Overview
In this chapter, we delved into various facets of equity transactions, focusing on different types of client accounts, margin positions, and types of orders. Below is a comprehensive summary.
Key Concepts Covered
Margin Accounts vs. Cash Accounts
Unlike clients with cash accounts, clients with margin accounts can buy or sell securities on credit. Margin accounts can hold both long and short positions, whereas cash accounts are limited to long positions.
Long Margin Positions
A long margin position enables investors to partially finance the purchase of securities by borrowing money from the dealer. Here’s a simple formula to understand the margin:
$$$$
$$ \text{Margin} = \text{Initial Cost of the Transaction} - \text{Loan}$$
The investor earns a profit when the underlying stock price appreciates.
Short Margin Positions
A short margin position allows investors to sell securities they do not own. Here’s a simplified sequence of events:
- The short seller’s dealer lends the securities to the investor.
- The investor sells those securities in the market.
- The trade is declared as a short sale.
The investor profits when the sell price is higher than the repurchase cost on closing the short position. However, if the stock price rises instead of falling, the short seller could face unlimited losses.
Trade Execution
When a trade is completed on an exchange, the exchange’s data transmission system reports the trade and provides trade details to the buying firm. Here’s the trade execution cycle:
graph LR
A[Trade Execution] --> B[Trade Report]
B --> C[Details to Buying Firm]
C --> D[Confirmation to Buyer and Seller]
D --> E[Payment by Buyer and Delivery by Seller on Settlement Date]
The settlement mechanism and timeframe depend on the type of the securities being traded.
Types of Buy and Sell Orders
Here’s a rundown of different types of trading orders:
- Market Order: Buy or sell at the prevailing market price.
- Limit Order: Buy or sell at a specified price or better.
- Day Order: Expires if not executed on the same day.
- Good through Order: Auto-cancelled on a specified date.
- On-stop Sell Order: Sell when price falls to a specified point.
- On-stop Buy Order: Buy when price reaches a specified point.
- PRO Order: For the accounts of partners, directors, officers, investment advisors, and specified employees.
Review Questions
Now that you have completed this chapter, test your comprehension by answering the Chapter 9 Review Questions.
Frequently Asked Questions
For any questions regarding this chapter, you can refer to the Chapter 9 FAQs available online.
Glossary
- Margin Account: An account that allows investors to buy securities on credit and hold long or short positions.
- Long Position: Buying and holding a security with the expectation that it will rise in value.
- Short Position: Selling securities not owned by the selling party with the hope of repurchasing them at a lower price.
- Market Order: An order to buy or sell at the best available current price.
- Limit Order: An order to trade a security at a specific price or better.
Key Takeaways
- Margin accounts provide flexibility by allowing the purchase or sale of securities on credit and offering the possibility of long and short positions.
- Long margin positions can result in profits when the price of the purchased stock increases, while short margin positions can be profitable if the stock price decreases.
- There are various types of orders with specific conditions and constraints to match the investor’s trading strategy.
Be sure to revisit these key points and utilize the Chapter 9 FAQs to reinforce your understanding.
📚✨ Quiz Time! ✨📚
## Which type of account allows clients to buy or sell securities on credit?
- [ ] Cash accounts
- [x] Margin accounts
- [ ] Savings accounts
- [ ] Registered Retirement Savings Plan (RRSP)
> **Explanation:** Unlike clients with cash accounts, clients with margin accounts can buy or sell securities on credit and hold both long or short positions.
## What is the main feature of a long margin position?
- [ ] The investor sells securities they do not own
- [ ] The investor does not require any margin
- [x] The investor borrows money from the dealer to partially finance the purchase of securities
- [ ] The investor must close the position by the end of the trading day
> **Explanation:** A long margin position allows investors to partially finance the purchase by borrowing money from the dealer, with the margin being the amount put up by the client.
## When does an investor earn a profit in a long margin position?
- [ ] When the underlying stock price falls
- [ ] When the investor borrows more money
- [ ] When the position is held overnight
- [x] When the underlying stock price rises
> **Explanation:** Investors earn a profit in a long margin position when the underlying stock price rises.
## What is one of the risks associated with a short margin position?
- [ ] Limited gain potential
- [ ] No need for borrowing
- [ ] Immediate need to buy securities
- [x] Unlimited loss potential if the security price rises
> **Explanation:** Among other risks, short sellers face the risk of unlimited loss if the price of the security rises rather than falls.
## What happens when a trade is completed on an exchange?
- [ ] The buyer provides payment and the seller delivers the security by the trade date
- [x] The exchange’s data transmission system reports the trade and provides details to the buying firm
- [ ] The trade is kept confidential
- [ ] The trading firms must arrange settlement separately
> **Explanation:** When a trade is completed on an exchange, the exchange's data transmission system reports the trade and provides the buying firm with trade details. Confirmation is sent to the buyer and seller.
## What is a market order?
- [ ] An order to buy or sell at a specific price or better
- [x] An order to buy or sell at the prevailing market price
- [ ] An order that expires if not executed on the day it is entered
- [ ] An order that is automatically cancelled on a specified date
> **Explanation:** A market order is an order to buy or sell at the prevailing market price.
## Which order specifies that it should be cancelled if not executed on the same day it is entered?
- [ ] Market order
- [ ] Limit order
- [x] Day order
- [ ] Good through order
> **Explanation:** A day order is an order that expires if it is not executed on the day it is entered.
## What is an on-stop sell order?
- [ ] An order only valid during the trading day
- [x] An order to sell a security when it falls to a specific price
- [ ] An order to buy a security only after a specified time
- [ ] An order that is only valid for institutional traders
> **Explanation:** An on-stop sell order is an order to sell a security when the price of a standard trading unit falls to a specified point.
## What is an on-stop buy order?
- [ ] An order to cancel a trade if not fulfilled in a given timeframe
- [x] An order to buy a security only after it has reached a specified price
- [ ] An order to buy a security at the best available market price
- [ ] An order for a security to be sold at a specific date in the future
> **Explanation:** An on-stop buy order is an order to buy a security only after it has reached a specified price.
## Who typically places a PRO order?
- [ ] General public investors
- [ ] Retail clients
- [x] Partners, directors, officers, investment advisors, and specified employees
- [ ] Market makers
> **Explanation:** A PRO order is for the accounts of partners, directors, officers, investment advisors, and specified employees.