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Market Mechanics:
An Educators Guide to U.S. Stock Markets
ALTHOUGH THE INNER WORKINGS OF THE
stock market are fascinating, few introductory texts have
the space to describe them in detail. Furthermore, the
U.S. stock market has been changing so rapidly in recent
years that many books have not yet caught up with the
changes. This quick note provides an up-to-date view of
how the U.S. stock market works today. This note will
teach you about:
the shares from the company itself. You are buying the explore the process of trading a stock step-by-step.
shares from another investor who already owned the Suppose that you wanted to buy 500 shares of a com-
shares. This is what economists call a secondary market mon stock. In this example, we will use the mythical
for shares. firm ABCD Examples, Inc, whose ticker symbol (the
standard abbreviation used to identify stocks in the
This is different from the primary market in which the U.S.) just happens to be ABCD. In order to buy this
company sold the shares directly to investors in the stock, you have to find someone willing to sell you the
first place. The initial public offering (IPO) occurs shares. If your cousin or your next-door neighbor
when the company first sells shares to the public and want to sell you the shares, that is fine. There is no law
arranges for the secondary trading of its shares. in the United States that requires an individual to go
through a registered broker in order to buy or sell
Financial markets perform a number of vital economic shares of stock. However, most of the time investors
functions in our economy. First, the primary market need help to find the other side of the trade, which is
provides promising companies with the capital they what brokerage firms do. (And most brokerage firms
need to invest in growing their businesses. Second, wont sell you shares in non-existent firms, but that
For a simple retail order, the investor tells the bro- What this information says is that the last reported
kerage firm what he or she wants to do. This can be trade in ABCD stock took place at $18.85. Right
done in person, over the phone, through the mail, now, the best bid is also $18.85, which means that
or via the internet. For example, you might click on someone is willing to pay $18.85 for up to 10,400
your brokers web site and find a screen that looks shares of ABCD. If you wanted to sell immediately,
like this: you could sell up to 10,400 shares right now at that
Then you enter what you want to do, in this case $18.85 price. The ask price (sometimes called the
buy 500 shares of ABCD. So far, so good. But at offer price) indicates that someone is willing to sell
what price? If you want your broker to get you the up to 1,000 shares of ABCD at $18.88. If you wanted
stock fast at the best price available at the moment, to buy immediately, you could buy up to 1,000
then you would place a market order. What price are shares at $18.88. Thus, a market order to buy 500
you likely to get? You can find out before you place shares would likely be filled at a price of $18.88.
the order by getting a quote that shows the bid and The difference between the bid and ask price is
the ask prices. For example, the quote for ABCD known as the bid-ask spread, and represents part of
might look like this: the cost of trading stock. Another way to remember
the difference between bid and ask prices is to think
Bid price: $18.85 > Bid size: 10,400
of the bid price as the price you get when you
Ask price: $18.88 > Ask size: 1,000
{Last trade: $18.85}
Reading the stock table
M NOVL NTAP NXTL ORCL PALM PAYX PCAR PMCS
SYM 52 Weeks 52 Weeks Div YLD% VOL (100s) HI LO CLOSE Net CHG
Hi Lo
ABCD 28.15 15.50 1.00 5.29 12,345 19.00 18.60 18.90 0.10
EFGH 15.50 9.95 0.00 0.00 5,678 14.00 13.63 13.95 -0.05
"trade-in" the stock and the higher ask price as the price
52 WEEKS HI LO: The highest and lowest reported prices in the you pay when you buy something at the retail price.
last 52 weeks.
SYM: The "ticker" symbol, an abbreviation that uniquely identi- If $18.88 is acceptable to you, you might go ahead and
fies the stock. Brokerage firms and markets usually use these
abbreviations to make sure that there is no confusion about the place a market order and would probably get filled at
security in question, because many stocks have similar sounding $18.88. Of course, if someone else snaps up those 1,000
names.
shares before your order arrives, the price you get could be
Div: The annual dividend expected to be paid by the firm.
slightly higher. Conversely, you will sometimes get price
YLD %: The annual dividend divided by the share price as a improvement if someone willing to sell at a lower price
percentage.
shows up just as your order arrives.
PE: The PE is the Price-Earnings ratio, which is calculated by
dividing the closing stock price by the latest 12 months of
earnings, if the company had positive earnings. The PE is a quick On the other hand, suppose that you are willing to be
"back-of-the-envelope" measure of how expensive the stock is
compared with its current earnings. Generally, investors are patient and think that you might be able to get a better
willing to pay more for stocks with good prospects for future
growth, and such stocks therefore have higher PE ratios. price. You could tell your broker the maximum price that
you are willing to pay, in which case your order is called a
VOL 100s: The reported share volume in lots of 100 shares.
limit order because you have placed a limit on the price
HI: The highest reported price for the day
you will accept. You would also tell your broker how long
LO: The lowest reported price for the day the order is valid. A day order expires at the end of the
CLOSE: The last reported price from the regular trading day, normal trading day. A good-till-cancelled order does not
which currently ends at 4:00 p.m.
expire until you cancel it, although many brokers will
NET CHG: This shows the difference between the most recent automatically cancel such orders if they are not filled
closing price and the closing price for the day before.
within 30 or 60 days.
Well, placing an order is one thing, but what happens makers and ECNs, and displays them in the Nasdaq
next? Your broker is under a legal obligation to make quote montage. The quotes from the individual par-
sure that you get the best execution for your order. If ticipants can be viewed on the Nasdaq workstation.
ABCD is listed on The Nasdaq Stock Market, your Nasdaq also provides systems that link all of these
broker can send the order to a market maker, or to participants together, so that your broker can route
an order matching facility called an ECN. Market your order electronically to a market maker or ECN,
makers are businesses that make a living by buying and so that other participants can also trade with
stock when others want to sell, and by selling when each other electronically.
others want to buy. Just like a shopkeeper, they often
keep inventory on hand to service their customers Typically, your broker decides where to send your
with immediate service. They make their money by order. Some brokers, called direct access brokers,
buying at the low bid price and selling at the higher allow you to choose how your order will be processed.
ask price, along with profits and losses on the inven- Most individuals, however, let their brokers do the
tory that they hold. Because the average bid-ask work of choosing how to process the order.
spread on a Nasdaq National Market stock is less
than $0.15, one market maker describes his business At any given time, several market makers may be
as one of picking up nickels and dimes in front of the quoting the best price. In addition, other market-
steam roller of rapidly changing stock prices. There making firms often guarantee that they will match
are over 400 market-making firms in the Nasdaq the best price, whatever it happens to be at that
market. Some market-making firms make markets in moment. How does your broker choose where to
only a few select stocks, and others make markets in send the order? Like other businesses, market-mak-
thousands of stocks. Many of these market-making ing firms compete not only on price but on other
firms also have retail brokerage and investment factors of execution quality, such as the speed of fill-
banking operations, and the market making helps to ing orders, not making mistakes, and providing good
support these other business lines. The average customer service when problems arise. Some market
Nasdaq stock has over 10 market makers competing makers will not only agree to match the best price,
for business in that stock, and many of the largest but also to trade in larger sizes than the best quote in
stocks have over 50 market makers. the market, so called depth improvement. Some large
brokerage firms are vertically integrated and act as
The Nasdaq Stock Market, Inc., gathers the quotes market makers as well as brokers. They feel they can
from all of these market participants, both market serve their customers faster and with less chance for
continued from previous page
I In this example, the ECN would add the order to buy 100 shares of VRSN VRTS VSTR VTSS WCOM XLNX XOXO YHOO
ABCD at $25 per share to its book. If another person wanted to sell
those shares at $25, he or she would electronically submit an order
to the ECN to sell the shares at $25. The ECN then matches the
buy and sell orders, and the trade is complete. ECNs make their
money by charging fees to people who trade using their systems. error by filling the orders in house (matching, of course,
Here is an example of the order book in ABCD from a typical ECN: the best price in the market) and not sending the order
out to another market maker. In this way they can earn
Snapshot of ECN Book for ABCD not only brokerage commissions but also trading profits.
B U Y O R DER S SE LL ORD E RS The competition between market makers for orders is so
SHARES PRICE SHARES PRICE intense that some market makers even share part of their
1,000 18.83 3,800 18.90
1,000 18.80 1,600 18.90 trading profits with the brokerage firms that send them
1,000 18.80 1,000 18.90 orders.
5 18.75 1,000 18.90
500 18.75 1,000 18.90
700 18.75 100 18.90 Your broker has a legal obligation to get you the best pos-
80 18.75 1,500 18.90
600 18.75 200 18.90 sible execution for the trade, and will weigh a variety of
1,000 18.75 5,000 19.00 these factors in choosing where to send your order.
11 18.75 420 19.00
100 18.75 500 19.00 Sometimes the brokerage firm routes the order to the
580 18.75 100 19.00
market maker or ECN that is displaying the best price.
370 18.75 300 19.00
385 18.60 100 19.00 Some firms find it more efficient to route all orders in a
250 18.60 500 19.00
given stock to a single market maker who promises to
Note that there are orders to buy ABCD at $18.83, the ECNs best match the best price at the moment rather than try to
bid, and to sell ABCD at $18.90, the ECNs best ask price. These are chase after the market maker who just happens to have
not necessarily the best prices in the whole market, just the best
prices in that particular ECN. The ECN then transmits its best bid the best price at the moment, because those shares may be
and offer into the Nasdaq quote montage so that all market par-
ticipants, not just the ECNs subscribers, can see the best bid and gone before the order gets there.
offer quotes in the entire market.
There are several ECNs in the Nasdaq market. The two biggest are What if you place a limit order instead of a market order?
Instinet, owned by Reuters, and Island. Other major ECNs include
Archipelago, Redi-Book, Obviously, if your limit price is away from the market you
Percent of Nasdaq
Bloomberg, and Brut. may not get the rapid fill that you would get with a mar-
Share Volume
Altogether, about a fourth E CN J an - Sept 20 0 0
of Nasdaqs volume passes ket order. Just as with market orders, there are numerous
through ECNs. Some erro- Archipelgo 0.9%
neously think that ECNs Attain 0.0% market makers and ECNs competing for the order. Your
have taken this volume Brut 1.3% broker has a strong financial incentive to send the order to
from Nasdaq. However, by B-Trade 1.3%
giving investors additional Instinet 11.2% the market maker or ECN that offers the best chance of
ways to trade, ECNs have Island 5.6%
actually added significantly NexTrade filling the order. After all, if the limit order is not filled,
0.0%
to the trading volume in your broker does not get a commission. If the limit price
Redi-Book 2.2%
Nasdaq-listed stocks.
Strike 0.1%
on your order is better than the best price currently in the
Total 22.7%
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market, then the market maker or ECN with the order is After the trade, the participants report the trade details to
legally required to display that quote through the Nasdaq the Securities Industry Automation Corporation (SIAC),
system so that other investors can find out about it and which disseminates the information to the outside world
perhaps trade with it. Also, under the Manning rules through data vendors. Just as with Nasdaq trades, a trade
(named after an arbitration case that established the rule), in an NYSE-listed stock settles through DTCC.
a customer order takes precedence, so that a market maker
holding a customer order has to fill that order if it trades
at the same price or better. Stock markets in the U.S.
The two largest stock markets in the United States are The
After the trade is executed, the parties to the trade report Nasdaq Stock Market, Inc. (Nasdaq) and the New York
the trade to Nasdaq, which transmits the information to Stock Exchange (NYSE). The companies that issue stock
the outside world through data vendors. The trade details to the public choose where they will list their stock for
are passed on to Depository Trust and Clearing trading. This means that they apply to have their shares
Corporation (DTCC) so that settlement can take place traded on the market and are willing to abide by the
after the trade, currently on the third business day investor protection rules of that market. In addition, they
or T+3. pay a listing fee and prove that they meet the listing
requirements for that market.
What if you wanted to trade a stock that was not Nasdaq-
listed? Then a different but still similar process is used. Some companies are not listed on any exchange. These
Suppose that you wanted to buy 500 shares of some companies either do not qualify for trading on a stock
NYSE-listed stock, such as U.S. Steel (ticker symbol: X). exchange, or they have decided for other reasons not to
You would enter the order just as you would for a Nasdaq- apply for listing. Such companies, if they have filed regis-
listed stock, but the trading process is a little different. tration statements with the SEC, can be traded on the
Your broker still chooses where to send the order, but the OTC Bulletin Board, which carries dealer quotes for those
broker has fewer choices. NYSE-listed stocks trade not stocks. Although Nasdaq operates the OTC Bulletin Board,
only on the NYSE, but also on the Nasdaq InterMarket
and on several regional stock exchanges. These different
exchanges are connected via the Consolidated Quote
System (CQS) which displays quote information, and the
Intermarket Trading System (ITS) which allows one
exchange to send trading interest to another exchange.
Depository Trust and
Clearing Corporation (DTCC)
Although some investors may think that a trade is finished
immediately after they click place order, it really isnt. A
job is never finished until the paperwork is done. Even
though the buyer and seller have agreed on the price and
quantity to be traded, the money has not yet been
exchanged for shares of stock. This process, called settle-
CS ment, usually takes place in the United States on the third BMET BRCM BVSN CEFT CHIR CHKP CIEN CMCS
business day after the trade, fondly known as T+3. The
Depository Trust and Clearing Corporation (DTCC) handles
the post-trade processing that results in the exchange of
cash for the shares. DTCC also operates a vault underneath
Manhattan that stores most of the physical stocks and Stock markets in the U.S. by
bonds in the United States. If you leave your stock in a trading volume, 1999
brokerage account, where it is held in street name, your
Tot al Sh a r e Vo l u m e
brokerage firm usually stores the stock in its account at
MA RK E T ( i n t h ou s an ds o f s h a r e s )
DTCC. Thus, when the time comes to deliver the stock to
another investor, the transaction can be done through a Nasdaq Stock Market 291,577,886 55.0%
book-entry on DTCCs computers without having to move New York Stock Exchange 204,063,545 38.5%
physical paper stock certificates. This reduces costs sub- Chicago Stock Exchange 14,398,471 2.7%
stantially. American Stock Exchange 8,230,868 1.6%
Pacific Exchange 4,167,452 0.8%
Boston Stock Exchange 4,022,431 0.8%
Cincinnati Stock Exchange 2,267,840 0.4%
Philadelphia Stock Exchange 1,649,333 0.3%
Chicago Board Options Exchange 1,157 0.0%
Total 530,378,983 100.0%
ture. Participation is not limited to any fixed number of Market # of Nasdaq Total
Participant Issues Share
participants. Any firm that meets the basic requirements MARKET MAKER Identifier Traded Volume (000s)
specialist is required to post bid and ask quotes at all The New York Stock Exchange (NYSE) traces its his-
times. The specialist also acts as an auctioneer, trying tory back to 1792, two years after the founding of
to match the orders of other customers that are sent the Philadelphia Stock Exchange.
to the NYSE floor. The specialist oversees the order
book of orders that are electronically routed to The American Stock Exchange
the floor of the NYSE. The American Stock Exchange evolved out of the
brokers who stood on the curb outside the New
In addition to the specialist, there are numerous York Stock Exchange to trade stocks that did not
floor brokers who negotiate larger orders face-to- qualify for the NYSE. Indeed, even after the brokers
face for their customers. Typically, a floor broker moved indoors, they were known as The New York
receives an order from a brokerage firm and then Curb Exchange. The Amex is the second-largest
walks over to the specialist post where the stock is options exchange in the U.S., after the Chicago
traded. The floor broker then negotiates with the Board Options Exchange. (The CBOE also trades a
specialist and any other floor brokers interested in few equity products.) The Amex pioneered
the same stock to try to fill the order. Smaller orders exchange-traded funds such as Spiders and now
on the NYSE are usually electronically routed to the does a substantial business in such funds. Finally, the
specialists order book. Amex still has a small equities business that trades
stocks in a floor environment similar to the NYSE.
NYSE membership is limited to 1,366 members,
who collectively own the NYSE. In order to become The Regional Stock Exchanges
a member, one has to purchase a membership, called Stock exchanges naturally sprang up in many cities
a seat, from another member who wants to sell. to accommodate the needs of local investors. Even
Memberships have recently been selling in the cities like Wheeling, WV and Spokane, WA at one
neighborhood of $2 million. However, purchasing a time had their own local stock exchanges. Advances
seat does not mean that you get to sit down. Few in communication such as the telegraph and tele-
NYSE members actually sit down for long during phone reduced the need for so many exchanges, and
the trading day. many of them merged with other stock exchanges.
However, a number of these so-called regional stock
exchanges still survive. Although some of these
exchanges have a few exclusive local stocks, these
exchanges mostly compete in the business of trading
continued from previous page
Stock exchanges such as Nasdaq and the NYSE are SROs because
they must monitor the trading in their markets to prevent
P shenanigans. Both markets devote a large number of resources to NXTL ORCL PALM PAYX PCAR PMCS PMTC PSFT
policing the trading in their markets.
3. Suppose that the quote for a stock was $50 bid, $50.03 asked. At what
price would a market buy order most likely be filled?
4. Go to the site www.nasdaq.com and look up the stock prices for two
stocks of your choice. What are the bid and offered prices?
6. What is the difference between the primary and the secondary markets?
Archipelago
www.tradearca.com
Attain
www.attain.com
Bloomberg Tradebook
www.bloomberg.com/products/trdbk.html
Brut
www.ebrut.com
MarketXT
www.marketxt.com
Instinet
www.instinet.com
Island
www.isld.com
Nextrade
www.nextrade.org
Redi-Book
www.redibook.com
Designed by:
B u r n e t t G r o u p
www.burnettgroupnc.com
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