How Stocks Trade

In order to understand how stocks trade, you should be familiar with the concept of a stock exchange. The purpose of a stock market is to link buyers and sellers. Simply put, a stock exchange is a place where people can buy and sell shares. These are of two types, physical exchange and virtual exchange; the names indicate their types and the difference between them.

Physical Exchange

A physical exchange is a place where the trading of stocks takes place on a trading floor by the open outcry system. You must have seen images of a physical exchange on TV, or, in the movies showing people wildly throwing up their arm, talking on the phones, waving or gesturing wildly at each other. The best example of a physical exchange is the New York Stock Exchange (NSYE). Brokerage firms that are members of the exchange, place orders for stocks and these are then passed on to floor brokers who are present on the trading post on the floor. The job of these floor brokers is to match buyers and sellers. Prices of the stocks are determined by auction; the highest price at which a person is willing to buy and the lowest price at which another is willing to sell. Once the transactions are complete, the floor brokers send the details to the brokerage firm they represent.

Apart from the NYSE, there are other important exchanges located in all countries across the world. The third largest exchange in the US is the American Stock Exchange (AMEX).The other two financial exchanges are the London Stock Exchange in London and the Hong Kong Stock Exchange in Hong Kong.

Virtual Exchange

In virtual market, exchange of securities between buyers and sellers takes place on an electronic medium, the internet and a network of computers. The most popular example of a virtual exchange, also known as an over-the-counter market (OTC), is the NASDAQ. Since there is no central location, trading is conducted through a telecommunication network of dealers. The NASDQ and other over-the-counter markets, don’t meet the listing requirements of any of the regulated markets. The transactions are carried out through brokerages who are the market makers. They continuously bid and ask prices within a prescribed percentage for the shares they are designated to trade in. In this process, they may match buyers and sellers, or, maintain an inventory of shares for the investors.

Primary Market and Secondary Market

In order to trade in stocks, you should also be able to differentiate between the primary market and the secondary market. In the primary market, companies create fresh issues of shares through the IPOs. In other words, while primary market is meant for purchasing new securities directly from the issuer, the secondary market is the place where investors can buy and sell pre-issued shares directly without any involvement of the issuing company. So, when people talk about a stock market, they are actually referring to a secondary market.