How Stocks Are Traded

Investment Snapshot

* Investors can trade stocks before and after the stock exchanges open and close for the day
* The spreads between the bid and ask price on a stock can be as low as 1 cent.
* With real-time quotes, prices of stocks are transparent.

THE STOCK EXCHANGES

A stock exchange is a marketplace where stocks of companies are bought and sold. The stock markets in the United States consist of the two major exchanges and an over-the-counter (OTC) market: the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), which have trading floors where stocks are traded, and the National Association of Securities Dealers Automated Quotations System (Nasdaq), which is an OTC market that trades primarily new, small-cap stocks of companies over telephone lines and computer networks. A public company lists its shares on one exchange by meeting the listing requirements of that particular exchange. Stocks listed on one exchange can be bought and sold on many exchanges, including the electronic computer networks (ECNs), which are Internet-only exchanges.

The stock markets have changed significantly because of advances in technology. The widespread use of personal computers and, more specifically, the Internet has given investors direct access to information that was unavailable previously. In addition, daily trading hours for investors have been lengthened. Whereas the stock markets were once open for trading only during specific hours, after-hours trading now takes place. The exchanges still close at the end of the official trading day (4:00 p.m., Eastern Standard Time), but after-hours trades transpire via ECNs before the market opens at 9:30 a.m. and after the market closes at 4:00 p.m. Eastern Standard Time (EST).

Trades on the NYSE are matched by specialists on the floor through open-outcry auction (see “Auction Market” later in this chapter), but the NYSE is moving toward allowing widespread automatic matching of buy and sell orders like its rival Nasdaq. One of the many advantages for investors using the Internet is that they can trade securities online without directly contacting a broker. Another advantage of the Internet is the greater stockpricing transparency offered. In other words, you can see the price that buyers and sellers are willing to settle on for a particular stock. The function of the security markets is to provide continuous and fair pricing. Buying and selling financial securities are auction processes. A specialist submits a bid price (the amount he or she is willing to pay), and a specialist submits an ask price (the amount at which he or she wants to sell). If these prices do not match, the bid and ask prices from other buyers and sellers are sought so that trades can be made.

Efficient markets provide up-to-date prices for certain securities. For stocks, you can get instantaneous prices through real-time pricing on the Internet or by calling your broker. You can easily obtain spreads between the bids and ask quotes for stocks. The spread is the difference between the bid and ask prices. The security markets in the United States are large, in that they have many buyers and sellers. The larger the number of buyers and sellers in a market, the more investors are assured of receiving fair pricing. Use of the Internet, along with the viewing of stock information on television stations (such as on CNBC and Bloomberg), has provided stock-price transparency, where investors can see changing prices from trade to trade, as well as the rapid transmittal of information that affects stock prices. In efficient markets, stock prices reflect all relevant information. Because stock prices in efficient markets reflect all relevant information, little likelihood exists that investors will trade their stocks at unfair prices.

The NYSE, also referred to as the “Big Board,” is the largest and the oldest stock exchange in the United States. It has the most stringent listing requirements. In addition to maintaining the requirements for listing on the exchanges, companies are expected to comply with certain regulations administered by the Securities and Exchange Commission (SEC), such as publishing quarterly and annual reports and releasing any information that affects the company’s ongoing operations. Companies that do not meet the listing requirements can be delisted. Generally, the largest, bestknown, and most financially secure companies that meet the listing requirements are listed on the NYSE.

When a buy or sell order is placed for a company listed on the NYSE, the broker or registered representative transmits the order electronically to the floor of the exchange. The order is then taken to the trading post for that stock, where a specialist executes the order. The ticker tape reports executed transactions. You can watch the trades on the ticker tape, which is shown on television networks such as CNBC during the trading session. After you place an order to buy or sell shares, you receive a confirmation of your executed trade from your brokerage firm.

The AMEX has less stringent listing requirements than the NYSE and generally has the listings of younger, smaller companies. The exchange has added the trading of stock options, stock indexes, and exchange-traded funds (ETFs). The AMEX, like the NYSE, has a physical trading floor, whereas the Nasdaq is an electronic exchange. The AMEX uses a specialist system like the NYSE. A company can be listed on the NYSE or the AMEX as well as on a regional exchange.

Five regional exchanges (Philadelphia, Boston, Cincinnati, Chicago, and the Pacific Exchange) list the stocks of companies in their geographic areas that are not large enough to qualify for listing on the two larger exchanges. These exchanges also can dual-list the same company. For example, General Electric is listed on the NYSE and on several regional exchanges. The advantage of these regional exchanges is that local brokerage firms that do not have memberships on the NYSE have access to these dual-listed shares. The Pacific Exchange has given up its physical trading floor and has become an electronic communications network (ECN). An ECN is a privately owned trading network that matches investors’ buy and sell orders electronically. The Pacific Exchange accounts for a large percentage of the options traded. The Philadelphia Exchange trades in options, stock, bond, and currency indexes. If trades are not transacted on the NYSE or the AMEX, they can be routed to the regional exchanges in order to get better prices.

Anumber of companies that issue stocks to the public may not be listed on any of the exchanges described in this section for a variety of reasons. Rather, they are traded over-the-counter. The OTC market is linked by a network of computers and telephones and can include stocks listed on the NYSE or the AMEX. The most actively traded issues are listed on the Nasdaq. The least actively traded issues that do not meet the listing requirements trade on the OTC Bulletin Board. These thinly traded stocks tend to be those of companies that may be more speculative with regard to their future survival. Astockbroker can provide the bid and ask prices for these bulletin board stocks by entering a company’s code into the Nasdaq computer system. Many large, reputable companies, such as Intel, Microsoft, Cisco, and Dell, have chosen to remain on the OTC market rather than move up to the AMEX or the NYSE. The listing fees are lower on the OTC market, which is another reason why a majority of the companies listed there are small-cap companies.

In the OTC, orders are executed differently from the way they are executed on the exchange floor. A customer’s order to buy is sent to the trading desk of the brokerage firm. From there, a trader at the brokerage firm contacts market makers (in the case of an OTC stock) or dealers (for a stock exchange–listed stock) in that stock to determine the lowest ask price. Market makers are the firms that buy stocks for or sell stocks from their own inventories. A markup is added to the ask price; you can determine this amount from the stock listings in the Nasdaq National Market Issues in the newspaper or online. Similarly, whenever a stock is sold, an amount called a markdown is subtracted from the bid price. In OTC trades, a brokerage firm cannot charge a commission and also act as the market maker. The brokerage firm has to choose between charging a commission and earning a markup or markdown. Market makers or dealers buy and sell securities for and from their own accounts.

Some structural flaws in the Nasdaq trading system encouraged the growth of ECNs. Not a single clearinghouse for OTC trades existed, so buy and sell orders were not always available to interested parties. This lack of centralization led to the charging of high spreads, which resulted in a $1 billion fine against the Nasdaq in 1997. In 1997, the SEC allowed ECNs to display their orders on the Nasdaq electronic trading bulletin board along with the orders of Nasdaq market makers in a system known as level 2 quoting. Level 2 quotes are bid and ask prices provided by all market makers of securities carried on the Nasdaq system.

ECNs provide individual and institutional investors with alternative trading systems. ECNs match trades (buy and sell orders) electronically and have increased their trading volume by lowering spreads. Trading on ECNs is advantageous for large institutional investors who want to trade large blocks of shares. If these institutional investors used the Nasdaq market makers (or the exchanges), the general investing public would see their trades, and the stock prices would change based on that knowledge. ECNs allow these institutional investors to trade their stocks anonymously. ECNs also allow individual investors to trade stocks before the stock market opens for the day and after the stock market has closed for the day.

The diversion of trades from the Nasdaq to the ECNs reduces Nasdaq’s revenue in that it cannot resell the quotes and trade data to brokers and investors (McNamee, 2002, p. 81). Sustained competition between the Nasdaq and the ECNs can only produce better prices for investors.

The NYSE acquired the ECN Archipelago in April 2005, which allowed the NYSE to broaden its position in options and futures markets, as well as being able to compete with the automated transaction market for Nasdaq-listed stocks and ETFs. Foreign stock exchanges list and trade the stocks of their respective markets. Financial newspapers and online financial Web sites, such as Yahoo!, quote the prices of the most actively traded foreign companies listed on the major European, Asian, Australian, South African, and Canadian exchanges (foreign exchanges).

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