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We now know where the stock transactions take place. Let’s discuss what types of transactions we can use to buy and sell our stocks, how much it costs to conduct those transactions, and how and where we can get stock quotes.
Types of Stock Transactions
There are several types of stock transactions. We will cover the four major types. If and when you ever take the Series 7 Registered Representative (aka Stockbroker) exam, you will need to learn many more. However, in Your Humble Author’s opinion, there is really only one type of transaction a prudent, long-term investor will ever need, the market order. A market order is an order to buy or sell at the current price. You want to buy some shares, you buy them and pay the current market price. If you want to sell some shares, you sell them and you receive whatever price the transaction offered. With today’s technology, the order will execute in milliseconds or sooner.
An investor may be thinking, “I want to buy this stock but the price is too high at $25. If it ever drops down to $20, I will buy 100 shares.” This investor would use a limit order. The investor would enter a limit order to buy the stock at the price they specify. The same situation would apply if an investor held shares and thought, “If the price ever reaches $30, I want to sell.” The investor would specify a limit order to sell the stock at $30. With a limit order, the investor knows what price they pay or receive. However, the downside is that the transaction might never take place. The price may never fall to the buy limit price or rise to the sell limit price.
A third type of transaction is called a stop-loss order, also known as a stop order. Stop-loss orders are similar to market orders. However, with a market order, the investors cannot specify what price the transaction will settle. With a stop-loss order, the investor is saying, “If the price ever reaches a price that I specify, execute the order as if it were a market order.” Stop-loss orders are typically used to protect an investor from incurring a loss. “If the price ever falls below this amount I specify, I want the stock to be sold.” This is why they are called stop-loss orders.
A stop-limit order is very similar to the stop-loss order. The key difference is that a stop-limit order becomes a limit order, not a market order, when the trigger point is reached. To illustrate this subtle difference, say an investor utilizes a stop-loss order to protect from a loss. “If the price ever falls to $20, sell at the market.” For whatever reason, what if the price fell quickly from $25 to $16. This is very unusual but it happens. The stop-loss order would be triggered and the investor would receive the $16 price for their shares. A stop-limit order might specify, “If the price ever falls to $20, sell my shares but only sell if the price stays at $20 or higher.”
Your Humble Author normally uses and recommends market orders. Short-term traders often state that they prefer limit orders, stop-loss orders, or stop-limit orders on all their trades. Although you can use limit orders to buy or sell at the price you want and stop-loss and stop-limit orders to “lock-in” profits or protect against losses, remember that they trigger automatically. If for some reason you change your mind, it is often too late to cancel the order. The order will be executed in thousandths of a second or quicker.
|Market order||Buy at the best price available. Order will execute almost instantaneously.||Sell at the best price available. Order will execute almost instantaneously.|
|Limit order||The order will be executed at the buy limit price or lower. The order may never be executed if the price does not fall low enough.||The order will be executed at the sell limit price or higher. The order may never be executed if the price does not rise high enough.|
|Stop order||The order will be converted to a market order to buy when the stock price crosses the stop price from below. Since the order becomes a market order, the price may be much higher than the stop trigger price.||The order will be converted to a market order when to sell when the stock price crosses the stop price from above. Since the order becomes a market order, the price may be much lower than the stop trigger price. Also called a stop-loss order.|
|Stop-limit order||Same as a stop order except the order is converted to a limit order when the price crosses the stop-limit price from below.||Same as a stop order except the order is converted to a limit order when the price crosses the stop-limit price from above.|
Traditionally, transaction costs were in the 1% to 5% range, sometimes higher. The largest portion was the brokerage commission. Deep-discount Internet brokers drove the commissions down to as low as $5 per trade. Two companies experimented with $0 trades but were unsuccessful. A few years ago, the brokerage firm Robinhood started offering free trades, targeted to young adults and has managed to stay afloat and disrupt the industry. Their success has prompted other brokerage firms to follow them with $0 trades. But have transaction costs really gone down? The quick answer is, “Yes, transaction costs have gone down.” However, more and more of the cost is now hidden from the investor.
Let’s look at an example. A deep-discount Internet broker offers trades for $5 or $7 or now $0. In the fine print of the client-broker agreement is included a provision for allowing the broker to solely utilize exclusive stock dealers / market makers. The quoted price the investor sees before making the trade is simply the best price available but at any one time, there are dozens of prices quoted as dealers and market-makers compete for buy and sell orders. The chosen dealer doesn’t necessarily have the best price. Instead of paying $20 per share, the investor might pay $20.05. So on a 100 share transaction, the investor sees the $5 or $7 or $0 commission on their confirmation. The investor does not see the extra $5 they paid on a 100 share purchase because of the dealer’s $0.05 markup.
The following disclaimer was included in each trade confirmation email from Scottrade (purchased by TD Ameritrade which was then purchased by Charles Schwab):
“SCOTTRADE INC. RECEIVES REMUNERATION FOR DIRECTING ORDERS TO PARTICULAR BROKER/DEALERS OR MARKET CENTERS FOR EXECUTION. SUCH REMUNERATION IS CONSIDERED COMPENSATION TO THE FIRM AND THE SOURCE AND AMOUNT OF ANY COMPENSATION RECEIVED BY THE FIRM IN CONNECTION WITH YOUR TRANSACTION WILL BE DISCLOSED UPON REQUEST
Our first observation is that the notice is in all upper case. Companies use all uppercase when they want something to appear important but they also don’t want their customers to read it. Uppercase sentences are actually harder to read than normal upper- and lower-case sentences. The second observation is that even if we did read it, it doesn’t make any sense. What are they saying? Scottrade is telling us that they are getting a kickback from the exclusive “particular broker / dealers or market centers” that they are using to execute their trades. This is how brokerage firms that charge no commissions are $0 are actually making money now. In Scottrade’s defense, at least they prominently disclose this relationship. Robinhood, on the other hand, brashly declares that they are not making money using this technique when they most obviously are, at least according to both Investopedia and CNBC.
So now you know how brokerage firms can offer commission-free trades. When a friend or family member or colleague brags that they trade for free, it is your responsibility as a Rising Investment Guru to explain that, no, the trades are not free. They are paying by not getting the best price available when they buy shares and when they sell shares. Oh, by the way, this system is innocently called, “payment for order flow,” or simply, “order flow.” Doesn’t that sound better than, “kickback?” Order flow has been in the news as the Securities and Exchange Commission has floated the idea of banning order flow. Stay tuned!
Wait a minute! Doesn’t the SEC say that “your broker has a duty to seek the best execution that is reasonably available for its customers’ orders?” Yes, but it is not a guarantee. According to Investopedia, “… the SEC requires broker/dealers to notify their customers if their orders are not routed for best execution. Typically, this disclosure is on the trade confirmation slip you receive … after placing your order.” And determining whether or not a customer got “best execution” can be very difficult. Here is an example of the SEC trying to enforce the rules and not doing a particularly good job.
The SEC was looking into making the costs more transparent. They possibly would require the brokerage firms to show their customers the difference between the dealer’s price and the best price available at the time of the transaction. They might even – gasp! – show the total cost of the transaction from the markup/markdown. Needless to say, the deep-discount brokers cried that it would drive up the cost of commissions and ultimately hurt the consumer and the proposal died. So it is up to you to check if you are getting the “best execution.” But how can you, a lone investor, determine if you are getting the best price if even the SEC has trouble watching over the brokerage companies? Wait. It gets worse.
High Frequency Trading
Who are these particular broker/dealers that the commission-free brokerage firms are routing their customers’ transactions to? They are typically High Frequency Trading (HFT) firms. HFT uses computers to transact large numbers of orders at very fast speeds. For example, Robinhood routes the majority of their transactions to a firm called Citadel. High Frequency Trading and firms such as Citadel were detailed in an excellent book, Flash Boys, written by famed investment author Michael Lewis. There is little doubt that High Frequency Trading has reduced transaction costs dramatically. However, at the same time, HFT firms have been accused of using their ability to transact at the microsecond level to “front-run” investors. They are essentially stealing tiny amounts of money from the average retail investor and even large players like mutual funds and pension funds.
In his book, Mr. Lewis is the first person to tell you that no one actually knows how much the HFT firms are stealing from investors from front-running. The HFT firms keep their technology under lock and key. From experts in the field at the time of the writing of the book, the best guesses ranged from five to fifteen billion dollars per year. To the average person, that is a staggering sum of money. However, if we split the difference and say $10 billion. That is approximately how much money is bet each year on the NCAA March Madness Basketball Tournament. In a system where trillions of dollars are changing hands every few days, $10 billion dollars per year is actually a very small sum of money.
The hero of Flash Boys, a victim himself of the HFT firms’ front running, started his own securities trading marketplace to combat the HFT firms, IEX, and garnered support from some major players in the world of investments including FranklinTempleton and the Capital Group. IEX created what they call a “speed bump” so the HFT firms cannot “jump” in front of you and “front-run” your transaction. In June 2016, the SEC approved IEX’s bid to become an exchange. In 2017, the New York Stock Exchange followed suit and added their own speed bump, but only for small- and mid-sized companies.
At the time of the writing of the book Flash Boys in the early 2010’s, there was much publicity and controversy regarding High Frequency Trading. FINRA, the Financial Industry Regulatory Authority, and the SEC, the Security and Exchange Commission, both were publishing statements saying how they were investigating HFT to determine whether or not HFT firms were taking unfair advantage of investors. And then in 2015 or so, the statements stopped. The best that one can guess from their silence is that, yes, the authorities are aware that the HFT firms have an unfair advantage and are exploiting that advantage. But at the same time, HFT has reduced transaction costs dramatically. To coin an old adage, do the authorities want to throw out the baby with the bath water?
The lesson we retail investors can learn from HFT is that we are once again reminded how difficult short-term trading is. Not only do we have to tame our human emotions, we are also up against firms with billions of dollars invested in systems that can trade millions of shares in milliseconds. We are totally outgunned. We come to the fight with our pistol; they come with automatic assault rifles, tanks, and jet fighters.
Round Lots, Odd Lots, Mixed Lots
Traditionally, brokerage firms would encourage their customers to buy shares in round lots. This was encouraged because it helped speed up the transaction process on the floor of the exchanges. A broker would call out, “25!” while pulling his arms toward himself. This meant that the broker wanted to buy 100 shares, one round lot, at 25 per share. If the broker had pushed her arms away from herself, it signified that she had 100 shares to sell at 25. “2 at 25!” meant that he had 200 shares, two round lots, to buy or sell.
An odd lot is a quantity to sell less than 100 shares. If a customer wanted to buy or sell 17 shares, the broker would need to yell, “17 shares at 25!” and either signal a purchase or a sale using their arms gestures. This slowed the trading process. Hence, brokers would charge their clients an odd-lot differential. Traditionally, this was typically 12½ cents to 25 cents extra per share. or increments of 100 shares. Mixed lots of more than 100 shares but not divisible by 100 were also subject to the odd-lot differential. The face-to-face double auction trading process is now part of ancient history and so the need to buy and sell in round lots is a thing of the past. The odd-lot differential now is typically waived or far less than 5 cents per share, often much less. Nevertheless, old habits die hard and some of your older friends or family members will admonish you to always buy in 100 share round lots. Don’t listen to them. Since this is such a small matter, there is no need to waste your time trying to convince them that it is no longer necessary to buy in round lots. Wait until they are ready to sell everything after the market has fallen 50%. That is when they really need your expertise.
The competition for your investment dollars has become so intense, in fact, that brokerage firms are now allowing investors to buy fractional shares of stocks. Was one share of Amazon too much for you at over $3,000 per share in February of 2022? If you had $100 to spare, you could have purchased 0.03000 shares with that $100. Ah, don’t expect to get a very decent price using a service such as this. The markup will be substantial. (In our BUS-121, Principles of Money Management, class, we warn students that the price of convenience is typically very high. Note: Amazon split their stock so as of February 2023, it was selling for around $100.) Your Humble Author does not use any of these services. If any students do, it would be greatly appreciated if you could relate your experiences. Did the brokerage show you the difference between the best price available and what price they sold you the fractional shares? One brokerage firm that offers this service is Schwab. In the fall of 2022, I contacted one of their representatives and asked how much they charged for this service. He had no idea and said he would do some research and get back to me. He never did.
Before the Internet (BI?), most people would wait until the next morning to read the price quotes of their favorite stocks. They were published in every major newspaper. If the need for a stock quote was urgent, you would call your broker who had a Quotron machine in his or her office. The Quotron machine was receiving data directly from the stock exchanges and OTC markets. How 20th Century!
Now we simply swipe our mobile device and a fire hose of information about our stocks drenches us. One peculiarity to know about stock quotes from the Internet is that they are typically not up to date. You may have an account with a broker that offers you real-time quotes. But unless you have been assured ahead of time from your source that you are receiving real-time quotes, the quotes are normally delayed 15 to 20 minutes. (Real-time quotes are yet another fee that stock markets charge for.) Also, always remember that the quoted prices are not the only prices available. At any one time, there are many prices available from many different dealers/market-makers. The quoted prices are simply the best prices available.
Different sources will contain different amounts of information. A few of the more popular free websites available are bloomberg.com, marketwatch.com (free version of Wall Street Journal), morningstar.com, finance.google.com, and finance.yahoo.com. Bloomberg, Marketwatch, Morningstar, and now Yahoo Finance will pepper you with solicitations to enroll in their monthly subscription services. There are others. If you have any experience with any other free websites that you believe would be worthwhile to your fellow students, please contact us.