Stock Order Types and Trading Mechanics

1. INTRODUCTION
In this article, we provide an overview of stock order types and trading mechanics with which stock investors must become familiar.

To begin, investors must recognize that stock shares which are listed on an exchange (or over-the-counter market) and purchased or sold through a broker are secondary market securities. This means that these securities are traded among investors, and the underlying company is not a party in the transaction. This is in contrast with the primary market, where companies sell their securities, usually to an underwriter, and receive the proceeds from the sale.

2. ORDER TYPES
An order is a command in which the client instructs the broker to purchase or sell a specific quantity of a stock. The order may also contain further instructions regarding the price, timing, and settlement of the transaction.

A stock quote displays the best bid and offer prices for the stock. The bid is the price at which someone is willing to buy, and the offer (ask) is the price at which someone is willing to sell. The quote is thus composed of the highest price at which someone is willing to sell (best offer). The difference between the best bid and best offer is known as the spread.

2.1. Price-Contingent Orders
A market order instructs the broker to buy or sell stock at the best available price. Market orders are the most widely-used order types. A market order guarantees execution but not price.

A limit order instructs the broker to buy or sell stock at a specified price or better. For a buy-limit order, the client instructs the broker to purchase stock at a price not to exceed a specified maximum. For a sell-limit order, the client instructs the broker to sell stock at a price at or above a specified minimum. With limit orders, trade execution is not guaranteed.

A stop-order is another type of price-contingent order. With this type of order, the trade is not executed unless the stock hits a price limit. A stop-loss order instructs the broker to sell the stock when the price falls below a stipulated level. The sale of the stock at a given price “trigger” stops further losses from accruing. A stop-buy order instructs the broker to buy the stock when the price rises above a specified amount. Stop-buys often accompany short sales (sales of borrowed stock) and are used to limit potential losses.

2.2. Additional Order Instructions
An investor may provide her broker with additional order instructions. Certain instructions indicate when an order may be filled in addition to how the order is filled.

A day order is an order to purchase or sell stock which expires at the end of the trading day. In other words, the order expires if not filled by the end of the trading day.

With a good-till-canceled order (GTC), the trader instructs the broker to keep the order open until it is either filled or canceled by the customer. In practice, brokers will often verify the order with the customer if the order has gone unfilled for a long period of time.

An immediate or cancel order (IOC) instructs the broker to fill the order (in whole or in part) at the time the broker enters the bid or offer. Any portion of the order which is not filled is immediately canceled.

A good-on-close order (GOC) is a type of order which can only be filled at the close of trading. These orders are used by institutions which want to establish or increase a position at the stock’s closing price.

3. ORGANIZED TRADING
There are three major trading systems used in the U.S.: over-the-counter (OTC) dealer markets, specialist-managed exchanges, and direct institution-to-institution trading over electronic networks.

3.1. Dealer Markets
The over-the-counter (OTC) market is a market in which securities are transacted by dealers through a computer network.

In 1971, the National Association of Securities Dealers Automatic Quotation System (NASDAQ), was formed to connect brokers and dealers over a computer network. The NASDAQ is the largest OTC market.

The NASDAQ has three levels of participants, known as “subscribers”. Level 1 subscribers have access to basic quotes, i.e., highest bid and lowest ask. Level 2 subscribers can see a stock’s full market, i.e., all bid and ask prices, but cannot enter quotes. Level 3 subscribers is for dealers and allows them to enter quotes.

3.2. Specialist Markets
In a specialist-driven market, such as the New York Stock Exchange, trading in each security is directed by a specialist who is assigned (by the exchange) responsible for that security. Although the specialist may trade for her own account, exchange rules prohibit the specialist from doing so if there is an outstanding order for the same price. Although the specialist maintains a physical location on the exchange floor where she can conduct trades with floor brokers (representatives for brokers who are exchange members) most trades are conducted through electronic matching of buy and sell orders.

The most important role for the specialist is the ensure a “fair and orderly market” in the stock in which she deals. The specialist does this by buying when no other buyers can be found (at least not at a fair price) and by selling shares from inventory when no other sellers are present.

3.3. Electronic Communication Networks (ECNs)
Electronic communication networks (ECNs) are alternative trading systems which allow participants to post orders (both market and limit) and directly trade with other institutions via computer network. The ECNs thus allow trades to occur without the intervention of a broker.

4. BUYING STOCKS ON MARGIN
An investor can receive permission from her brokerage to borrow a portion of a stock purchase. This practice is buying on margin. The use of leverage in the purchase can enhance the investor’s return if the stock price increases but can also magnify the investor’s loss should the stock price decline.

The term margin refers to the portion of the purchase price which is funded by the investor (the investor’s equity). The margin loan refers to the borrowed funds, on which the investor pays interest to the brokerage. The broker sets both an initial margin requirement and a maintenance margin requirement. These margin limits are ultimately set by the Federal Reserve. If the margin percentage falls below the maintenance margin level, the broker will initiate a margin call and demand the investor post additional collateral (cash or securities) to the margin account. If additional collateral is not posted, the brokerage can sell the securities from the investor’s account.

As an example of how margin purchases work, suppose an investor purchases a stock for $20 using 50% margin. The brokerage has a 40% maintenance margin, meaning the trader’s equity must not fall below $8 (.4 x $20). Since the margin loan is $10, the trader will receive a margin call from the broker when the stock falls below $18 ([.4 x $20] + $10).

5. SHORT SALES
A trader who believes the price of a stock will decline can borrow shares of the stock from her broker and then sell them with a promise to repurchase them later. This type of trade is known as a short sale. The short seller (the trader who is shorting the stock) profits when the stock declines and can be bought back at a lower price than it was sold for. However, the short seller must still replace the stock even if it rises. Since a stock can only fall to zero, but theoretically has unlimited upside, the short seller has limited gain and unlimited losses.

The trader must keep the proceeds of the short sale in her account with the brokerage. The short sale proceeds act as collateral for the stock which the brokerage has lent. Because the shares may rise in price, the collateral may not be adequate to cover the loan. Thus, short sellers are subject to maintenance margin levels. The short sellers can receive a margin call from the broker if the maintenance margin level has been breached.

Sources:
Bodie, Zvi, Alex Kane, Alan J. Marcus. Investments, 8th ed. New York: McGraw-Hill, 2009.
Reilly, Frank K., and Edgar A. Norton. Investments, 6th ed. Mason: South-Western, 2003.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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