Secondary Markets and How Securities are Traded

After new stocks have been sold, investors can trade them on the secondary markets. The company (original issuer of the securities) does not receive any proceeds on these trades. Instead, the trades are made between the buyers and sellers of the securities. The secondary markets are important for providing not only liquidity and fair pricing for securities but also a baseline for the pricing of new issues and IPOs.

How Stocks Are Traded

Individual investors place their orders for stocks through their brokers, who buy and sell stocks for their investors. These orders can be filled in two major trading systems: the auction market and the dealer market.

Auction Market

An auction market is a centralized location where bid and ask prices are given for stocks. Bid and ask prices are matched by specialists and floor brokers in an open-outcry auction; shares with the lowest ask price are bought from investors, and shares with the highest bid prices are sold to investors. This process takes place on the NYSE and the AMEX. A specialist is a member of an exchange who makes a market in one or more of the securities listed on the exchange.

An example best illustrates the process of order execution on the NYSE. Suppose that you are an interested in buying 200 shares of Home Depot, Inc. You call your broker for a quote or go online for this information. The bid price is $34.90 per share, and the ask price is $34.91 per share. The bid means that the specialist is willing to buy Home Depot shares at $34.90 per share, and the ask means that the specialist is willing to sell Home Depot shares at $34.91 per share. The spread is $0.01 per share. On the NYSE, the Home Depot specialist makes a market in the stock.

You then decide to buy 200 shares of Home Depot at the market price. The transaction should be close to the $34.91 price per share if you place the order immediately after receiving the quote and if the market price of Home Depot does not fluctuate widely.

Your broker fills out a buy order (or you fill out an online order), which is transmitted electronically to the floor of the exchange. Figure 7–1 provides an example of an online buy-sell order. There, the floor broker (member of an exchange who executes orders on the exchange floor) takes the order to the Home Depot trading post to execute the buy order, from either another floor broker who has a sell order for 200 Home Depot shares or the specialist. When your order is executed, the brokerage firm mails or e-mails you a confirmation that the order has been executed.

Specialists are allowed to trade the assigned stocks in their own accounts and to profit from those trades. However, specialists are required to maintain a fair and orderly market in stocks assigned to them. For example, specialists are not allowed to compete with customers’ orders. If a customer places a market order to buy, the specialist cannot buy for his or her own account ahead of the unexecuted market order. Similarly, specialists cannot sell from their accounts ahead of unexecuted market orders to sell. The purpose of allowing specialists to act as traders is to minimize the effects of imbalances in the supply and demand of assigned stocks. Specialists are prohibited by law from manipulating stock prices. Even though the SEC monitors the trading activities of specialists and ensures that they follow its numerous rules, maintaining an orderly market, along with the profit motivations of the specialist, means stepping into a gray area. The reputation of the NYSE was tarnished by trading abuses of specialists and floor brokers on the exchange floor who traded stocks ahead of investors’ orders for their own profit in 2003. A useful Web site providing basic information on the markets and how those markets work is www.pathtoinvesting.org.

Dealer Market

In a dealer market, dealers make markets in stocks from their inventories by using a computerized system. Numerous dealers can provide both bid and ask prices for the same stock. This form of trading takes place in the Nasdaq system for OTC trades. The NASD implemented the Nasdaq, which allows subscribing brokerage firms to obtain price quotations on stocks in the system.

Figure 7-1
A Typical Online Order Ticket


When buying or selling an OTC stock, you place an order with a brokerage firm. That order is sent to the brokerage firm’s trading department, which then shops among that stock’s market makers for the best price. To serve the needs of different brokerage firms, the Nasdaq provides three levels of quotes:

Level 1. This basic level provides a single quote for each stock. The price is updated continuously.
Level 2. This level provides instantaneous quotes (bid and ask prices) for Nasdaq stocks from all the different market makers. Abrokerage firm takes an investor’s order for a particular stock to find the best price (the lowest ask price if the investor is buying and the highest bid price if the investor is selling) from those quotes.
Level 3. This level, for market makers and dealers, provides level 2 quotes and the capacity to change those quotes.

Many criticisms have been leveled at the potential conflict of interest between market makers and dealers regarding execution of trades on the OTC market. That brokerage firms can act simultaneously as agents for their customers and self-interested dealers might be a conflict of interest. Acting as an agent, a broker should find the best price for customers. This responsibility becomes blurred when the agent’s brokerage firm is also looking to profit from the deals it makes. You have no need to look for more competitive prices if your brokerage firm can fill your order as a market maker and thereby fulfill its profit objective.

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