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Difficulty: Very hardTypes of Orders and Order Execution Strategies

An investor holding a short position in a volatile equity security currently trading at 52.00persharewishestohedgeagainstsignificantupsidepricerisk.However,theinvestorwantstoensurethatifthehedgeistriggered,thebuytransactionwillnotbeexecutedatapricehigherthan52.00 per share wishes to hedge against significant upside price risk. However, the investor wants to ensure that if the hedge is triggered, the buy transaction will not be executed at a price higher than 57.00. The investor enters a Good-Til-Canceled (GTC) Buy Stop 55.00, Limit 57.00 order. The following morning, due to an unexpected positive earnings surprise, the stock gaps up and opens at 58.50pershare,tradingthroughoutthedaybetween58.50 per share, trading throughout the day between 58.00 and $60.00. Which of the following best describes the status and execution of the investor's order?

  1. The order was activated when the market opened at 58.50,turningintoanactivebuylimitorderat58.50, turning into an active buy limit order at 57.00, but it remains unexecuted because the market price never fell to or below the $57.00 limit price.Answer
  2. B
    The order was executed immediately at the opening price of 58.50becauseonceactivatedbyatradeabove58.50 because once activated by a trade above 55.00, a stop order guarantees an immediate market execution.
  3. C
    The order was automatically canceled by the trading system at market open because the opening price gap of $58.50 bypassed both the stop trigger and limit price.
  4. D
    The broker-dealer must fill the order from its proprietary inventory at $57.00 under FINRA best execution rules to protect the customer from market gap risk.

Answer

The order was activated when the market opened at 58.50,turningintoanactivebuylimitorderat58.50, turning into an active buy limit order at 57.00, but it remains unexecuted because the market price never fell to or below the $57.00 limit price.
A Buy Stop-Limit order operates in two distinct phases: activation and execution. The activation trigger for a Buy Stop is a market price at or above the stop price (55.00).Whenthestockopensat55.00). When the stock opens at 58.50, the stop trigger is satisfied, and the order immediately transforms into a Buy Limit order at 57.00.ABuyLimitorderinstructsthebrokertobuyonlyatthelimitpriceorlower(57.00. A Buy Limit order instructs the broker to buy only at the limit price or lower ( 57.00 or better). Since the stock trades strictly between 58.00and58.00 and 60.00 throughout the day, the market price never reaches $57.00 or lower. Consequently, the order remains active and unexecuted on the order book.

Step-by-Step Solution

1
Analyze the components of the order entered by the investor.
The order is a Buy Stop-Limit with a stop price of 55.00andalimitpriceof55.00 and a limit price of 57.00.
Understanding the two-stage execution mechanic of a stop-limit order is required to evaluate trigger vs. execution conditions.
2
Determine if and when the stop trigger condition is met.
A buy stop triggers when the market price rises to or above the stop price. The stock gap-opened at 58.50,whichisabove58.50, which is above 55.00.
The opening price of $58.50 satisfies the activation threshold, converting the stop order into a live limit order.
3
Evaluate the execution criteria for the resulting limit order.
The resulting order is a Buy Limit at 57.00.Abuylimitordercanonlybeexecutedat57.00. A buy limit order can only be executed at 57.00 or lower.
Because prevailing market prices during the trading day ranged between 58.00and58.00 and 60.00, the market price was higher than the limit price, preventing execution.

Key Concept

Two-Stage Execution of Stop-Limit Orders and Limit Price Constraints
Estimated Time:1m 30s
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Topics

Types of Orders and Order Execution Strategies