Trading, Settlement, and Corporate Actions

This page of our SIE Study Guide covers trading, settlement, and corporate actions. Specific topics reviewed here include types of orders, strategies, investment returns, and more.

Types of Orders

Market Order: When an investor wishes to purchase, or sell, a specific security and is willing to pay or sell for whatever its current market price is, with no negotiation or haggling.

Limit Order: When an investor has a specific maximum price they’re willing to pay to buy a specific security or a specific minimum price at which they wish to sell. If their limit price is never reached, then the order will never be executed.

Stop Order: An investor who already owns a stock may wish to put in an order to sell the stock if it declines below a specific level, called the stop price. This can be an effective way to protect already-existing profits in a stock. In the past, Wall Street referred to these as stop loss orders because they were widely used to stop the erosion of a position, to stop losses from growing excessively.

Good-til-Canceled Order: If an investor places an order which has a specific limit price, or stop price, then they must inform their brokerage firm how long they want the order to remain on the books. A day order is good for today only and, if not executed, will be canceled at the close of the market. A good-til-canceled (GTC) order is one in which the investor wants the order to remain on the books until it is filled, or until they change their mind and cancel it.

Discretionary vs. Non-Discretionary Order: There are instances in which a client wishes to give their registered representative (RR) limited power of attorney, enabling the RR to make trading decisions on behalf of the client without having to contact the client in advance. This is referred to as discretionary power and the account is a discretionary account. Discretion may not be used until the proper documents are signed by the client and returned to the brokerage firm.

Solicited vs. Unsolicited Order: When an investor knows what they want to buy or sell, they contact their RR and place the order. This is known as an unsolicited order since it is 100% the client’s idea. A solicited order occurs when the RR makes a recommendation to the client that results in a transaction. All order tickets must be marked solicited or unsolicited to comply with regulations.

Trade Capacity

Most securities firms are required to register with the SEC and join a self-regulatory organization (SRO) like FINRA, thereby becoming member firms and agreeing to abide by all rules and regulations set forth by the SRO. Two such examples are brokers and dealers, with many acting in both capacities (known as broker-dealers).

Broker-dealers may act as an intermediary between a buying customer and a selling customer in an agency capacity, acting as a broker. They may also sell directly to a buying customer out of the firm’s inventory in a principal capacity, acting as a dealer. To put it another way, a firm acts a broker when it executes an order on behalf of its customer and as a dealer (or principal) when it executes an order for its own account.

  • All publicly traded stocks have a bid price and an ask (or offer) price. The bid price is what an investor is willing to pay for a particular stock at a particular time and the ask price is what an investor is willing to receive for a particular stock at a particular time. The difference between a stock’s bid price and ask price is known as the bid-ask spread.

Types of Strategies

Similar to how there are many different types of securities offerings and orders, there are also many different trading strategies available to investors depending on their risk tolerance levels. Strategies include but are not limited to those described below.

Long-Short Equity: When an investor (usually a hedge fund) takes long positions in stocks they expect will rise and short positions in stocks they expect will drop. At their most basic levels, a long position involves owning a stock whereas a short position involves borrowing a stock.

Naked Options: When a sophisticated investor sells an options contract without owning the underlying security. If the option ends up being exercised, then the seller will have to buy the security at market price in order to meet their obligation of delivering the security at the option strike price.

Naked call writing specifically is when an investor sells a call option without owning the underlying security, believing the price of the underlying security will trade below the option strike price on the expiration date and thereby collecting a premium (the maximum potential gain). If the price of the underlying security ends up trading above the option strike price, then the maximum potential loss is theoretically unlimited.

Naked put writing is when an investor sells a put option without owning the underlying security, believing the price of the underlying security will trade above the option strike price on the expiration date and thereby collecting a premium (the maximum potential gain). If the price of the underlying security ends up trading below the option strike price, then the maximum potential loss is theoretically unlimited. Using naked options as a trading strategy carries significant risk and is thus reserved only for sophisticated investors.

Covered Options: In contrast to naked options, this is when an investor sells an options contract while owning the underlying security. Covered call writing specifically is when an investor sells a call option on a security they already own and, similarly, covered put writing is when an investor sells a put option on a security for which they have enough cash on hand to purchase if the option gets exercised.

Bearish: Bearish investors expect prices to decline. They can be bearish about an individual security, sector, or the market as a whole. For example, an investor who believes that the stock price of Company XYZ will decline soon is bearish on that particular company. A bear market is characterized as a prolonged 20% decline in securities prices.

Bullish: Bullish investors expect prices to rise. Like bearish investors, this can apply to an individual security, sector, or the market as a whole. A bull market is generally characterized as a prolonged rise in securities prices, though there is no specific percentage to meet as with bear markets.

Trade Settlement

As of March 2017, most securities transactions are required to settle within two business days of their transaction date, with rare exceptions. This is known as T+2.

  • T: Transaction date.
  • T+1: For U.S. government bonds and government agencies, one business day after the date of the transaction.
  • T+2: For stocks and most mutual funds, two business days after the date of the transaction. Note that, under Federal Reserve Board Regulation T, two days is the maximum amount of time an investor has to pay for a stock after it has been purchased.

The transfer of ownership of a stock or bond certificate is made via a book entry or a physical entry. Book entries—the method of tracking securities ownership electronically—cover the majority of cases and are processed by the Depository Trust Company. Physical entries, on the other hand, mean that certificates are physically delivered to the buyer and ownership is kept on the books of the securities issuer.

All publicly traded corporations are required by law to keep and maintain an accurate list, updated every business day, of who owns its shares and bonds. This list is referred to as the corporate record and is kept by an entity known as the transfer agent, which is typically a bank or trust company hired to do so by the corporation.

Investment Returns

Bond Interest: Investors purchase corporate, municipal, or government bonds to earn a stated rate of interest every year until the bond matures. This interest is known as their return on investment (ROI).

Dividends: Investors purchase stocks in order to earn a cash dividend which the corporate board of directors will determine each year based upon how well the company did that year. The board may elect to give dividends to common stockholders in the form of additional shares of stock rather than cash, thereby increasing the company’s total number of shares outstanding. These are known as stock dividends. Note that the share price will decrease in order to adjust for the additional shares, as the company’s value will remain the same.

There are four dates to keep in mind with respect to dividends:

  • On the declaration date, a company announces the type and size of the dividend as well as the record date and the payment date.
  • The record date is the date a shareholder must be on the company’s books in order to receive the dividend. To clarify, if a shareholder owns shares on or before this date, then they will receive the dividend.
  • The payment date is when the dividend actually gets paid.
  • For new shareholders, the ex-dividend date is the date of disqualification for the next dividend payment; those who purchase shares on or after this date will not receive the dividend. Therefore, investors would need to purchase shares prior to the ex-dividend date in order to qualify.

Capital Gains — Realized vs. Unrealized: If an investor purchases ABC stock at $80 and it rises to $110, we would call that a $30 appreciation (or increase in value). Is that rise in value taxable? Not unless—and until—the investor sells the stock and takes the $30 gain. This would be called a realized gain once the sale takes place and an unrealized gain if the investor hangs on to the stock.

In the case of an inherited mutual fund, the shares may receive a stepped-up basis, meaning their market value is determined as of the benefactor’s time of death. If the beneficiary later decides to sell the shares, then their cost basis (original value—or purchase price—of an investment for tax purposes) is the net asset value of the shares at market close on the day of the benefactor’s death. The capital gains tax to be paid by the beneficiary is calculated according to this basis, if one occurred. Otherwise, it will be calculated on the difference between the shares’ initial net asset value and their net asset value at redemption.

Corporate Actions

When publicly-traded companies undergo events that have material impacts on the company and/or its shareholders, these events are known as corporate actions. Corporate actions are generally initiated by a company’s board of directors and can be mandatory or voluntary. Mandatory corporate actions, like stock splits or company name changes, do not require any action from shareholders. Voluntary corporate actions, however, require shareholders to respond in order for any changes to be applied to their investments.

Some common examples of corporate actions are described below.

Buybacks (From Section 1.4 Offerings): A stock buyback, or share repurchase, occurs when a company buys back its shares from the market using company funds. It is one way for a company to re-invest in itself. The repurchased shares are referred to as treasury stock and may be re-sold to the investing public later or used for a variety of other purposes such as conversions of convertible bonds.

  • The number of outstanding shares on the market is reduced and, with fewer shares on the market, the relative ownership percentage of each investor increases.
  • Shareholders are not required to participate. When a buyback occurs in lieu of paying a dividend, any resulting increase in stock value constitutes a tax deferral for stockholders not participating and may also give a tax benefit to participants, assuming the capital gains tax rate is below the ordinary income tax rate applicable to dividends.

Tender Offers: When an investor (commonly referred to as an acquirer) makes a public offer directly to a target company’s shareholders to buy some or all of their shares, often at a price higher than the current market price. The offer can be conditional on a minimum or maximum number of shares being purchased though shareholders are not required to participate. Tender offers are one way to acquire a company and can sometimes be hostile, depending on whether the target company’s board approves.

Exchange Offers: Similar to tender offers, exchange offers are optional events directly targeting company shareholders. They are given the option to exchange one type of security, such as common stock, for another type of security such as preferred stock or debt. The securities being exchanged can be with the same firm or with another; for example, ABC Inc. might offer shareholders common shares of its subsidiary company XYZ Inc. in exchange for common shares of ABC Inc.

Rights Offerings: When a company offers its existing shareholders the right to buy additional new shares (typically at a discount) in the company, proportional to their current holdings. These are similar to options in that participating shareholders own the right—but not the obligation—to purchase new shares. Additionally, if the rights are transferable, then participating shareholders can also freely trade them in the open market like any other securities.

Mergers & Acquisitions (M&A): Though commonly referred to together as M&A, mergers and acquisitions are two separate and distinct transactions that can materially impact a company. In a merger, two companies combine under a new single entity with new ownership and a new management team. In practice, this occurs less often than an acquisition, which is when one company takes over another (often smaller) company. The acquiring company is typically either a financial buyer, such as a private equity firm, or a strategic buyer that operates in the same industry.

Stock Splits: When a company’s stock price begins to rise and reach triple-digit levels, it is common for them, in an effort to bring down the price to more affordable levels, to initiate a stock split. For example, if ABC is trading at $150 per share and the board declares a 3 for 1 stock split, then the price will drop to $50 per share and everyone will now own 3 times as many shares as before. For stock prices that are declining, the board may direct a reverse stock split, such as a 1 for 2 reverse stock split, which aims to boost the stock price by reducing the total number of shares outstanding.

  • Adjustments to Market Price and Cost Basis: In the above 3 for 1 stock split example, the market price will drop to one-third of its previous value but everyone will now own 3 times as many shares. On the other hand, a 1 for 2 reverse stock split would double the stock price but halve the number of shares owned.

Companies are generally required to notify FINRA at least 10 days prior to the record date for dividend distributions, stock splits or reverse splits, and rights offerings. For other corporate actions, like mergers or bankruptcies, companies are required to notify FINRA no later than 10 days prior to the effective date of such action. Securities exchanges notify shareholders of announcements for public company corporate actions whereas FINRA handles shareholder notifications for companies traded OTC.

For corporate action events subject to shareholder approval (typically voted on at the annual general meeting), a shareholder may elect to legally authorize somebody to vote on their behalf in a process known as proxy voting. Prior to the annual meeting, shareholders will receive proxy documents containing important information relevant to issues that will be voted on. These documents are required to be filed with the SEC on an annual basis and are available to the public under the name SEC Form DEF 14A.

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