Question

Please answer the following questions:

1. Describe the differences among the following three types of orders: market, limit, and stop loss.
2. What is a short sale?
3. Describe buying on margin.
4. Why is it illegal to trade on insider information?

Answer 1

A market order does not specify the price of the order. It will execute the order at the best price available at the time of placing the order. A market order ensures guarantee of execution, but uncertainty of price.

A limit order specifies the price at which the order should be executed. The order will be executed only if the specified price is available. A limit order ensures certainty of price, but no guarantee of execution

A stop loss order specifies a trigger price at which the order should be executed. If the stock price hits the trigger price, the order will be executed. A stop-loss order can be a stop-loss market order or a stop-loss limit order. In a stop-loss market order, if the stock price hits the trigger price, the order is executed as a market order. In a stop-loss limit order, if the stock price hits the trigger price, the order is placed as a limit order.

A short sale is a security is sold without being owned. In effect, the short seller borrows the securities from another market participant, and sells the securities. At the time of closing the short sale, the short seller buys the securities in the market and returns the required number of securities to the original lender. A short seller will profit if the price of the securities decreases during the holding period of the short sale. They will suffer a loss if the price of the securities increases during the holding period of the short sale.

Buying on margin is a form of leverage. It involves putting up a margin amount, which is quoted as a percentage, to buy securities. For example, for a security with 20% margin, only 20% of the price needs to be provided by the buyer to buy the security. If the price of the security falls such that the 20% margin is depleted, the broker will make a "margin call" to the trader to deposit more funds into the margin account. If the traders fails to do so, the broker may sell the securities.

Insider information is governed by a lot of rules, regulations and laws that prohibit insiders from trading on that information. This is because insiders such as managers, directors, auditors, employees etc. have better access to information regarding the company. Trading on the basis of such information gives an unfair advantage to the insiders, and an unfair disadvantage to non-insiders. Insider information can also be used to manipulate stock prices. It violated the free and fair market for the stock. Hence it is illegal .