The Mechanism of Trading in Stock Exchanges
Original post by Matt Petryni of Demand Media
Stock exchanges are used by millions of investors every business day to trade shares of ownership in public corporations, either as long-term investments in the company's growth or short-term speculation on movement in the shares' price. The mechanism of trading differs from one exchange to another, and some limits are placed on how they operate by government. The mechanism of trading that an exchange uses is important to investors because different mechanisms lend themselves to different trading volume limitations and pricing behaviors.
A stock exchange, according to the Business Dictionary, is an "organized and regulated financial market where securities (bonds, notes, shares) are bought and sold at prices governed by the forces of demand and supply." Exchanges facilitate capital markets liquidity by providing a place where buyers may meet and exchange cash for shares of equity in companies, called securities. They enable a more open and transparent system of exchange through well-defined trading mechanisms. Stock exchanges have existed in some form since the 17th century, according to finance scholar Lodewijk Petram.
Stock exchanges like the New York Stock Exchange and the Hong Kong Exchange are primarily auction markets. They use a system of bidding and asking prices executed through a specialist who matches buyers with sellers at a equilibrium price --- the buyer's highest bid and the seller's lowest asking price. On an auction market, traders compete for the best price for their side of the transaction, and orders are only executed when the buyer's price and the seller's price are successfully matched. In modern markets, this process usually takes place electronically.
Limit Order Books
To match prices at this auction, specialists popularly known as "market makers" maintain a limit order book, which essentially is a list of all of the unexecuted orders and their limit prices. The limit price for buyers is the highest price they're willing to pay; for sellers it is the lowest price at which they're willing to sell. On the NYSE, the vast majority of trades are executed at auction with a limit order book. However, auction markets like the NYSE often use a different mechanism of trading called a dealer market for large orders, because of the practical difficulty of executing a large trade at auction.
Dealer markets, such as the London Stock Exchange and --- traditionally --- the NASDAQ, operate a little differently than auction markets. Instead of matching buyers' bids with sellers' asking prices, orders are placed directly with dealers of shares, who offer quotes to purchasers. Quotes are usually "take it or leave it" on a dealer market, according to Joel Hasbrouck of New York University, though purchasers may try to negotiate prices with dealers. Large trades on the NYSE are often executed in a dealer market, according to researchers at Duke University.
- Finance Concepts; Trade Transparency in OTC Equity Derivatives Markets; 2010
- Business Dictionary; Stock Exchange; 2011
- Hong Kong Exchanges and Clearing: Trading Mechanism
- New York University; Dealer Markets; Joel Hasbrouck; 2010
- Journal of Financial Markets; Market Architecture: Limit-Order Books Versus Dealership Markets; S. Viswanathan and James Wang; 2002
- NYSE Euronext: Pure Market Order
- Rochester University; Costs of Trading; Rajiv Dewan and G. William Schwert; 1997
- Universiteit van Amsterdam; The World's First Stock Exchange; Lodewijk Petram; 2011
About the Author
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.
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