Now that we have some working knowledge about what a stock is and how it functions let’s discuss how it is traded. The stock market is one of the most often discussed things in everyday financial life. To this day in discussions with my aging father he sometimes makes the comment “Did you see what the market did today?” The U.S. stock market is half of the size of the U.S. bond market. So why does the stock market get all of the glory, media attention, and yelling pundits? It gets this following because it is the place where people can go from rags to riches (or vice versa) very quickly, or to be blunt it’s exciting. You will see that much of the stock market is very jargon heavy so at any point remember that the definitions of the terms can be found at the post in case you need a quick refresher. So what are the mechanics of this wondrous machine?
- The primary market is the market where new securities are sold to investors. The secondary market is the market in which securities are traded are among investors.
- Stocks are traded on both organized exchanges and Over-the-Counter (OTC) exchanges with differences between the two.
- Brokers and dealers are two types of agents in markets who provide liquidity and help the market function.
Primary vs. Secondary Market
When people discuss the stock market there is an important distinction to be made. The primary market refers to the market for stocks in which companies first offer their stock. The everyday investor will interact with this area of the stock market most commonly with the situation known as an Initial Public Offering (IPO). An IPO takes place when a company that has previously not sold stock (known as a private company) decides to sell stock on the open market. Some well-known companies that have undergone IPOs in recent years include Twitter, Facebook, and LinkedIn. By undergoing IPOs these companies transformed from private companies to public companies. A company may later issue another “batch” of stock in a process known as a seasoned equity offering (SEO). The entire process of an IPO or SEO requires the use of a specialized financial firm called an investment bank and involves many complex steps which I will not delve into in this lesson. Suffice to say the everyday investor will interact much more commonly with the secondary market as IPOs are not a frequent occurrence
The secondary market is where previously issued securities are traded between investors. Say you still have DixinStuff stock and believe that the company will perform poorly in the future. You desire to get rid of the stock before its price in the market decreases as a result of this poor performance. As obvious as it may seem if you had no means to interact with investors, you would have no means of selling off this stock. Thus the need for the secondary stock market emerged. The secondary market is where buyers and sellers of stock exchange their stock. What is an interesting fact to remember is that if someone is buying that share of DixinStuff from you, the buyer believes the stock will increase in value while you believe it will decrease! Who is right and who is wrong? Time alone knows the answer.
Organized Exchanges vs. Over-the-Counter Markets
So we know there needs to be some place or location where investors can trade stocks relatively quickly. Enter the need for organized exchanges and Over-the-Counter (OTC) markets to facilitate this. The largest and most well-known organized stock exchange is the New York Stock Exchange (NYSE). Other major organized exchanges include the Nikkei in Tokyo and the London Stock Exchange in London. In contrast to these exchanges are the Over-the-Counter (OTC) market the most well-known and active being the NASDAQ (National Association of Securities Dealers Automated Quotation System) Now I know what you are thinking “What is the difference between an organized stock exchange and an OTC market?” There are two main differences.
- An organized exchange like the NYSE has a physical, brick-and-mortar location where you can go visit. AN OTC market is a purely electronic network where trades are done via telecommunication devices.
- The market in an organized exchange (NYSE) is primarily driven by floor traders who represent different brokerage firms and process buy and sell orders. Thus you could say an organized exchange is broker driven. An OTC market is primarily driven by “market makers” who are dealers who acquire an inventory of stocks and buy and sell at different prices to earn a profit. Thus the OTC market is dealer driven.
Brokers vs. Dealers
I made mention of both of these types of positions in the prior section without fully explaining them.
A broker is simply an agent whose job it is to match up a buyer and a seller of an asset. Think of a broker as a real estate agent. The agent does not own the house he/she only assists in the buying or selling of the house. Brokers make their profits on commission on the deals they make. Thus brokers provide liquidity to the stock markets. When you as an investor begin investing you will probably employ an online brokerage agency who will facilitate the trades you wish to make.
In contrast a dealer is an agent who maintains an inventory of assets and sells and buys the assets at different prices to make a profit. Think of a dealer as a fruit vendor who buys and sells different types of fruit while maintaining a constant inventory. The price a dealer sells an asset is commonly called the ask price whereas the price a dealer will buy an asset is referred to as the bid price. A dealer attempts to make a profit by “buying low and selling high.” By creating a small market for certain stocks a dealer also provides liquidity to the stock markets.
So there’s some of the simple mechanics of the stock market. As you will see in the coming lessons some of the features discussed here extend to nearly all markets, including the bond market.
- Primary market: The market in which securities are first sold to investors.
- Secondary market: The market in which previously issued securities are sold between investors
- Initial Public Offering (IPO): A procedure in which a company issues stock on an exchange allowing the investing public to buy shares
- Public company: A company whose stock is traded on an exchange.
- Private company: A company whose stock is not traded on an exchange.
- Organized exchange: A market with a physical location where trading takes place.
- Over-the-Counter (OTC) market: A market without a physical location where trading takes place
- Broker: An agent who provides liquidity to a market by matching buyers and sellers.
- Dealer: An agent who provides liquidity to a market by maintaining an inventory and buying and selling assets.