Securities Markets - Transacting Securities
Previously we have discussed where securities are traded, the systems used and key players involved. Let's now examine how securities are traded by investors.
Long and Short Sales
When an investor has a long position in a stock, he or she has purchased and owns a stock. On the other hand, an investor with a short position in a stock has sold a stock that is not owned, the security is owed by the investor .
- Investors with this position believe that the price of the stock will rise, and expects to profit in the future by selling their stock.
- When the investor eventually sells this long position, the sale is known as a long sale.
- Long positions have limited risk as the investor can lose only what was paid for the stock,
- Investor expects the price of a stock to fall.
- The customer initially borrows the stock from a broker-dealer to sell in the market, expecting that the stock's price will go down.
- At a later date, the investor plans to buy the stock back at a much lower price to replace the borrowed shares (known as closing the short position) while making a profit - that is, the difference between the original sale price of the borrowed shares and the value of the stock purchased back at a lower price.
- Note that a short sale is a risky position for an investor to assume. Instead of declining towards zero, the price of the shorted stock could actually rise to an infinite, or unlimited, degree. (In other words, the position has unlimited riskassociated with it.) If this scenario were to occur, the short seller would be obligated to replace the original, borrowed stock at a price much higher than the initial sale price.
Types of Orders
There are several different order types, and each has different characteristics and costs.
If you are a beginner to the world active trading, see our Basics of Order Entry article for a quick primer on the various types of orders, from the perspective of the investor.
- Market Orders: Market orders are the most common types of orders. The order merely instructs the broker to buy or sell a stock at whatever price is available when the order reaches the floor of the exchange. While the customer will not know the price at which the stock was bought or sold until the order is completed, a market order will always be executed.
- Limit Orders: A limit order is executed at a specified price or better. A buy limit order is executed at the order price or lower, while a sell limit order is filled at the specific limit price or higher. Unlike a market order, a limit order might not be executed if the price never reaches the specified limit price.
- Stop Orders: A stop order becomes a market order to buy or sell a security once the stock reaches a certain price, called the stop price. Again, as with the market order, there is no price guarantee, but the investor order will be executed once the stop is activated.
- Stop-Limits:A stop-limit order is a combination of both a stop and a limit order. The stock must reach the stop price to activate the order, but once it is activated, the order becomes a limit order, which will only be filled at a specific price or better. That is, unlike the stop order, a stop-limit order guarantees a certain price if that limit price is reached. Otherwise, the investor runs the same risk as with a limit order - missing the market for the stock. Note that a buy stop-limit will always be placed above the current price of the stock, while a sell stop-limit will always be placed below the current stock price.
Exam Tips and Tricks
In past Series 6 exams, one of the fundamental exam questions has covered the basic types of orders. Make sure you understand all of them and how they are used in different trading situations.