Overview
By now, you should have a good understanding of the different types of securities that trade in the market. In this chapter, we turn our attention to the mechanical process by which investments are acquired, held, and sold.
Mechanics of Trading
On the surface, buying or selling a stock on an exchange seems fairly straightforward. However, there is more to trading than simply calling an investment dealer or self-directed broker and placing a buy or sell order. Various advanced strategies and techniques can significantly influence the trader’s outcomes.
Key Concepts:
- Margin Trading: Buying shares by borrowing a portion of the purchase price from a broker, usually by using the purchased shares as collateral.
- Short Selling: Selling shares that the investor does not own but has borrowed, hoping to buy them back at a lower price.
- Order Types: Different methods to place trade orders in the market, including market orders, limit orders, stop orders, and more.
Different Order Types
- Market Order: An order to buy or sell a stock immediately at the best available current price.
- Limit Order: An order to buy or sell a stock at a specific price or better.
- Stop Order: Also known as a stop-loss order, it becomes a market order once a specified price level is reached.
- Stop-Limit Order: An order placed with a stop price and a limit price. Once the stop price is reached, the order becomes a limit order instead of a market order.
- Trailing Stop Order: A stop order where the stop price is set at a certain percentage below (for sell) or above (for buy) the market price.
Investment Strategies with Risks and Benefits
These considerations are important to the decision-making process and, ultimately, to the choice of investment strategy. Various strategies present different levels of risks and are suitable for different market conditions.
Margin Trading
Advantages:
- Potential for higher returns using leverage.
Risks:
- Risk of margin calls and losing more than the initial investment.
Short Selling
Advantages:
- Profiting in a declining market.
Risks:
- Unlimited potential losses if the stock price rises.
Placing Orders with Conditions
Advantages:
- Greater control over trade execution and risk management.
Risks:
- Possibility of orders not being executed if conditions are not met.
FAQ
What is the primary advantage of using a market order?
The primary advantage of a market order is the certainty of execution. You are guaranteed to buy or sell the stock immediately at the best available current price.
What is a margin call?
A margin call occurs when the value of the securities in your margin account falls below the broker’s required minimum. When this happens, you are required to deposit additional funds or sell some of your assets to cover the shortfall.
Which investors are best suited for short selling?
Short selling is best suited for experienced investors who are familiar with the high risks and can closely monitor their investments. These investors usually have a bearish outlook on specific stocks or the market as a whole.
Key Takeaways
- Understanding the mechanical processes of trading is essential for implementing effective investment strategies.
- Margin trading and short selling involve high risks but also the potential for high rewards.
- The type of order placed can significantly impact the outcome of a trade.
- Always consider the conditions under which a trade is executed to align with your investment goals and risk tolerance.
Glossary
- Margin Call: A demand by a broker that an investor deposit additional money or securities to cover possible losses.
- Collateral: An asset that a borrower offers as a way for a lender to secure the loan.
- Leverage: Using borrowed capital for an investment, expecting the profits made to be greater than the interest payable.
- Bearish: Expecting that the price of an asset will decline.
References
- [Canadian Securities Course] – Course materials and additional readings provided by the institution.
- [Financial Industry Regulatory Authority (FINRA)] – A comprehensive resource for understanding various trading mechanisms and regulations.
📚✨ Quiz Time! ✨📚
## What is the primary focus of Chapter 9.1?
- [ ] Types of securities that trade in the market
- [ ] The history of stock exchanges
- [x] The mechanical process by which investments are acquired, held, and sold
- [ ] Long-term investment strategies
> **Explanation:** Chapter 9.1 turns attention to the mechanical process by which investments are acquired, held, and sold, giving insights into trading beyond simply placing buy or sell orders.
## What additional options does an investor have when buying shares besides placing a market order?
- [x] Buying on margin or short selling the stock
- [ ] Only through mutual funds
- [ ] Only through ETFs
- [ ] Only by holding for dividends
> **Explanation:** An investor can buy shares on margin, short sell the stock, place a limit price on the trade, or add other conditions.
## What does it mean to buy shares "on margin"?
- [ ] Buying shares at market value
- [ ] Buying shares through a mutual fund
- [x] Borrowing money from a broker to purchase shares
- [ ] Buying shares without paying any commission
> **Explanation:** Buying shares "on margin" involves borrowing money from a broker to purchase shares, which can amplify gains and losses.
## What does "short selling" a stock involve?
- [x] Selling borrowed shares with an expectation of buying them back at a lower price
- [ ] Selling shares you own at a loss
- [ ] Buying shares at a discounted price
- [ ] Selling shares at market price
> **Explanation:** Short selling involves borrowing shares and selling them, hoping to buy them back at a lower price to make a profit.
## Why might an investor place a limit on a trade?
- [ ] To ensure the trade is executed immediately
- [x] To control the price at which the trade is executed
- [ ] To buy or sell only large volumes of shares
- [ ] To automate long-term investment strategies
> **Explanation:** An investor places a limit on a trade to ensure that the trade is executed at or better than a specified price.
## Which of the following is NOT covered in Chapter 9.1?
- [ ] Margin trading
- [ ] Short selling
- [x] Fundamental analysis of stocks
- [ ] Various buy and sell orders
> **Explanation:** Chapter 9.1 focuses on mechanical processes of trading, including margins, short selling, and different types of orders, but not on fundamental analysis.
## What is a key consideration in choosing a trading strategy?
- [ ] Ensuring it matches other investors' strategies
- [ ] Making sure it's the cheapest strategy
- [x] Understanding the risks, advantages, and disadvantages
- [ ] Selecting the oldest available strategy
> **Explanation:** Key considerations in choosing a trading strategy include understanding the associated risks, advantages, and disadvantages.
## How might an investor use a limit price on a trade?
- [ ] To purchase stocks immediately regardless of price
- [x] To specify the maximum or minimum price at which they are willing to trade
- [ ] To exclude taxes from the transaction
- [ ] To apply to dividend collections
> **Explanation:** Placing a limit price on a trade means an investor specifies the maximum price they are willing to pay (for buys) or the minimum price they are willing to accept (for sells).
## What are some conditions an investor might add to a trade order?
- [ ] One-investor only condition
- [ ] Manual processing only
- [x] Limit price, margin, or short-sale conditions
- [ ] Future value prediction requirements
> **Explanation:** Investors might add conditions such as limit price, margin, or short-sale to the trade orders.
## Why is understanding different buy and sell orders important for investors?
- [ ] To follow trends without knowledge
- [ ] To match other investors' orders
- [x] To make informed decisions and choose suitable trading strategies
- [ ] To automate all trades entirely
> **Explanation:** Understanding different buy and sell orders is crucial for making informed decisions and choosing appropriate strategies tailored to their goals and risk tolerance.