Basics: How Stocks Trade
stocks are traded on exchanges, which are places
where buyers and sellers meet and decide on
a price. Some exchanges are physical locations
where transactions are carried out on a trading
floor. You've probably seen pictures of a trading
floor, in which traders are wildly throwing
their arms up, waving, yelling, and signaling
to each other. The other type of exchange is
a virtual kind, composed of a network of computers
where trades are made electronically.
The purpose of a stock market is to facilitate
the exchange of securities between buyers and
sellers, thus reducing the risks of investing.
Just imagine how difficult it would be to sell
shares if you had to call around the neighborhood
trying to find a buyer. Really, a stock market
is nothing more than a super-sophisticated farmers
market linking buyers and sellers.
Before we go on, we should distinguish between
the "primary" market and the "secondary"
market. The primary market is where securities
are created while, in the secondary market,
investors trade previously-issued securities
without the involvement of the issuing-companies.
The secondary market is what people are referring
to when they talk about "the stock market."
It is important to understand that the trading
of a company's stock does not directly involve
that company. To learn more about this, see
our article entitled "Where Securities
York Stock Exchange
prestigious exchange in the world is the New
York Stock Exchange (NYSE). The "Big Board"
was founded over 200 years ago in 1792 with
the signing of the Buttonwood Agreement by 24
New York City stockbrokers and merchants. Currently
the NYSE, with stocks like General Electric,
McDonald's, Citigroup, Coca-Cola, Gillette,
and Wal-mart, is the market of choice for the
largest companies in America.
The NYSE is the first type of exchange (as we
referred to above), where much of the trading
is done face-to-face on a trading floor. This
is also referred to as a "listed"
exchange. Orders come in through brokerage firms
that are members of the exchange and flow down
to floor brokers who go to a specific spot on
the floor where the stock trades. At this location,
known as the trading post, there is a specific
person known as the "specialist" whose
job is to match buyers and sellers. Prices are
determined using an auction method: the current
price is the highest amount any buyer is willing
to pay and the lowest price at which someone
is willing to sell. Once a trade has been made,
the details are sent back to the brokerage firm,
who then notifies the investor who placed the
order. Although there is human contact in this
process, don't think that the NYSE is still
in the Stone Age; computers do play a huge role
in the process.
type of exchange is the virtual sort called
an over-the-counter (OTC) market, of which the
Nasdaq is the most popular. These markets have
no central location or floor brokers whatsoever.
Trading is done through a computer and telecommunications
network of dealers. It used to be that the largest
companies were listed only on the NYSE while
all other "second tier" stocks traded
on the other exchanges. The tech boom of the
late 90s changed all this; now the Nasdaq is
home to several big technology companies such
as Microsoft, Cisco, Intel, Dell, and Oracle.
This has resulted in the Nasdaq becoming a serious
competitor to the NYSE. On the Nasdaq brokerages
act as "market makers" for various
stocks. A market maker provides continuous bid
and ask prices within a prescribed percentage
spread for shares for which they are designated
to make a market. They may match up buyers and
sellers directly but usually they will maintain
an inventory of shares to meet demands of investors.
We won't get into the process here since we
cover this in detail in our tutorial entitled
"Electronic Trading and Market Makers."
largest exchange in the U.S. is the American
Stock Exchange (AMEX). The AMEX used to be an
alternative to the NYSE, but that role has since
been filled by the Nasdaq. In fact, the National
Association of Securities Dealers (NASD), which
is the parent of Nasdaq, bought the AMEX in
1998. Almost all trading now on the AMEX is
in small-cap stocks and derivatives.
There are many stock exchanges located in just
about every country around the world. American
markets are undoubtedly the largest and thus
most important, but they still represent only
a fraction of total investment around the globe.
The two other main financial hubs are London,
home of the London Stock Exchange, and Hong
Kong, home of the Hong Kong Stock Exchange.
We've got a complete list of exchanges from
around the world here.
The last place worth mentioning is the over-the-counter
bulletin board (OTCBB). The Nasdaq technically
is an over-the-counter market, but the term
commonly refers to small public companies that
donít meet the listing requirements of any of
the regulated markets, including the Nasdaq.
The OTCBB is home to penny stocks because there
is little to no regulation. This makes investing
in an OTCBB stock very risky. You really need
to know what you're doing here or you'll get
burnt! Chances are, if you're reading this tutorial
you don't want even to consider the OTCBB.