Terminology

Quick Answer

A market order fills immediately but the price is not guaranteed; a limit order guarantees price but may never fill. A stop becomes a market order when triggered; a stop-limit becomes a limit order. Short sales need a margin account. Cash accounts require full payment in the Reg T period, and margin accounts run on 50% initial and 25% maintenance.

This section works through each piece of that vocabulary in turn: how quotes are built, what each order type promises and does not promise, the extra risks of short selling, and how cash and margin accounts, trading capacity, and payment for order flow fit together.

What Are Bid, Ask, and the Spread?

Bid: the highest price a buyer (dealer) is willing to pay for a security

Ask (Offer): the lowest price a seller (dealer) is willing to accept

Bid-ask spread: Ask minus Bid; the dealer's compensation in market making

Investor perspective:

Buying: investor pays the ask (the higher price)

Selling: investor receives the bid (the lower price)

The spread is an implicit transaction cost; a round-trip trade loses the spread

Dealer/Market Maker: Buys At Bid price; Sells At Ask price

Investor: Buys At Ask price; Sells At Bid price

Example: Bid $50.00 / Ask $50.20; investor who buys immediately and sells immediately loses $0.20 per share.

How Does Spread Width Relate to Liquidity?

Narrow spread = highly liquid (large-cap stocks, major exchange-traded funds)

Wide spread = thinly traded, illiquid (small-cap over-the-counter stocks, penny stocks, bonds)

Quote: the current bid and ask prices displayed for a security.

Exam Tip: Gotchas

Investors buy at the ask (higher) and sell at the bid (lower). The dealer does the opposite.

What Are the Four Main Order Types?

Market: Execution Immediate at best price; Price Guarantee No; Execution Guarantee Yes; Use Case Speed over price

Limit: Execution At specified price or better; Price Guarantee Yes; Execution Guarantee No; Use Case Control over price

Stop (stop-loss): Execution Becomes market order at trigger; Price Guarantee No; Execution Guarantee No; Use Case Limit losses or protect gains

Stop-limit: Execution Becomes limit order at trigger; Price Guarantee Yes; Execution Guarantee No; Use Case Price control with protection

What Does a Market Order Guarantee?

Executed immediately at the best available price

Guarantees execution, not price

Default order type if none is specified

What Does a Limit Order Guarantee?

Customer specifies maximum price to pay (buy) or minimum price to accept (sell)

"Better" means lower for buy limits and higher for sell limits

Guarantees price, not execution

Buy limit: Placed Below current market; Executed At Limit price or lower

Sell limit: Placed Above current market; Executed At Limit price or higher

How Does a Stop Order Work?

A stop order requires two events:

1. Trigger: stock trades at or through the stop price (activates the order)

2. Execution: order becomes a market order and executes at the next available price

Buy stop: Placed Above current market; Triggered When Price rises to/through stop; Purpose Protect short position; catch breakout

Sell stop: Placed Below current market; Triggered When Price falls to/through stop; Purpose Protect long position; catch breakdown

How Does a Stop-Limit Order Differ from a Stop Order?

Combines a stop order with a limit order

Once triggered, becomes a limit order (not a market order)

Provides price protection after trigger but may not execute if the market gaps through the limit

Exam Tip: Gotchas

Market order guarantees execution but not price. Limit order guarantees price but not execution.

Stop order becomes a market order at the trigger price; no price guarantee; can slip in fast markets. Stop-limit order becomes a limit order; price protected but may not execute if the market gaps through.

Buy limits and sell stops are placed below the market. Sell limits and buy stops are placed above the market. The exam tests which side of the market each order sits on.

What Are the Risks and Requirements of a Short Sale?

Short sale: borrowing and selling a security the investor does not own, with the obligation to buy it back later

The short seller profits when the price falls (buy low, return the borrowed shares)

Unlimited loss potential: the price can rise indefinitely

Short sales require a margin account: they cannot be executed in a cash account

The short seller must eventually cover (buy back) the shares to return them to the lender

Short sellers are responsible for paying any dividends declared while the position is open

Exam Tip: Gotchas

Short sellers have theoretically unlimited loss potential. The stock price can rise without limit.

Short selling requires a margin account. You cannot short in a cash account. A common exam distractor states that risk can be reduced by confining short sales to cash accounts; this is wrong because cash accounts cannot hold short positions at all.

The short seller owes dividends to the share lender while the position is open.

What Are the Rules for Cash Accounts?

Investor pays 100% of the purchase price within one Reg T payment period: the standard settlement cycle (T+1) plus two business days, not merely by settlement date

No borrowing of funds from the broker-dealer

Cannot execute short sales or strategies with unlimited loss potential

Regular-way settlement: T+1 (one business day after trade date) for stocks, bonds, exchange-traded funds (ETFs), mutual funds, and options

Changed from T+2

U.S. government securities also settle T+1

If payment is not received in time, the broker-dealer must cancel or liquidate the position.

Exam Tip: Gotchas

Settlement is T+1 for most securities. The exam may still reference T+2 in older contexts, but T+1 is the current standard.

How Do Margin Accounts Work?

Margin accounts allow investors to borrow money from the broker-dealer to purchase securities (buying on margin). Governed by Regulation T (Federal Reserve Board), the FINRA margin rule, and individual firm requirements.

What Are the Key Margin Thresholds?

Initial margin: Source Regulation T; Amount 50% of the purchase price, or a higher percentage set by the regulatory authority where the trade occurs, whichever is greater

Minimum maintenance margin: Source Self-regulatory minimum (FINRA); Amount 25% equity for long positions

Minimum equity: Source Self-regulatory minimum (FINRA), not Regulation T; Amount $2,000 to open a margin account, except that on a purchase the deposit need not exceed the cost of the security

What Triggers a Margin Call?

Issued when account equity falls below the maintenance margin requirement

The investor must deposit additional cash or securities to restore equity

If the margin call is not met, the broker-dealer can liquidate securities without the customer's consent

How Is Buying Power Calculated?

With 50% initial margin, an investor who deposits $10,000 can purchase up to $20,000 in securities ($10,000 cash + $10,000 borrowed)

Margin amplifies both gains and losses (leverage risk)

Exam Tip: Gotchas

The $2,000 minimum equity is a FINRA self-regulatory requirement, not a Regulation T rule. On a purchase, the deposit need not exceed the cost of the security, so a small purchase can require less than $2,000.

A small initial short position (e.g., $400 worth of stock) still requires a $2,000 deposit. For short sales, the $2,000 minimum applies regardless of position size.

The firm (house) maintenance requirement can be higher than FINRA's 25% minimum. Many firms require 30-35%. The exam tests FINRA's 25% unless stated otherwise.

BD can liquidate securities without the customer's consent if a maintenance call is not met. The customer does not choose which positions are liquidated.

How Do Principal and Agency Trades Differ?

A broker-dealer can execute trades in two capacities:

Principal (dealer): Role Trades for its own account, usually from its own inventory; Compensation Markup (sell to customer) or markdown (buy from customer); Disclosure Must disclose capacity on every trade confirmation; the markup or markdown is itemized only in specific cases

Agency (broker): Role Intermediary between buyer and seller; Compensation Commission; Disclosure Must disclose commission amount on trade confirmation

The firm must disclose whether it acts as principal or agent. A principal trade earns a markup or markdown; the firm cannot add a separate agency commission on top of that markup or markdown, even by disclosing the double charge.

Riskless principal: dealer receives a customer order, immediately buys the security in the market for its own account, then resells to the customer (technically principal, functionally like agency)

Exam Tip: Gotchas

The key to identifying capacity is compensation. Commission = agency. Markup/markdown = principal. The exam describes a scenario and asks you to identify which capacity the firm is acting in.

Riskless principal = principal trade (markup applies) even though the BD had no inventory risk.

Capacity is the one item every principal confirmation carries. The markup or markdown is itemized only in specific cases: a riskless principal equity trade by a firm that is not a market maker in it, or a same-day offset trade in corporate or agency debt with a non-institutional customer.

"Principal = dealer = markup or markdown" describes how the dealer is paid. It does not mean every confirmation shows that amount.

What Is Payment for Order Flow and How Is It Disclosed?

Payment for order flow: compensation that a broker-dealer receives from a market maker or other venue for routing customer orders to that venue for execution

The broker-dealer is paid by the market maker in exchange for the opportunity to execute those orders

PFOF is legal but must be disclosed to customers

The order-routing disclosure rule imposes two separate duties:

a public quarterly report on the routing of non-directed orders

on a customer's request, disclosure of where that specific customer's orders were routed

A firm receiving PFOF must still satisfy its best execution obligation

PFOF may create a conflict of interest: the firm may route orders to the venue that pays the most rather than the venue offering the best price

Exam Tip: Gotchas

PFOF does not automatically violate best execution. However, a broker-dealer must not allow PFOF to interfere with its duty to obtain the best reasonably available price for customers.

PFOF is paid by the market maker to the broker, not by the investor directly.

What Should You Check on Exam Day?

Investors buy at the ask and sell at the bid; the spread is the dealer's implicit compensation

Market orders guarantee execution, not price; limit orders guarantee price, not execution

A stop order becomes a market order at the trigger; a stop-limit becomes a limit order at the trigger

Buy limits and sell stops sit below the market; sell limits and buy stops sit above the market

Short sales require a margin account and carry unlimited loss potential; the short seller owes any dividends declared while the position is open

Cash accounts require full payment within one Reg T payment period (T+1 plus two business days), not merely by settlement date; nonpayment alone triggers a mandatory cancel-or-liquidate

Initial margin is 50% of purchase price under Regulation T (or a higher regulatory-authority percentage, whichever is greater); maintenance margin is a FINRA self-regulatory 25% minimum

The $2,000 minimum equity to open a margin account is a FINRA rule, not Regulation T, and does not apply to a purchase costing less than $2,000; it does apply to short sales regardless of size

Compensation identifies capacity: commission means agency, markup/markdown means principal; riskless principal is still a principal trade

PFOF is legal but must be disclosed: a public quarterly routing report plus, on customer request, that customer's own routing disclosure