When you buy or sell securities on your brokerage firm, it may seem instantaneous because all you see is the confirmation when your order gets filled.
However, in reality, a lot is happening in the background. Whenever you sell a stock, someone else is on the other side of the trade buying the stock. The time your order takes to get executed depends on many factors, including the type of order, trade settlement, clearing, liquidity, market capitalization, trading hours, etc.
We will go over everything that happens behind the scenes when you sell stocks so you can get a complete picture of what is going on when you make a trade.
- Settlement refers to the official transfer of assets to the buyer or money to the seller. As per SEC rules, settlement follows T+2, or the trade day plus two business days.
- There are three types of settlement violations: (1) good faith violations, (2) freeriding violations, and (3) liquidation violations.
- Common types of orders used by investors and traders include market orders, limit orders, stop orders, trailing stops, and take profit/stop-loss orders.
- Other factors to consider when selling stocks are market capitalization, liquidity, and trading hours.
Trade Settlement and Clearing
In the financial markets, settlement refers to the official transfer of securities to the buyer or cash to the seller. Settled funds may include incoming cash to your account, available margin borrowing value in a margin account, and settled sale proceeds of fully paid-for securities. Many investors assume that trades happen instantaneously, but the settlement process takes a few days to occur.
The Securities and Exchange Commission (SEC) requires settlement to occur over two business days after the day an order executes, or T+2 (trade date plus two days). In addition to stocks, the T+2 rule also applies to other securities, such as bonds, municipal securities, and mutual funds. For example, if you place a buy order for 20 shares of Apple stock on Wednesday, it would usually settle on Friday. Note that in your investment account, it may seem instantaneous.
With T+2, when you buy stocks, your brokerage firm must receive your payment no later than two business days after your trade gets executed. When you sell, your shares must get delivered to your brokerage firm within two business days. If you buy shares of Tesla on Tuesday, they would need to arrive in your investment account on Thursday. Likewise, your money would need to get delivered to the seller's account on Thursday.
T+2 may seem outdated in a world where most people complete trades electronically. However, we have to keep in mind that T+2 was established in the U.S. less than five years ago. Change takes time and resources!
Before 1995, U.S. settlement cycles were set to T+5 until they got shortened to T+3 later that year. In 2014, most European Union member states shortened their settlement cycles to T+2 while other Asian/Pacific regions were already on T+2 or T+1. That same year, the U.S. started considering moving to a shorter settlement cycle. But, the transition to T+2 did not get completed until September of 2017.
There are several benefits of T+2:
- T+2 functions as a risk reduction. It keeps the market orderly and efficient by limiting the possibility of investors and traders defaulting. If trades had no time limits to settle, buyers and sellers would get exposed to an unlimited amount of gain or loss potential before the trades get officially settled. When the market crashes, prolonged settlement times could lead to investors scrambling to pay for their trades.
- Most major global markets currently operate on T+2. With everyone operating under the same settlement cycle, that creates harmony across the world's markets.
- For dividend investors in particular, T+2 has important implications. If you want to receive dividend payments, you need to purchase the shares before the company's "ex-dividend" date. To ensure that you are an official shareholder of record, your trade must get settled at least two business days before the dividend date, which is also known as the record date.
Usually, clearinghouses work in the shadows of the financial markets. But, if you've been following the Gamestop saga that happened in January 2021, then you may have seen clearinghouses get mentioned in the news. To deflect the heat, Robinhood, Webull, E*Trade, and other brokerages blamed their clearinghouses and regulatory restrictions as the reason they halted trading for high-profile meme stocks.
So, what exactly is a clearinghouse?
A clearinghouse is a middleman, or third party, between a buyer and seller in a financial market. They validate and finalize transactions to ensure that both parties honor their contractual obligations when buying or selling securities. As a middleman, a clearinghouse will "clear" or finalize trades, settle trading accounts, report trading data, monitor the delivery of assets to buyers, and collect margin payments.
The role of clearinghouses is to stabilize financial markets by providing security and efficiency. Usually, a clearinghouse will take the opposite of each trade to reduce the cost and risk of settling multiple transactions among different parties. While their goal is to minimize risk, as both the buyer and seller of a trade, they face default risks from both sides. That is why clearinghouses often impose margin requirements.
When you make a new trade without settled funds, you could be subject to a stock settlement violation. Though most settlement violations occur in cash accounts, there are a few occasions when they can occur in margin accounts.
Good Faith Violation
A good faith violation occurs when you buy a stock with unsettled funds and attempt to sell it before your funds settle.
For example, let's say you sell 50 shares of Square at $45 for a total of $2,250.
Your profits will take two business days to settle (T+2), but you decide to invest all of it into Microsoft on the same day.
The next day, you sell all your Microsoft shares for $2,500 - one day before your Square trade settles.
In this scenario, you've committed a good faith violation because you bought Microsoft shares using unsettled funds from your sale of Square shares, and then sold your Microsoft shares before the Square proceeds were settled.
Usually, your brokerage firm will send you a notification if you make a good-faith violation for the first time, but not restrict your account. If you have two to four violations within one year, your firm may put a 90-day settled-cash restriction on your account. This restriction limits your trades to settled funds only. If you commit a fifth violation (of any kind), you may be restricted to settled cash permanently. However, the rules can vary between different brokerages.
A freeriding violation occurs when you buy a security in a cash account that doesn't have enough settled funds to cover the purchase, and then sell the same security before you deposit the funds required to pay for your purchase. This violation can occur if you purchase and sell a security either on the same day or on different days.
For example, let's say you have $300 of settled cash in your account.
You buy $2,000 of Enphase stock. The remaining $1,700 needed to cover your trade is due by the settlement date on T+2.
You sell your Enphase shares for $2,200 the next day, but you have not deposited the outstanding $1,700 you owe.
In this situation, you've committed a freeriding violation by selling stock before paying for the purchase in full.
With freeriding violations, industry regulations require your brokerage firm to freeze your account for 90 days and restrict your trading to settled funds only. Most firms will not waive this restriction. But, if you deposit the required funds within the payment period, your brokerage may downgrade the violation to a good faith violation.
There are two types of liquidation violations, which are based on trade dates instead of settlement dates:
- Cash liquidation violations
- Margin liquidation violations
A cash liquidation violation is very similar to a freeriding violation, but there is a difference with the security sold. Cash liquidation violations occur when an investor sells a security and uses the profits to pay for the purchase of a different security you previously bought.
Let's say you have settled shares of Roku and $500 in settled cash.
You buy $1,500 of Square stock, which will need to get fully paid for using settled funds by the settlement date on T+2.
But, on T+2, you choose to sell some of your Roku shares instead of depositing the remaining $1,000 needed to pay for your Square.
As a result, you have committed a liquidation violation by selling your Roku shares on the settlement date for the Square purchase instead of depositing the money you owe. Instead, you should sell your Roku shares the same day you buy Square stock to meet your obligation.
A margin liquidation violation happens when an investor receives both a Fed call and a regulatory maintenance call in their margin account and decides to sell securities in that account to cover the calls.
- Regulation T (Reg T) requires investors to have an initial margin of at least 50%, though some brokerage firms may set higher requirements. That means investors must pay at least 50% of the security's costs upfront if they use margin. A Reg T margin call, or a federal (fed) margin call, gets triggered if an investor does not have enough capital to meet the minimum equity requirement. If an investor does not deposit enough money to meet the requirement, their brokerage firm can place a liquidation violation on their account.
- The Federal Reserve Regulation T sets a 25% maintenance margin after an investor makes the initial purchase, though some brokerages may require more. That means an investor must have at least 25% or more equity in their margin account at all times or risk a margin call. If a security in the account falls below a certain price and an investor is no longer able to meet the maintenance margin, they will receive a maintenance margin call. To satisfy the margin call, the investor must either deposit more money into their account or sell positions in their account.
The same consequences as the good faith violation will apply here.
Types of Orders
When I first started trading in the stock market, I only used market orders because that was the default option. However, now that I've done more research, I am aware of other types of orders and generally avoid market orders.
The order type you use will determine the time it takes for your trade to go through and what happens when you make a trade. For example, if you use a market order to buy Tesla stock, you are a price-taker, meaning you will purchase the shares at the current market price. If you use a limit order, you set a price to buy or sell a stock. However, the downside is that your order is not guaranteed to execute. If you set a price below or above the current market price, you may have to wait some time before your order gets filled.
Below are common types of orders used by investors and traders.
When you place a market order, you tell your brokerage to give you the best available price in the market. For most investors, this is the default option for buying and selling securities because market orders get filled nearly instantaneously. However, you cannot control the prices you receive because you are taking the current market price. Market orders are best for investors who want their orders executed immediately.
When you place a limit order, you instruct your brokerage to execute the trade at a specified price. If you are buying a stock, that means you will only enter a position if the stock price falls below the price you set. If you are selling stock, you will only sell if the stock price rises above your desired price. While this will guarantee a price point, your order may not get filled until the stock market reaches your set price.
As a primarily buy-and-hold investor, limit orders are my preferred order type. Whenever I buy stocks and cryptocurrencies, I look at the trendline to see where potential support areas or floors will be and set my limit orders to those prices. Note that if your limit order is set too low or high, there is a possibility that your order will take weeks or months to get filled or might never get filled at all.
When you place a stop order, you will buy or sell a security when its price moves past a certain point. The goal of a stop order is to set predetermined entry or exit positions to either limit your loss potential or lock in profits.
There are several types of stop orders:
- Buy-stop orders tell a brokerage firm to buy a security when it hits a predetermined price. Once the price reaches that level, the order becomes either a limit or a market order. A buy-stop order gets commonly used to protect investors against unlimited loss potential when they have an uncovered short position.
- Sell-stop orders tell a brokerage firm to sell a security at the market price when it falls below the stop price. In other words, if a stock's price falls within the designated stop price parameter, a market order will get triggered to sell the stock.
- Stop-loss orders tell a brokerage firm to buy or sell a security when it hits a specified price, also known as the stop price.
- Stop-market orders are a type of stop-loss order designed to limit potential losses. When a security reaches a specified price point for buying or selling, the stop order becomes a market order.
- Stop-limit orders combine the features of a stop-loss order and a limit order. They give traders and investors complete control over when their orders should get filled. But, like a limit order, there is no guarantee that the order will get executed.
A trailing stop is a modified version of a stop order and has the option of being either a limit order or market order. With a trailing stop, an investor sets defined percentages or dollar amounts away from a security's current market price. For long positions, investors will place a trailing stop loss at a price point below the current market price. For short positions, an investor will place a trailing stop at a price point above the current market price.
The goal of a trailing stop is to either lock in profits or limit potential losses. The order will only execute if the price moves favorably and does not move back in the other direction. Most investors will place a trailing stop at the same time they place the initial trade, but they can be placed afterward.
Take-profit orders are often used in conjunction with stop-loss orders. As its name implies, a take-profit order is a type of limit order that tells the brokerage firm to close an open position for a profit at a set price. If a stock rises to the take-profit point, the order will execute. If a stock falls to the stop-loss point, the order will execute.
With this strategy, investors and traders can better manage their risks. However, this strategy can cut into potential profits as well. That is why it gets commonly used by short-term traders rather than long-term investors.
Other Factors to Consider
A stock's market capitalization, or the overall value of a company, affects its liquidity. Larger companies, such as Apple, Amazon, and Microsoft, have higher market caps. Smaller companies, such as 1-800-FlOWERS.COM and Comfort Systems USA, have lower market caps.
Liquidity refers to the availability of assets in a given financial market. If a stock is highly liquid, you can buy or sell shares more quickly and easily. However, if a stock is illiquid, demand for the stock is weak, making it harder to sell the stock.
Each stock market has established market hours. The hours for the NYSE and the NASDAQ are 9:30 AM to 4 PM EST from Mondays to Fridays. However, individual brokerages may have pre-trading and extended trading hours available to their customers. For example, Webull allows trading from 4 AM to 8 PM EST. The trading hours determine when your orders can get executed. If you place an order outside these hours of operations, your trade will not get executed until the market opens.
The Bottom Line
Though the question we started out with is quite simple, there are many factors we need to take into consideration. We recommend taking some time to digest all this information, but don't wait too long!
The first step is always the hardest, but we hope that we've equipped you with enough knowledge to get started!