On a spring morning in 1792, twenty-four merchants gathered beneath a buttonwood tree on Wall Street and agreed to trade only with each other. That handshake deal gave birth to organized securities trading in America.
Today, most trades happen in microseconds across electronic networks, and the term "exchange" has expanded far beyond any physical location. Understanding where and how securities trade is fundamental to everything else on your Series 7 exam.
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Section 1: Types of Trading Markets
Why This Section Matters
The securities industry uses a numbering system to categorize different trading venues. These aren't arbitrary labels—they reflect real differences in how trades are executed, who participates, and what rules apply.
Primary vs. Secondary Markets
The primary market is where new securities are sold to the public for the first time—IPOs and new bond issues. The secondary market is where those securities trade afterward between investors.
The distinction between exchange and over-the-counter trading goes back centuries. Exchanges were formal buildings with membership rules; OTC trading happened informally in coffee houses and on street corners. The technology has changed dramatically, but the conceptual distinction persists.
First Market: Exchange Trading
The first market refers to the trading of exchange-listed securities on a major stock exchange. The largest stock exchange with a physical trading floor is the New York Stock Exchange (NYSE). The largest U.S. stock exchange overall is Nasdaq, which has no physical trading floor.
Consolidated Quotation System (CQS)
The Consolidated Quotation System (CQS) creates current price quotes for exchange-listed securities, regardless of where the quote is generated. This allows price discovery between markets and arbitrage opportunities.
NYSE Designated Market Makers (DMMs)
A designated market maker (DMM) is a firm that specializes in trading specific securities. DMMs are wholesalers that deal primarily with NYSE members, always offering to buy at one price (bid) and sell at a higher price (ask).
Second Market: Over-the-Counter (OTC) Trading
Many securities cannot meet an exchange's listing requirements. Such securities trade over-the-counter (OTC). Almost all corporate bonds and money market instruments trade OTC, as do U.S. government bonds and municipal bonds.
OTC Markets Group has 3 tiers based on disclosure levels:
- OTCQX — Premium companies
- OTCQB — Best-researched companies
- Pink Market — Speculative companies
Third Market: OTC Trading of Exchange-Listed Issues
OTC firms may also trade securities that are otherwise exchange-listed. This is the third market. Most trading occurs via electronic communication networks (ECNs).
ECNs offer lower costs, allow institutional investors to trade directly without brokers, operate 24 hours a day, and provide anonymity.
Fourth Market: Direct Trading Between Institutions
The fourth market is direct trading between institutions without a broker. A dark pool is a private trading system that allows participants to make transactions without displaying quotes publicly.
| Market | Type | Securities Traded |
|---|---|---|
| First | Exchange (auction) | Exchange-listed |
| Second | OTC (negotiated) | Unlisted |
| Third | OTC (negotiated) | Exchange-listed |
| Fourth | Dark pools/ATS | Listed and unlisted |
Broker-Dealers: Agents vs. Principals
When a firm acts as a broker, it serves as an agent earning commissions. When acting as a dealer, it's a principal putting its own money at risk, earning markups or markdowns.
| Comparison | Agent/Broker | Principal/Dealer |
|---|---|---|
| Role | Middleman | Trade Counterparty |
| Inventory | None held | Firm holds inventory |
| Risk | No risk | At risk |
| Compensation | Commission | Markup/Markdown |
(The distinction between acting as agent versus principal is tested heavily—if you remember nothing else from this section, remember that brokers charge commissions and dealers make markups.)
FINRA's 5% Policy
FINRA's 5% Policy suggests firms cannot charge more than 5% for a commission, markup, or markdown. However, 5% is merely a guideline—the actual rule states compensation must be fair and reasonable.
Test Tip: Mutual funds are exempt from the 5% Policy (max sales charge is 8.5%). Municipal bonds are also exempt but have similar MSRB rules requiring fair pricing.
Trading Halts
Market-wide halts triggered by S&P 500 declines:
- Level 1 (7% drop): 15-minute halt before 3:25 PM ET
- Level 2 (13% drop): 15-minute halt before 3:25 PM ET
- Level 3 (20% drop): Trading halted for remainder of day
| Topic | Key Details |
|---|---|
| Four Markets | First (exchange), Second (OTC unlisted), Third (OTC listed), Fourth (institutional/dark pools) |
| Broker vs. Dealer | Broker = agent/commission; Dealer = principal/markup |
| 5% Policy | FINRA guideline for fair compensation (not a hard rule) |
| Circuit Breakers | 7%, 13%, 20% S&P 500 drops trigger market-wide halts |
Section 2: Basic Order Types
In 1867, Edward Calahan invented the stock ticker—a device that printed stock prices on paper tape. Before that, you had to be on the trading floor to know what was happening. The ticker transformed investing from a physical presence game to an information game.
Steps in a Typical Securities Trade
- Investor contacts broker (verbally or online—texts/emails not permitted)
- Broker representative places order via trader or electronic network
- Order routed to exchange, market maker, ECN, or ATS
- Order executed
- Trade reported to consolidated tape
- Trade cleared and settled (T+1)
Buy and Sell Orders
A long position is an initial order to buy—the investor owns shares and profits if the price rises. A short position is an initial order to sell borrowed shares—the investor profits if the price falls.
| Order Type | Position | Risk Profile |
|---|---|---|
| Buy Long | Bullish | Unlimited gain potential; loss limited to investment |
| Sell Short | Bearish | Gain limited to stock going to zero; unlimited loss potential |
Size of Order
- Round lots: Standard 100-share increments
- Odd lots: Fewer than 100 shares; harder to fill
- Block orders: Very large trades (10,000+ shares); often executed off market
Orders Based on Time
Test Tip: All orders are assumed to be day orders unless specifically stated otherwise.
| Order Type | Duration |
|---|---|
| Day Order | Valid until end of trading day |
| GTC (Good 'til Canceled) | Persists until canceled (some firms set 90-day limit) |
| MOO/MOC | Market-on-open or Market-on-close |
Miscellaneous Order Types
| Order Type | Description |
|---|---|
| Market-Not-Held | Trader has discretion on timing/price; must complete that day |
| Fill-or-Kill (FOK) | Entire order filled immediately or canceled |
| All-or-None (AON) | Entire order must fill (not immediate); can work throughout day |
| Immediate-or-Cancel (IOC) | Fill what's available immediately; cancel the rest |
| Topic | Key Details |
|---|---|
| Long vs. Short | Long = buy/bullish; Short = sell borrowed/bearish |
| Order Sizes | Round (100), Odd (<100), Block (10,000+) |
| Time Orders | Day (default), GTC, MOO/MOC |
| Special Orders | FOK (all now or cancel), AON (all eventually or cancel), IOC (partial OK) |
Section 3: Orders Based on Price
Market Orders
A market order executes immediately at the prevailing price. No price is specified. Market orders will always be filled but may not be ideal for thinly traded securities with wide spreads.
Limit Orders
Limit orders specify a price at which to buy or sell. The order executes at that price or better—but may not fill at all if the limit price isn't reached.
Test Tip: Buy limit orders are placed below market price. Sell limit orders are placed above market price.
Stop Orders
A stop order acts as a trigger. When the market price reaches the stop price, the order converts to a market order. Stop orders are also called stop-loss orders because they help limit losses.
Stop Limit Orders
A stop limit order converts to a limit order (not market order) when triggered. This provides price protection but may not fill.
SLOBS: Sell Limit Over the market Buy Stop
Sell limit and buy stop orders are placed ABOVE current market price.
BLUSS: Buy Limit Under the market Sell Stop
Buy limit and sell stop orders are placed BELOW current market price.
Order Reductions
When a cash dividend is paid, buy limits and sell stops (orders below market) are reduced. Stock dividends and forward splits adjust both order size and price. Adjustments occur on the ex-dividend date.
Test Tip: If a reverse split occurs, all orders (buy and sell) are canceled.
| Order Type | Key Characteristics |
|---|---|
| Market | Immediate execution; always fills; no price control |
| Limit | Price control; may not fill |
| Stop | Trigger converts to market order; protects gains/limits losses |
| Stop Limit | Trigger converts to limit order; price protection but may not fill |
| Topic | Key Details |
|---|---|
| Market Orders | Immediate fill, no price control |
| Limit Orders | Price control, may not fill; buy below/sell above market |
| Stop Orders | Trigger to market order; buy above/sell below market |
| Corporate Actions | Cash dividends reduce certain orders; reverse splits cancel all orders |
Chapter 7 Key Terms Glossary
| Term | Definition |
|---|---|
| Primary market | Where new securities are sold for the first time |
| Secondary market | Where previously issued securities trade |
| First market | Exchange trading of listed securities |
| Second market | OTC trading of unlisted securities |
| Third market | OTC trading of exchange-listed securities |
| Fourth market | Direct institutional trading via dark pools/ATS |
| DMM | Designated market maker on NYSE |
| ECN | Electronic communication network |
| Dark pool | Private trading without public quote display |
| Broker | Firm acting as agent, earning commission |
| Dealer | Firm acting as principal, earning markup/markdown |
| NBBO | National Best Bid and Offer across all venues |
| 5% Policy | FINRA guideline for fair compensation |
| Circuit breaker | Market-wide halt from severe decline |
| Long position | Buying, expecting price increase |
| Short position | Selling borrowed shares, expecting decline |
| Day order | Valid only for current trading day |
| GTC order | Good 'til canceled |
| Market order | Buy/sell immediately at current price |
| Limit order | Buy/sell at specified price or better |
| Stop order | Becomes market order when triggered |
| Stop limit order | Becomes limit order when triggered |
| FOK | Fill-or-kill; entire order immediately or cancel |
| AON | All-or-none; entire order or cancel |
| IOC | Immediate-or-cancel; partial fill OK |
Chapter 7 covers where and how securities trade. Master market structure and order types before moving to Chapter 8: Trade Processing and Settlement, which explains what happens after the order is executed.