Just as a meat market is a place to buy meat, a stock market is a place in which stocks (or shares) of corporations are bought and sold. The stock of a company represents an ownership interest in that firm; when you buy the stock of a corporation, you own a piece of that firm. Stock markets facilitate the purchase and sale of shares between investors. Some stock markets are auction markets, wherein a firm assigned the stock serves as the auctioneer, while others are strictly electronic markets in which trades are executed through a dealer. The two largest stock markets in the U.S. today are the New York Stock Exchange (NYSE) and Nasdaq. The NYSE is an auction market. Nasdaq is a dealer-structured, electronic market.
Regardless of whether the market is an auction market or a dealer market, in order to be traded on a specific market, the stock has to be listed on that market, and in order to be listed, the stock has to meet a set of listing requirements. The listing requirements vary depending on the market. In the U.S., the NYSE and Nasdaq have the most stringent listing requirements. These include items such as the minimum aggregate pre-tax income a company must have earned over the last three years, the minimum number of publicly-held shares, the minimum price per share, and the market value of the publicly-held shares:
|Aggregate pre-tax income over past 3 years||$10 million||$11 million|
|Number of publicly-held shares||1.1 million||1.25 million|
|Minimum price per share||$4||$4|
|Minimum market value of publicly-held shares||$100 million||$110 million|
In addition to meeting these listing requirements (and others), firms that want to have their shares traded on one of these exchanges must pay a fee. The NYSE has an entry fee of $250,000, and companies must also pay an annual fee, based on its number of shares. Nasdaq’s entry fee is much lower. It ranges from $50,000 to $75,000, and the average annual fee is $27,500.
There are smaller domestic stock markets as well, such as the NYSE American and the NYSE Chicago Exchange. The listing requirements of the smaller stock markets are lower, providing a trading venue for the stocks of firms that can’t meet the requirements of the larger exchanges. For example, the NYSE American stock exchange has a minimum aggregate three-year pre-tax income requirement of just $750,000 and a minimum price per share of $2.
Shares of companies that can’t meet the listing requirements of any exchange—or companies that, for whatever reason, choose not to be listed on an exchange—can be bought and sold in the over-the-counter market. Don’t confuse “over-the-counter” with “under-the-table,” though. More than 11,000 stocks trade in the over-the-counter market, which, like Nasdaq, is a dealer-structured market. There are three basic tiers to this electronic market. Established domestic and foreign companies that have high financial standards and corporate governance practices and are in compliance with U.S. Securities Exchange Commission (SEC) rules trade on the first tier, the OTCQX. Developing domestic and foreign companies that agree to certain reporting and oversight requirements trade on the second tier, the OTCQB. The last tier, the OTCPink, often referred to as “pink sheets,” have no reporting requirements. These are very low-priced stocks; some even sell for less than a dollar, hence the term “penny stocks” although, technically, the term “penny stock” is used to refer to the stock of a very small company that sells for less than $5 a share. While a few of these may be good buys, it’s definitely a case of “Buyer Beware” when considering a pink sheet stock since there are no disclosure requirements. There have been multiple cases of fraud involving penny stocks, some perpetrated by the issuing company and others by unscrupulous investors.
In an auction market, orders to buy or sell are transmitted to the exchange floor on which the stock is listed. Each stock is assigned a Designated Market Maker (DMM), which serves as the auctioneer for the stock. When the order reaches the exchange floor, an associate of the broker-dealer that placed the order takes it to the representative of the DMM for that stock and participates in the auction. If it is an order to buy, the associate attempts to buy it for the lowest ask price (the price at which another associate is ready to sell it); if it is an order to sell, the associate attempts to sell it to an associate with the highest bid price. Alternatively, the DMM can conduct the auction electronically, which is the primary method used in this day and age.
The DMM agrees to maintain a fair and orderly market in each of its assigned stocks. This means if there are more people wanting to sell one of their stocks than there are buyers, the DMM must buy the shares itself. Conversely, if there are more people wanting to buy the shares than there are sellers, the DMM sells shares of the stock that it holds. Many DMMs apply to be assigned more than one stock. For example, IMC is a designated market maker for over 550 NYSE-listed stocks. As you might have guessed, DMMs are companies, not individuals, since they need to have enough capital to buy shares of stocks when sales orders exceed buy orders.
The DMM also executes limit orders in its assigned stocks. A limit order is an order to buy or sell a stock at a specified price. When a limit order is placed with the DMM, the DMM executes that order when the specified price is reached during the auction.
A dealer is an individual or firm that buys stocks for and sells stocks from his/its own inventory, similar to a car dealership. In contrast to an auction market, wherein there is one DMM per stock, there may be multiple dealers, or market makers, for an individual stock in a dealer-driven market. For example, there is an average of 14 dealers per stock on the Nasdaq exchange. When your broker receives your order to buy or sell a stock, he can access the list of dealers in that stock. If it is an order to buy, he will submit it to the dealer with the lowest ask price; if it is an order to sell, he will submit it to the dealer with the highest bid price. The whole process takes less than a minute.
When you contact your broker with an order to buy or sell stock, you will not know whether the trade takes place on the NYSE, Nasdaq, a smaller domestic exchange, or in the over-the-counter market. Your broker can execute your trade in any of these venues that trade the stock in question. Sometimes, if your broker is also a dealer in the stock, it will fill the order on its own. It will sell you the stock from its own inventory if you’ve entered a buy order or buy the stock from you if you’ve entered a sell order. This said, your broker has the duty of “best execution.” That is, it is charged with seeking the best execution available for the order you have placed. In a fast-moving market, your broker is required to consider whether it should place the order where it can be executed as quickly as possible or, instead, where the best price currently exists since that price might change by the time the order gets processed.
If you want to have total control, you may be able to specify that your trade be executed on a particular exchange or with a specific market maker (dealer). Some brokers may charge for this service, however, although many brokers offer this service at no cost to active traders.