to a specialist or trade with another floor broker.
• Two-dollar brokers (independent brokers): These people assist floor brokers in getting their orders executed on busy days. (By the way, they’re called two-dollar brokers because many, many years ago, they used to receive $2 per trade. Commissions may have gone up a bit since then.)
• Designated market makers (specialists): These market professionals manage the auction market trading for a particular security (or for a few securities, if not actively traded). For more information about a specialist, visit “Designated Market Maker and the Super Display Book (SDBK),” toward the end of this chapter.

Under NYSE rules, only members are permitted to accept offers, make bids, or consummate transactions on the floor of the exchange. These transactions are typically handled by floor brokers or DMMs. However, firms who have a booth on the exchange may have supervised booth clerks process orders sent to the booth.

Negotiating trades over-the-counter

Unlike exchanges, the OTC market is a negotiated market. Instead of yelling out bid and ask prices, traders buy and sell securities by way of telephone or computer transactions. There’s no central location for trading OTC securities. Thousands of securities — both listed and unlisted — are traded this way. In fact, unlisted securities, which aren’t listed on an exchange, can only trade OTC.

The OTC equities market is divided into NASDAQ issues (issues that meet the NASDAQ listing requirements) and non-NASDAQ issues. Non-NASDAQ issues are unlisted and trade on the Over The Counter Bulletin Board (OTCBB) or in the OTC Pink Market.

U.S. government and municipal bonds trade only over-the-counter.

The NASD Automated Quotation service (NASDAQ) is the largest U.S. equities trading venue by volume. NASDAQ is an electronic quotation system that displays bid and ask prices of the most actively traded OTC stocks. Additionally, NASDAQ also includes quotes of preferred stock, convertible bonds, and warrants.

To be a market maker on NASDAQ, the dealer must have a minimum net capital requirement, be registered with FINRA, and must provide regular bid and ask prices for a security.

To make trades, people need accurate, current info on bid and ask prices. Not everyone can get the same amount of information, though. Here are the access levels of NASDAQ (the computer displays with NASDAQ information):

• Level I: The most basic level of NASDAQ, this quotation screen displays up-to-the-minute inside bid and ask prices (highest bid and lowest ask prices) for several hundred OTC stocks. Level I is the computer screen that you’ll most likely have on your desk when you’re working as a registered rep. Level I is the most basic level of NASDAQ and includes quotes that are subject to change (subject quotes). Level I does not display the market makers offering to buy or sell the securities.
• Level II: The second level of NASDAQ provides up-to-the-minute firm bid and ask prices (firm quotes) of each market maker (dealers or principals) and quote sizes for a security. Most brokerage firm traders use this level.
• Level III: The most complete level of NASDAQ, this level not only shows the bid and ask prices of all market makers and their firm quotes, but also allows a market maker to enter and change quotes. Once a market maker enters a quote, they will appear on the system right away.

Firm versus subject quotes

Because market makers are buying and selling securities from their own inventory, they can make firm quotes even though those quotes may only be for a limited period of time. If a market maker enters a quote for a security and then fails to purchase or sell the stated amount of securities at the quoted price, it is a violation known as backing away. Market makers may remove or change their quotes during the course of the trading day based on market conditions. When a price is not firm and is subject to confirmation by the market maker, it is considered a subject (nominal) quote. Subject quotes are for informational purposes only and are subject to change. For example, you could tell a customer that “ABC is trading currently trading at 22.00-22.25 subject.”

Traders

A firm's trading department works on positioning (buying and selling securities). Traders handle the brokerage firm's inventory and execute all customers's orders. Traders must have a Series 7 and a Series 57 license.

Recommending OTC equity securities

It is up to you to look out for your client's best interest. Because OTC equity securities are riskier than many other securities, FINRA requires members to review financial statements and current material business information about the issuer before making a recommendation to purchase or sell short the security. In addition, the recommendation should fit into the client's investment profile and you must have a reasonable basis for making the recommendation.

Talking about order types

You can definitely expect a few questions on the Series 7 exam relating to orders. The following sections explore the order types.

Handling limit and stop orders

Because stop and limit orders are price-specific, they may or may not be executed. Additionally, even if limit orders do reach or surpass the limit price, the order may not be executed if more orders were placed ahead of the investor’s.

One of the exhibits that you may see on the Series 7 exam is a ticker tape. You may have to determine the price at which a limit order is executed or a stop order is triggered. When you’re dealing with stop limit orders, remember that the order is first a stop order; after the stop order is triggered, it becomes a limit order. Using the BLiSS and SLoBS acronyms can help you out tremendously when you’re trying to keep the prices straight:

• BLiSS (buy limit or sell stop): The BL stands for buy limit, and the SS stands for sell stop. All BLiSS orders are entered at or below the market price of the security. Another thing to remember about BLiSS orders is that they get reduced on the ex-dividend date (the first day a stock trades without a dividend).

  The BL in BLiSS helps you remember that the orders are placed BeLow the market price.

• SLoBS (sell limit or buy stop): The SL stands for sell limit, and the BS stands for buy stop. All SLoBS orders are entered at or above the market price of the security. Unlike BLiSS orders, SLoBS orders remain the same on the ex-dividend date.

  A good way for you to remember that SLoBS orders remain unchanged on the ex-dividend date is to remember the phrase “once a slob, always a slob.”

The following question tests your understanding of trigger and execution prices.

The following question tests your ability to answer a stop limit question.

Factoring in order features

Besides knowing the basic types of orders (market, stop, and limit — see “Talking about order types”), you should have a handle on some additional features that may be added to the order to make your customers happy. A lot of them exist, but for the most part, the name of the order feature pretty much explains what it is:

• Day: If a day order hasn’t been filled by the end of the trading day, it’s canceled. All price-specific orders (stop and limit) are assumed to be day orders unless marked to the contrary.

• Good-till-canceled (GTC): Good-till-canceled orders are also called open orders because the order is kept open until executed or canceled. For example, say that an investor wants to purchase ABC stock at $30. While the price of ABC is at $35, she enters an open buy limit order for ABC at $30. If the price of ABC ever hits $30 or below, the order will likely be executed; however, if the price of ABC never hits $30 or below, the order stays open until canceled. Regardless of when an open order is placed, a designated market maker clears it out of his book at the end of April or October, and the order has to be reentered.

  Note: An investor may specify that she wants the order canceled next week, next month, in two months, and so on. However, the designated market maker only enters the orders as GTC, so it is up to the broker-dealer who accepted the order to cancel the order with the designated market maker on the correct date if not already executed.

• Not held (NH): This order gives the broker discretion about when to execute the trade. Typically, investors use not held orders when the broker believes she can get the customer a better price later in the day.

  Not held orders deal only with timing. For registered reps to choose the security, number of shares, and/or whether to buy or sell, the customer needs to open a discretionary account, which requires a written power of attorney. See Chapter 16 for details.

• Fill or kill (FOK): This order instructs a floor broker either to immediately execute an entire order at the limit price or better, or to cancel it.
• Immediate or cancel (IOC): These limit orders are similar to FOK orders except that the order may be partially filled. Any portion of the order that’s not completed is canceled.

• All or none (AON): These limit orders have to be executed either in their entirety or not at all. AON orders don’t have to be filled immediately (several attempts to fill the order completely are allowed) and may be day orders or good-till-canceled orders.

  As of 2005, the NYSE does not accept AON orders.

• At the open (market-on-open): These orders are to be executed at the security’s opening price. At the open orders can be market or limit orders, but if they aren’t executed at the opening price, they’re canceled. These orders allow for partial execution.
• At the close (market-on-close): This order is to be executed at the closing price (or as near as possible). If this order isn’t completed, it’s canceled. NYSE market-on-close orders must be entered before 3:40 p.m. EST to be executed at the closing price.
• Do not reduce (DNR): This order says not to reduce the price of a stop or limit order in response to a dividend. For example, say that QRS stock is currently trading at $50 on the day prior to the ex-dividend date. If QRS previously announced a $0.50 dividend, the next day’s opening price would be $49.50. If a customer had placed a DNR limit order to buy 1,000 shares of QRS at $45, the order wouldn’t be reduced by the $0.50 dividend.
• Alternative: The alternative order is also known as a one cancels the other order (OCO) or an either/or order. This type of order instructs the broker to execute one of two orders and then cancel the other. For example, say Mr. Smith owns stock at $60 per share. He enters a sell stop order at $55 for protection and a sell limit order at $70 in the event that the stock price increases. If one of the orders is executed, the other order is canceled immediately.
• Buy minus order: When a person enters a buy minus order it means that he only wants to buy the stock below the previous sale price.
• Bid wanted: This order is an indication or notice that an investor or broker-dealer wants to sell a security at a specific price. Bid wanted is used most often when no current buyers of a security are available.
• Offer wanted: This order is an indication or notice that an investor or broker-dealer wants to buy a security at a specific price. Offer wanted is used most often when no current sellers of a security are available.

Not all exchanges accept all of the different types of order qualifiers but many broker-dealers do. So you do need to be familiar with all order qualifier types when taking the Series 7. Fortunately, the names pretty much describe what they are. All order qualifiers must be marked on the order ticket.

Adjusting orders for dividends and splits

As you can imagine, certain orders on the DMMs book would have to be adjusted due to dividends or splits. Rules for cash dividends, stock dividends, forward splits, and reverse splits are a little different.

Trade reporting systems

In order to help facilitate trading and the dissemination of quotes and trading activity, there are now several systems available. The following are the ones you'll have to recognize when taking the Series 7 exam:

• Alternative Trading System (ATS): An ATS is a trading system that meets the definition of “exchange” but is not required to register as such. An ATS must register with the SEC and FINRA as a broker-dealer. Although an ATS is not required to register as an exchange, it's subject to FINRA rules. Examples of ATSs include ECNs and Dark Pools.
• Order Audit Trail System (OATS): OATS was established by FINRA as a way of tracking trades of all NMS stocks and OTC equity securities. OATS is an automated computer system which records orders, quotes, and other trade information. OATS tracks the orders from the initial time of entry and all the way through execution or cancellation. Through OATS, FINRA is more easily able to monitor member firms.
• Trade Reporting and Compliance Engine (TRACE): Like OATS, TRACE was also created by FINRA, but TRACE facilitates the over-the-counter secondary market reporting of certain fixed-income securities (mostly corporate debt securities, although certain asset-backed securities, treasuries, and CMOs are also eligible). All broker-dealers who are members of FINRA are required to report transaction in corporate bonds under SEC rules. TRACE helps make the market more transparent as trade information is released immediately to the public. TRACE is not an execution system; it is a reporting system only. Both the buying firm and selling firm must report trades. All trades must be reported within 15 minutes. TRACE includes the trade date, the time of trade, the price, yield, quantity, and so on.
• Electronic Municipal Market Access (EMMA): EMMA provides information about municipal securities. (Please see Chapter 8 for more information.)
• Real-Time Transaction Reporting System (RTRS): RTRS is a web interface that allows municipal dealers to report customer and inter-dealer transactions directly to the MSRB. (Chapter 8 has more information.)
• Trade Reporting Facility (TRF): TRF provides members of FINRA with a way to report transactions of certain securities when the transaction is not effected on an exchange. There are three TRFs: FINRA/NASDAQ TRF Carteret, FINRA/NASDAQ TRF Chicago, and FINRA/NYSE TRF. TRFs allow members to report trade data such as price and volume electronically after the trade has taken place. So even though the securities could've been traded on an exchange floor, TRFs is a reporting system for members when trades are negotiated between broker-dealers.
• OTC Reporting Facility (ORF): The ORF works similarly to the TRF, but the ORF only reports trades of OTC securities that don't trade on NASDAQ or other exchange markets.
• Electronic Communications Networks (ECNs): ECNs are quotation systems operated by banks and brokerage firms. ECNs are an Alternative Trading System (ATS). ECNs were created to allow trades to be executed with lower transaction costs and to add more liquidity. In addition, buyers and sellers remain anonymous. When institutions trade with other institutions, trades are normally executed through ECNs. ECNs are available for trading 24 hours per day and are not financially involved in transactions. ECNs are strictly electronic exchanges.

Regulation NMS (National Market System)

Regulation NMS is an SEC regulation designed to bring trading and reporting consistency to U.S. securities markets. It is designed to help improve U.S. exchanges by setting standards for displaying of quotes and access to market data. It is designed to link trading on different exchanges to make sure customers are getting the best prices.

You should be aware of the sub-penny rule: All equity securities quotes must be in increments of a penny. However, if the security trades for less than a dollar, the quotes may be displayed up to 1/100th of a penny.

Trading halts: NYSE Rule 80B

To keep investors from panicking when things are going the wrong way, the NYSE has put in place a way to halt trading temporarily if the market drops too quickly. There are different levels put in place to halt trading if the S&P 500 Index drops too much from the previous day's closing price. During that time, the Exchange shall halt trading in all stocks and will not reopen the trading for the time periods specified below:

• Level 1: A halt will occur if the S&P 500 Index declines 7 percent or more from the previous day's close.
• Level 2: A halt will occur if the S&P 500 Index declines 13 percent or more from the previous day's close.
• Level 3: A halt will occur if the S&P 500 Index declines 20 percent or more from the previous day's close.

If a Level 1 or Level 2 decline occurs after 9:30 a.m. EST and up to 3:25 p.m. EST (12:25 p.m. on days the Exchange closes early), the Exchange will halt trading in all stocks for a period of 15 minutes. For a Level 1 or Level 2 market decline, the Exchange will only halt trading once per trading day. If the market decline happens after 3:25 p.m. EST (12:25 p.m. on days the Exchange closes early), the Exchange will not halt trading.

If a Level 3 decline occurs any time during the trading day, the Exchange will halt trading in all stocks until the next trading day.