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Section 3: Understanding Trading, Customer Accounts and Prohibited Activities (31% of SIE Exam)

This section is about how you place orders, how your account is set up, and the strict rules that brokers must follow.

1. How Trading Works: Orders and Settlement

When you want to buy or sell a stock, you don't just yell "Buy!" into the void. You place specific types of "Orders".

  • Market Order: You tell your broker, "Buy this stock right now at whatever the current price is." This guarantees the trade will happen immediately, but it doesn't guarantee what price you will pay.
  • Limit Order: You tell your broker, "I only want to buy this stock if the price drops to $50." This guarantees the price you pay, but it does NOT guarantee the trade will ever happen (if the stock never drops to $50, you don't get it).
  • Stop Order: Often used to protect profits or limit losses. You tell your broker, "If the stock falls to $40, sell it." Once the stock hits $40, the order turns into a Market Order and executes immediately.
  • Stop-Limit Order: Similar to a stop order, but once the trigger price is hit, it turns into a Limit Order instead of a Market Order.

Trade Settlement

When you execute a trade, the ownership of the stock doesn't change hands the very same second.

  • T+1 Settlement: As of May 2024, regular-way settlement for U.S. equities occurs one business day after the trade date (T+1). If you buy stock on Monday, you must pay for it by Tuesday, and ownership officially transfers on Tuesday.
  • Cash Settlement: A less common arrangement where the trade settles on the exact same day it is executed (T+0).

2. Types of Customer Accounts

Before you can trade, you have to open an account with a broker.

  • Cash Account: Very simple. If you want to buy $500 of stock, you must have $500 of cash in your account. No borrowing allowed. Retirement accounts (like IRAs) and accounts for minors must be cash accounts.
  • Margin Account: Think of this like a credit card for stocks. You can borrow money from your broker to buy more stock than you actually have cash for. It magnifies your gains, but it also magnifies your losses. It is very risky.
    • Regulation T: Set by the Federal Reserve, this requires you to deposit at least 50% of the purchase price when buying on margin.
    • Minimum Maintenance: FINRA requires that your account equity never falls below 25% of the total market value of the securities. If it does, you get a "margin call" and must deposit more cash immediately.
  • Joint Account: An account owned by two or more people.
    • JTWROS (Joint Tenants with Right of Survivorship): If one owner dies, the other owner gets 100% of the account automatically.
    • TIC (Tenants in Common): If one owner dies, their share of the account goes to their estate (their heirs), not the other owner.
  • Discretionary Account: An account where the customer has given the broker written permission to make trading decisions (what to buy, how much, and when) without asking the customer first.

Retirement Accounts

  • Traditional IRA: Funded with pre-tax dollars (you get a tax deduction now). The money grows tax-deferred, and you pay ordinary income tax on withdrawals in retirement. Required Minimum Distributions (RMDs) must begin at age 73.
  • Roth IRA: Funded with after-tax dollars (no tax deduction now). The money grows tax-free, and qualified withdrawals in retirement are completely tax-free. There are no RMDs during the owner's lifetime.
  • 529 College Savings Plan: Used for education. Funded with after-tax dollars, but qualified withdrawals (for tuition, books, etc.) are tax-free.

3. Anti-Money Laundering (AML) and Account Documentation

Broker-dealers are on the front lines of stopping financial crimes.

  • Bank Secrecy Act (BSA): The primary law against money laundering.
  • Currency Transaction Report (CTR): Must be filed within 15 days anytime a customer deposits or withdraws more than $10,000 in cash in a single day. It doesn't matter if the transaction is suspicious; if it's over $10,000, a CTR is required.
  • Suspicious Activity Report (SAR): Must be filed within 30 days if a firm detects suspicious activity involving $5,000 or more. (E.g., a customer trying to deposit $9,000 on Monday and $2,000 on Tuesday to avoid the $10,000 CTR limit — a practice called "structuring").

4. Prohibited Activities (What you CANNOT do)

The financial industry is heavily regulated to prevent cheating.

  • Insider Trading: Trading stocks based on material, non-public information.
  • Market Manipulation: Trying to artificially pump up or crash a stock's price.
    • Pump and Dump: Spreading false rumors to drive up a cheap stock's price, then selling your shares before the crash.
    • Marking the Close: Buying or selling large amounts of stock right before the market closes at 4:00 PM to artificially influence the final closing price.
  • Commingling: A broker is never allowed to mix their personal money with a customer's money.
  • Front-Running: A broker gets a massive order from a client that will push the stock price up. Before executing the client's order, the broker buys the stock for their own personal account to make a quick profit. Highly illegal.
  • Selling Away: A registered rep sells securities to a client outside of their broker-dealer's oversight without permission. (E.g., selling your client shares in your buddy's startup without telling your firm).
  • Churning: A broker excessively trades a customer's account purely to generate commission fees, ignoring what is actually best for the customer.

Key Terms Glossary

  • Margin: Borrowed money used to purchase securities.
  • Market Order: An order to buy or sell immediately at the best available current price.
  • Front-Running: The illegal practice of a broker executing trades for their own account before filling a customer's large order.
  • Structuring: The illegal act of breaking up large cash deposits into smaller ones under $10,000 to avoid triggering a CTR.

Mini-Quiz

Q1. A customer wants to buy 100 shares of XYZ stock but ONLY if they can get it for $30 or less. What type of order should they place?

  1. Market Order
  2. Limit Order
  3. Margin Order

Answer: B. A limit order sets a maximum price the buyer is willing to pay.

Q2. A broker overhears the CEO of a company in a restaurant saying they are going bankrupt tomorrow. The broker immediately sells all their clients' shares in that company. What violation occurred?

  1. Commingling
  2. Insider Trading
  3. Front-Running

Answer: B. The broker traded on material, non-public information.

Q3. If a customer deposits $12,000 in physical cash into their brokerage account, what must the firm file?

  1. SAR within 30 days
  2. CTR within 15 days
  3. Form U4 within 10 days

Answer: B. Cash transactions over $10,000 trigger a Currency Transaction Report (CTR) within 15 days.