1. STOCK MARKET BASICS

1.1. Stock Market

1.1.1. What is the Stock Market?

The stock market refers to the collection of markets and exchanges where regular activities of buying, selling, and issuance of shares of publicly-held companies take place. Such financial activities are conducted through institutionalized formal exchanges or over-the-counter (OTC) marketplaces which operate under a defined set of regulations. There can be multiple stock trading venues in a country or a region which allow transactions in stocks and other forms of securities.

While both terms - stock market and stock exchange - are used interchangeably, the latter term is generally a subset of the former. If one says that she trades in the stock market, it means that she buys and sells shares/equities on one (or more) of the stock exchange(s) that are part of the overall stock market. The leading stock exchanges in the U.S. include the New York Stock Exchange (NYSE), Nasdaq, the Better Alternative Trading System (BATS). and the Chicago Board Options Exchange (CBOE). These leading national exchanges, along with several other exchanges operating in the country, form the stock market of the U.S. Though it is called a stock market or equity market and is primarily known for trading stocks/equities, other financial securities - like exchange traded funds (ETF), corporate bonds and derivatives based on stocks, commodities, currencies, and bonds - are also traded in the stock markets.

1.1.2. Understanding the Stock Market

While today it is possible to purchase almost everything online, there is usually a designated market for every commodity. For instance, people drive to city outskirts and farmlands to purchase Christmas trees, visit the local timber market to buy wood and other necessary material for home furniture and renovations, and go to stores like Walmart for their regular grocery supplies.

Such dedicated markets serve as a platform where numerous buyers and sellers meet, interact and transact. Since the number of market participants is huge, one is assured of a fair price. For example, if there is only one seller of Christmas trees in the entire city, he will have the liberty to charge any price he pleases as the buyers won’t have anywhere else to go. If the number of tree sellers is large in a common marketplace, they will have to compete against each other to attract buyers. The buyers will be spoiled for choice with low- or optimum-pricing making it a fair market with price transparency. Even while shopping online, buyers compare prices offered by different sellers on the same shopping portal or across different portals to get the best deals, forcing the various online sellers to offer the best price.

A stock market is a similar designated market for trading various kinds of securities in a controlled, secure and managed the environment. Since the stock market brings together hundreds of thousands of market participants who wish to buy and sell shares, it ensures fair pricing practices and transparency in transactions. While earlier stock markets used to issue and deal in paper-based physical share certificates, the modern day computer-aided stock markets operate electronically.

1.1.3. How the Stock Market Works

In a nutshell, stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence with zero- to low-operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and as secondary markets.

As a primary market, the stock market allows companies to issue and sell their shares to the common public for the first time through the process of initial public offerings (IPO). This activity helps companies raise necessary capital from investors. It essentially means that a company divides itself into a number of shares (say, 20 million shares) and sells a part of those shares (say, 5 million shares) to common public at a price (say, $10 per share).

To facilitate this process, a company needs a marketplace where these shares can be sold. This marketplace is provided by the stock market. If everything goes as per the plans, the company will successfully sell the 5 million shares at a price of $10 per share and collect $50 million worth of funds. Investors will get the company shares which they can expect to hold for their preferred duration, in anticipation of rising in share price and any potential income in the form of dividend payments. The stock exchange acts as a facilitator for this capital raising process and receives a fee for its services from the company and its financial partners.

Following the first-time share issuance IPO exercise called the listing process, the stock exchange also serves as the trading platform that facilitates regular buying and selling of the listed shares. This constitutes the secondary market. The stock exchange earns a fee for every trade that occurs on its platform during the secondary market activity.

The stock exchange shoulders the responsibility of ensuring price transparency, liquidity, price discovery and fair dealings in such trading activities. As almost all major stock markets across the globe now operate electronically, the exchange maintains trading systems that efficiently manage the buy and sell orders from various market participants. They perform the price matching function to facilitate trade execution at a price fair to both buyers and sellers.

A listed company may also offer new, additional shares through other offerings at a later stage, like through rights issue or through follow-on offers. They may even buyback or delist their shares. The stock exchange facilitates such transactions.

The stock exchange often creates and maintains various market-level and sector-specific indicators, like the S&P 500 index or Nasdaq 100 index, which provide a measure to track the movement of the overall market. The stock exchanges also maintain all company news, announcements, and financial reporting, which can be usually accessed on their official websites. A stock exchange also supports various other corporate-level, transaction-related activities. For instance, profitable companies may reward investors by paying dividends which usually comes from a part of the company’s earnings. The exchange maintains all such information and may support its processing to a certain extent.

1.1.4. Functions of a Stock Market

A stock market primarily serves the following functions:

Fair Dealing in Securities Transactions:

Depending on the standard rules of demand and supply, the stock exchange needs to ensure that all interested market participants have instant access to data for all buy and sell orders thereby helping in the fair and transparent pricing of securities. Additionally, it should also perform efficient matching of appropriate buy and sell orders.

For example, there may be three buyers who have placed orders for buying Microsoft shares at $100, $105 and $110, and there may be four sellers who are willing to sell Microsoft shares at $110, $112, $115 and $120. The exchange (through their computer operated automated trading systems) needs to ensure that the best buy and best sell are matched, which in this case is at $110 for the given quantity of trade.

Efficient Price Discovery:

Stock markets need to support an efficient mechanism for price discovery, which refers to the act of deciding the proper price of a security and is usually performed by assessing market supply and demand and other factors associated with the transactions.

Say, a U.S.-based software company is trading at a price of $100 and has a market capitalization of $5 billion. A news item comes in that the EU regulator has imposed a fine of $2 billion on the company which essentially means that 40 percent of the company’s value may be wiped out. While the stock market may have imposed a trading price range of $90 and $110 on the company’s share price, it should efficiently change the permissible trading price limit to accommodate for the possible changes in the share price, else shareholders may struggle to trade at a fair price.

Liquidity Maintenance:
While getting the number of buyers and sellers for a particular financial security are out of control for the stock market, it needs to ensure that whosoever is qualified and willing to trade gets instant access to place orders which should get executed at the fair price.
Security and Validity of Transactions:
While more participants are important for efficient working of a market, the same market needs to ensure that all participants are verified and remain compliant with the necessary rules and regulations, leaving no room for default by any of the parties. Additionally, it should ensure that all associated entities operating in the market must also adhere to the rules, and work within the legal framework given by the regulator.
Support All Eligible Types of Participants:
A marketplace is made by a variety of participants, which include market makers, investors, traders, speculators, and hedgers. All these participants operate in the stock market with different roles and functions. For instance, an investor may buy stocks and hold them for long term spanning many years, while a trader may enter and exit a position within seconds. A market maker provides necessary liquidity in the market, while a hedger may like to trade in derivatives for mitigating the risk involved in investments. The stock market should ensure that all such participants are able to operate seamlessly fulfilling their desired roles to ensure the market continues to operate efficiently.
Investor Protection:

Along with wealthy and institutional investors, a very large number of small investors are also served by the stock market for their small amount of investments. These investors may have limited financial knowledge, and may not be fully aware of the pitfalls of investing in stocks and other listed instruments. The stock exchange must implement necessary measures to offer the necessary protection to such investors to shield them from financial loss and ensure customer trust.

For instance, a stock exchange may categorize stocks in various segments depending on their risk profiles and allow limited or no trading by common investors in high-risk stocks. Derivatives, which have been described by Warren Buffett as financial weapons of mass destruction, are not for everyone as one may lose much more than they bet for. Exchanges often impose restrictions to prevent individuals with limited income and knowledge from getting into risky bets of derivatives.

Balanced Regulation:
Listed companies are largely regulated and their dealings are monitored by market regulators, like the Securities and Exchange Commission (SEC) of the U.S. Additionally, exchanges also mandate certain requirements – like, timely filing of quarterly financial reports and instant reporting of any relevant developments - to ensure all market participants become aware of corporate happenings. Failure to adhere to the regulations can lead to suspension of trading by the exchanges and other disciplinary measures.

1.1.5. Regulating the Stock Market

A local financial regulator or competent monetary authority or institute is assigned the task of regulating the stock market of a country. The Securities and Exchange Commission (SEC) is the regulatory body charged with overseeing the U.S. stock markets. The SEC is a federal agency that works independently of the government and political pressure. The mission of the SEC is stated as: “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

1.1.6. Stock Market Participants

Along with long-term investors and short term traders, there are many different types of players associated with the stock market. Each has a unique role, but many of the roles are intertwined and depend on each other to make the market run effectively.

  • Stockbrokers, also known as registered representatives in the U.S., are the licensed professionals who buy and sell securities on behalf of investors. The brokers act as intermediaries between the stock exchanges and the investors by buying and selling stocks on the investors’ behalf. An account with a retail broker is needed to gain access to the markets.
  • Portfolio managers are professionals who invest portfolios, or collections of securities, for clients. These managers get recommendations from analysts and make the buy or sell decisions for the portfolio. Mutual fund companies, hedge funds, and pension plans use portfolio managers to make decisions and set the investment strategies for the money they hold.
  • Investment bankers represent companies in various capacities, such as private companies that want to go public via an IPO or companies that are involved in pending mergers and acquisitions. They take care of the listing process in compliance with the regulatory requirements of the stock market.
  • Custodian and depot service providers, which are institution holding customers’ securities for safekeeping so as to minimize the risk of their theft or loss, also operate in sync with the exchange to transfer shares to/from the respective accounts of transacting parties based on trading on the stock market.
  • Market maker: A market maker is a broker-dealer who facilitates the trading of shares by posting bid and ask prices along with maintaining an inventory of shares. He ensures sufficient liquidity in the market for a particular (set of) share(s), and profits from the difference between the bid and the ask price he quotes.

1.1.7. How Stock Exchanges Make Money

Stock exchanges operate as for-profit institutes and charge a fee for their services. The primary source of income for these stock exchanges are the revenues from the transaction fees that are charged for each trade carried out on its platform. Additionally, exchanges earn revenue from the listing fee charged to companies during the IPO process and other follow-on offerings.

The exchange also earns from selling market data generated on its platform - like real-time data, historical data, summary data, and reference data – which is vital for equity research and other uses. Many exchanges will also sell technology products, like a trading terminal and dedicated network connection to the exchange, to the interested parties for a suitable fee.

The exchange may offer privileged services like high-frequency trading to larger clients like mutual funds and asset management companies (AMC), and earn money accordingly. There are provisions for regulatory fee and registration fee for different profiles of market participants, like the market maker and broker, which form other sources of income for the stock exchanges.

The exchange also makes profits by licensing their indexes (and their methodology) which are commonly used as a benchmark for launching various products like mutual funds and ETFs by AMCs.

Many exchanges also provide courses and certification on various financial topics to industry participants and earn revenues from such subscriptions.

1.1.8. Competition for Stock Markets

While individual stock exchanges compete against each other to get maximum transaction volume, they are facing threat on two fronts.

Dark Pools:
Dark pools, which are private exchanges or forums for securities trading and operate within private groups, are posing a challenge to public stock markets. Though their legal validity is subject to local regulations, they are gaining popularity as participants save big on transaction fees.
Blockchain Ventures:
Amid rising popularity of blockchains, many crypto exchanges have emerged. Such exchanges are venues for trading cryptocurrencies and derivatives associated with that asset class. Though their popularity remains limited, they pose a threat to the traditional stock market model by automating a bulk of the work done by various stock market participants and by offering zero- to low-cost services.

1.1.9. Significance of the Stock Market

The stock market is one of the most vital components of a free-market economy.

It allows companies to raise money by offering stock shares and corporate bonds. It lets common investors participate in the financial achievements of the companies, make profits through capital gains, and earn money through dividends, although losses are also possible. While institutional investors and professional money managers do enjoy some privileges owing to their deep pockets, better knowledge and higher risk taking abilities, the stock market attempts to offer a level playing field to common individuals.

The stock market works as a platform through which savings and investments of individuals are channelized into the productive investment proposals. In the long term, it helps in capital formation & economic growth for the country.

KEY TAKEAWAYS

  • Stock markets are vital components of a free-market economy because they enable democratized access to trading and exchange of capital for investors of all kinds.
  • They perform several functions in markets, including efficient price discovery and efficient dealing.
  • In the US, the stock market is regulated by the SEC and local regulatory bodies.

1.1.10. Examples of Stock Markets

The first stock market in the world was the London stock exchange. It was started in a coffeehouse, where traders used to meet to exchange shares, in 1773. The first stock exchange in the United States of America was started in Philadelphia in 1790. The Buttonwood agreement, so named because it was signed under a buttonwood tree, marked the beginnings of New York’s Wall Street in 1792. The agreement was signed by 24 traders and was the first American organization of its kind to trade in securities. The traders renamed their venture as New York Stock and Exchange Board in 1817.

1.2. A Look at Primary and Secondary Markets

The word “market” can have many different meanings, but it is used most often as a catch-all term to denote both the primary market and the secondary market. In fact, “primary market” and “secondary market” are both distinct terms; the primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors.

Knowing how the primary and secondary markets work is key to understanding how stocks, bonds, and other securities trade. Without them, the capital markets would be much harder to navigate and much less profitable. We’ll help you understand how these markets work and how they relate to individual investors.

KEY TAKEAWAYS

  • The primary market is where securities are created, while the secondary market is where those securities are traded by investors.
  • In the primary market, companies sell new stocks and bonds to the public for the first time, such as with an initial public offering (IPO).
  • The secondary market is basically the stock market and refers to the New York Stock Exchange, the Nasdaq, and other exchanges worldwide.

1.2.1. Primary Market

The primary market is where securities are created. It’s in this market that firms sell (float) new stocks and bonds to the public for the first time. An initial public offering, or IPO, is an example of a primary market. These trades provide an opportunity for investors to buy securities from the bank that did the initial underwriting for a particular stock. An IPO occurs when a private company issues stock to the public for the first time.

For example, company ABCWXYZ Inc. hires five underwriting firms to determine the financial details of its IPO. The underwriters detail that the issue price of the stock will be $15. Investors can then buy the IPO at this price directly from the issuing company.

This is the first opportunity that investors have to contribute capital to a company through the purchase of its stock. A company’s equity capital is comprised of the funds generated by the sale of stock on the primary market.

A rights offering (issue) permits companies to raise additional equity through the primary market after already having securities enter the secondary market. Current investors are offered prorated rights based on the shares they currently own, and others can invest anew in newly minted shares.

Other types of primary market offerings for stocks include private placement and preferential allotment. Private placement allows companies to sell directly to more significant investors such as hedge funds and banks without making shares publicly available. While preferential allotment offers shares to select investors (usually hedge funds, banks, and mutual funds) at a special price not available to the general public.

Similarly, businesses and governments that want to generate debt capital can choose to issue new short- and long-term bonds on the primary market. New bonds are issued with coupon rates that correspond to the current interest rates at the time of issuance, which may be higher or lower than pre-existing bonds. The important thing to understand about the primary market is that securities are purchased directly from an issuer.

1.2.2. Secondary Market

For buying equities, the secondary market is commonly referred to as the “stock market.” This includes the New York Stock Exchange (NYSE), Nasdaq, and all major exchanges around the world. The defining characteristic of the secondary market is that investors trade among themselves.

That is, in the secondary market, investors trade previously issued securities without the issuing companies’ involvement. For example, if you go to buy Amazon (AMZN) stock, you are dealing only with another investor who owns shares in Amazon. Amazon is not directly involved with the transaction.

In the debt markets, while a bond is guaranteed to pay its owner the full par value at maturity, this date is often many years down the road. Instead, bondholders can sell bonds on the secondary market for a tidy profit if interest rates have decreased since the issuance of their bond, making it more valuable to other investors due to its relatively higher coupon rate.

The secondary market can be further broken down into two specialized categories: auction market and dealer market.

  • Auction market: In the auction market, all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. Thus, theoretically, the best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually agreeable prices to emerge. The best example of an auction market is the New York Stock Exchange (NYSE).
  • Dealer market: In contrast, a dealer market does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks. The dealers hold an inventory of security, then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. An example of a dealer market is the Nasdaq, in which the dealers, who are known as market makers, provide firm bid and ask prices at which they are willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for investors.

Fast Facts The so-called “third” and “fourth” markets relate to deals between broker-dealers and institutions through over-the-counter electronic networks and are therefore not as relevant to individual investors.

1.2.3. The OTC Market

Sometimes you’ll hear a dealer market referred to as an over-the-counter (OTC) market. The term originally meant a relatively unorganized system where trading did not occur at a physical place, as we described above, but rather through dealer networks. The term was most likely derived from the off-Wall Street trading that boomed during the great bull market of the 1920s, in which shares were sold “over-the-counter” in stock shops. In other words, the stocks were not listed on a stock exchange, they were “unlisted.”

Over time, however, the meaning of OTC began to change. The Nasdaq was created in 1971 by the National Association of Securities Dealers (NASD) to bring liquidity to the companies that were trading through dealer networks. At the time, few regulations were placed on shares trading over-the-counter, something the NASD sought to improve. As the Nasdaq has evolved over time to become a major exchange, the meaning of over-the-counter has become fuzzier. Today, the Nasdaq is still considered a dealer market and, technically, an OTC. However, today’s Nasdaq is a stock exchange and, therefore, it is inaccurate to say that it trades in unlisted securities.

Nowadays, the term “over-the-counter” refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE, or American Stock Exchange (AMEX). This generally means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies.

$13.4 trillion

The market cap of the New York Stock Exchange, the largest stock exchange in the world. Stock exchanges are considered to be part of the “secondary” market.

1.2.4. Third and Fourth Markets

You might also hear the terms “third” and “fourth” markets. These don’t concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions. The main reason these third- and fourth-market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor.

The Bottom Line

Although not all of the activities that take place in the markets we have discussed affect individual investors, it’s good to have a general understanding of the market’s structure. The way in which securities are brought to the market and traded on various exchanges is central to the market’s function. Just imagine if organized secondary markets did not exist; you’d have to personally track down other investors just to buy or sell a stock, which would not be an easy task.

In fact, many investment scams revolve around securities that have no secondary market, because unsuspecting investors can be swindled into buying them. The importance of markets and the ability to sell a security (liquidity) is often taken for granted, but without a market, investors have few options and can get stuck with big losses. When it comes to the markets, therefore, what you don’t know can hurt you, and in the long run, a little education might just save you some money.

1.3. How to Buy and Sell Stocks on Your Own

In order to buy stocks, you need the assistance of a stockbroker since you cannot usually just call up a company and ask to buy their stock on your own. For inexperienced investors, there are two basic categories of brokers to choose from: a full-service broker or an online/discount broker.

1.3.1. Full-Service Brokers

Full-service brokers are what most people visualize when they think about investing—well-dressed, friendly business people sitting in an office chatting with clients. These are the traditional stockbrokers who will take the time to get to know you personally and financially. They will look at factors such as marital status, lifestyle, personality, risk tolerance, age (time horizon), income, assets, debts, and more. By getting to know as much about you as they can, these full-service brokers can then help you develop a long-term financial plan.

Not only can these brokers help you with your investment needs, but they can also provide assistance with estate planning, tax advice, retirement planning, budgeting and any other type of financial advice, hence the term “full-service.” They can help you manage all of your financial needs now and long into the future and are for investors who want everything in one package. In terms of fees, full-service brokers are more expensive than discount brokers but the value in having a professional investment advisor by your side can be well worth the additional costs. Accounts can be set up with as little as $1,000. Most people, especially beginners, would fall into this category in terms of the type of broker they require.

1.3.2. Online/Discount Brokers

Online/discount brokers, on the other hand, do not provide any investment advice and are basically just order takers. They are much less expensive than full-service brokers since there is typically no office to visit and no certified investment advisors to help you. Cost is usually based on a per-transaction basis and you can typically open an account over the internet with little or no money. Once you have an account with an online broker, you can usually just log on to its website and into your account and be able to buy and sell stocks instantly.

Remember that since these types of brokers provide absolutely no investment advice, stock tips or any type of investment help, you’re on your own to manage your investments. The only assistance you will usually receive is technical support. Online (discount) brokers do offer investment-related links, research, and resources that can be useful. If you feel you are knowledgeable enough to take on the responsibilities of managing your own investments or you don’t know anything about investing but want to teach yourself, then this is the way to go.

The bottom line is that your choice of broker should be based on your individual needs. Full-service brokers are great for those who are willing to pay a premiumfor someone else to look after their finances. Online/discount brokers, on the other hand, are great for people with little start-up money and who would like to take on the risks and rewards of investing upon themselves, without any professional assistance. Direct Stock Purchase Plan

Sometimes, companies (often blue-chip firms) will sponsor a special type of program called a DSPP, or Direct Stock Purchase Plan. DSPPs were originally conceived generations ago as a way for businesses to let smaller investors buy ownership directly from the company. Participating in a DSPP requires an investor to engage with a company directly rather than a broker, but every company’s system for administering a DSPP is unique. Most usually offer their DSPP through transfer agents or another third-party administrator. To learn more about how to participate in a company’s DSPP, an investor should contact the company’s investor relations department.

ADVISOR INSIGHT

You can buy or sell stock on your own by opening a brokerage account with one of the many brokerage firms. After opening your account, connect it with your bank checking account to make deposits, which are then available for you to invest.

However, do not equate the ease of opening an account with the ease of making good investment decisions. It is generally recommended that beginners speak to a qualified financial advisor. New investors should read “The Intelligent Investor” by Benjamin Graham. Smart investing can be highly satisfying so take it slow, do your research, and seek out an advisor that has your best interests in mind.

1.4. Trading hours of world’s major stock exchanges

Closing times for stock market exchanges vary, but they generally close in the evening – except on holidays. A stock market exchange is a marketplace where stocks are traded throughout the day; it functions as an entity that ensures orderly trading and efficient dissemination of price quotes for stocks on the exchange. Some of the main stock market exchanges are the Shanghai Stock Exchange, Swiss Exchange, London Stock Exchange, New York Stock Exchange and Nasdaq. Trading is generally conducted on Monday to Friday of each week. Getting access to any of the following markets and exchanges would require a stockbroker.

Investopedia’s list of the best online stock brokers can give you a great first look at some of the top brokers in the industry.

1.4.1. Trading Hours in the United States / Americas

The New York Stock Exchange (NYSE) is based in New York City. The NYSE is one of the largest stock exchanges in the world, and it is a public entity. As of 2019, the NYSE has normal trading hours from 9:30 a.m. to 4 p.m. local time, unless there’s an early close due to a holiday.

The Nasdaq is an American stock exchange that serves as a global electronic marketplace for securities trading. Pre-market trading hours are from 4 a.m. to 9:30 a.m. local time, and after-hours trading extends from 4 p.m. to 8 p.m. The normal trading hours begin at 9:30 a.m. and end at 4 p.m.

Canada’s Toronto Stock Exchange opens at 9:30 a.m. and closes at 4 p.m. local time, with no break in trading for a lunch period.

1.4.2. Trading Hours in Asia

The Shanghai Stock Exchange opens at 9:30 a.m. and closes at 3 p.m. local time, and it has a lunch period from 11:30 a.m. to 1 p.m.

Japan’s Tokyo Stock Exchange opens at 9:00 a.m. and closes at 3 p.m. local time, with a lunch period from 11:30 a.m. to 12:30 p.m.

The Hong Kong Stock Exchange opens at 9:30 a.m. and closes at 4 p.m. local time, and it has a lunch period from 12 p.m. to 1 p.m.

1.4.3. Trading Hours in Europe

The London Stock Exchange opens at 8 a.m. and closes at 4:30 p.m. local time with no lunch period. Euronext Paris opens at 9 a.m. and closes at 5:30 p.m. local time with no lunch period. The Swiss Exchange opens at 9:00 a.m., closes at 5:30 p.m. local time and has no lunch period.

1.5. Getting to Know the Stock Exchanges

A stock exchange does not own shares. Instead, it acts as a market where stock buyers connect with stock sellers. Stocks can be traded on one or more of several possible exchanges such as the New York Stock Exchange(NYSE). Although you will most likely trade stocks through a broker, it is important to understand the relationship between exchanges and companies, and the ways in which the requirements of different exchanges protect investors.

1.5.1. How Does It All Start?

The primary function of an exchange is to help provide liquidity; in other words, to give sellers a place to “liquidate” their shareholdings.

Stocks first become available on an exchange after a company conducts its initial public offering (IPO). In an IPO, a company sells shares to an initial set of public shareholders (the primary market). After the IPO “floats” shares into the hands of public shareholders, these shares can be sold and purchased on an exchange (the secondary market).

The exchange tracks the flow of orders for each stock, and this flow of supply and demand sets the stock price. Depending on the type of brokerage accountyou have, you may be able to view this flow of price action. For example, if you see that the “bid price” on a stock is $40, this means somebody is telling the exchange that he or she is willing to buy the stock for $40. At the same time you might see that the “ask price” is $41, which means somebody else is willing to sell the stock for $41. The difference between the two is the bid-ask spread.

1.5.2. Auction Exchanges - NYSE

The NYSE is primarily auction-based, which means specialists are physically present on the exchange’s trading floors. Each specialist “specializes” in a particular stock, buying and selling the stock in the auction. These specialists are under competitive threat by electronic-only exchanges that claim to be more efficient (that is, they execute faster trades and exhibit smaller bid-ask spreads) by eliminating human intermediaries.

The NYSE is the largest and most prestigious exchange. Listing on the NYSE affords companies great credibility, because they must meet initial listing requirements and also comply annually with maintenance requirements. For example, for U.S. companies to remain listed, the NYSE companies must keep their price above $4 per share and their market capitalization (number of shares times price) above $40 million.

Furthermore, investors trading on the NYSE benefit from a set of minimum protections. Among several of the requirements that the NYSE has enacted, the following two are especially significant:

  1. Companies must get shareholder approval for any equity incentive plan (for example, stock option plan or restricted stock plan). In the past, companies were allowed to sidestep shareholder approval if an equity incentive plan met certain criteria; this, however, prevented shareholders from knowing how many stock options were available for future grant.
  2. A majority of the board of directors’ members must be independent. However, each company has some discretion over the definition of “independent,” which has caused controversy. Furthermore, the compensation committee must be entirely composed of independent directors, and the audit committee must include at least one person who possesses “accounting or financial expertise.”

1.5.3. The Nasdaq (an Electronic Exchange)

The Nasdaq, an electronic exchange, is sometimes called “screen-based” because buyers and sellers are connected only by computers over a telecommunications network. Market makers, also known as dealers, carry their own inventory of stock. They stand ready to buy and sell Nasdaq stocks, and they are required to post their bid and ask prices.

Nasdaq has listing and governance requirements similar to the NYSE. For example, a stock must maintain a $4 minimum price. If a company does not maintain these requirements, it can be delisted to one of the OTC markets discussed below.

1.5.4. Electronic Communication Networks (ECNs)

ECNs are part of an exchange class called alternative trading systems (ATS). ECNs connect buyers and sellers directly. Because they allow for direct connection, ECNs bypass the market makers. You can think of them as an alternative means to trade stocks listed on the Nasdaq and, increasingly, other exchanges as well (such as the NYSE or foreign exchanges).

There are several innovative and entrepreneurial ECNs, and they are generally good for customers because they pose a competitive threat to traditional exchanges, and therefore push down transaction costs. Currently, ECNs do not really serve individual investors; they are mostly of interest to institutional investors.

There are several ECNs, including INET (the result of an early 2004 consolidation between the Instinet ECN and Island ECN) and Archipelago (one of the four original ECNs that launched in 1997).

1.5.5. Over-the-Counter (OTC)

Over-the-counter (OTC) refers to markets other than the organized exchanges described above. OTC markets generally list small companies, and often (but not always) these companies have “fallen off” to the OTC market because they were delisted from Nasdaq.

Some individual investors will not even consider buying OTC stocks due to the extra risks involved. On the other hand, some strong companies trade on the OTC. In fact, several strong companies have deliberately switched to OTC markets to avoid the administrative burden and costly fees that accompany regulatory oversight laws such as the Sarbanes-Oxley Act. On balance, you should be careful when investing in the OTC if you do not have experience as several penny stocks trade over-the-counter. (To learn more about penny stocks, read our penny stock series).

There are two OTC markets:

  • Over-the-Counter Bulletin Board (OTCBB) is an electronic community of market makers. Companies that fall off the Nasdaq often end up here. On the OTCBB, there are no “quantitative minimums” (no minimum annual sales or assets required to list).
  • Companies that list on the OTC Pink are not required to register with the SEC. Liquidity is often minimal. Also, keep in mind that these companies are not required to submit quarterly 10Qs.

The Bottom Line

To be traded, every stock must list on an exchange where buyers and sellers meet. The two big U.S. exchanges are the NYSE and the fast-growing Nasdaq. Companies listed on either of these exchanges must meet various minimum requirements and baseline rules concerning the “independence” of their boards. But these are by no means the only legitimate exchanges. Electronic communication networks are relatively new, but they are sure to grab a bigger slice of the transaction pie in the future. Finally, the OTC market is a fine place for experienced investors with an itch to speculate and the know-how to conduct a little extra due diligence.