04 - Stock Basics: How Stocks Trade

Most 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 made on a trading floor. You've probably seen pictures of this where traders are wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of exchange is virtual, 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.

The New York Stock Exchange
The most prestigious exchange in the world is the New York Stock Exchange (NYSE). The "Big Board" was founded over 200 years ago with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants in 1792. Currently the NYSE is the market of choice for the largest companies in America with stocks like General Electric, McDonald's, Citigroup, Coca-Cola, Gillette, and Wal-mart all residing on the NYSE.
 

The trading floor of the NYSE
The NYSE is the first type of exchange 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" who's job is to match buyers and sellers. Prices are determined using an auction method, the price is the highest amount any buyer is willing to pay (and the lowest price someone is willing to sell at). 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.

The Nasdaq
The second 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 only listed on the NYSE with all other "second tier" stocks trading on the other exchanges. The tech boom of the late 90s changed all this because the Nasdaq is home to several big technology companies such as Microsoft, Cisco, Intel, Oracle, and Sun Microsystems. This has resulted in the Nasdaq being compared as a serious competitor to the NYSE.
 

The Nasdaq Marketsite in Times Square

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 in 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 as we cover this in detail in our tutorial entitled: Electronic Trading and Market Makers.

Other Exchanges
The third 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 still only represent 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 is commonly used for small companies that don't meet the listing requirements of any of the regulated markets, including Nasdaq. The OTCBB is home to penny stocks, the fact that there is little to no regulation makes investing an an OTCBB stock very risky. You really need to know what you're doing to invest here. Chance are, if you're reading this tutorial you don't want to even consider the OTCBB