Reader Question: What is a Stock Exchange?

 I had an interesting reader question recently that relates to the blackout at the New York Stock Exchange this past Wednesday.  What is a stock exchange and what do the numbers in something like the Dow represent?

It’s a great question since the ups and downs of the market make news almost every day. If you believe in investing in diverse, low-cost investments for the long haul, the daily ups and downs of the market shouldn’t bother you. But you should definitely understand how the stock market works and what the numbers that flash by actually mean.

I’m going to take the questions separately because they each deserve their own post. Here’s what you need to know about Market.

The Market

Overall, the stock market is where shares of publicly traded companies are issued and traded. Investors can purchase shares of a company in order to grow their initial investment through the appreciation of the company’s value (capital gain) or getting a share of the company’s profits  (dividends).  

This relationship benefits both the investors and the companies. Investors can possibly grow their investment without the burden of owning and running a company. In addition, they can buy and sell their interest at anytime.  In exchange, the company gets capital in which to grow its business and increase profits.  The market provides quick cash to a company, instead of it having to take a loan.

The market contains two different sections: the primary market and the secondary market. The primary market is where newly issued stock is sold through an initial public offering (IPO). Most regular investors don’t participate in the primary market. It’s mostly for large, institutional investors that purchase shares from investment banks. Most individual investors buy and trade in the secondary market through stock exchanges.

The Stock Exchanges

Stock exchanges are where investors go to buy and sell pieces of stock. Exchanges exist all over the world, including the Shangai Stock Exchange in China, the Deutsche Borse in Germany, and the London Stock Exchange in the United Kingdom.

The most famous exchanges are right here in the US – the New York Stock Exchange, (NYSE) founded in 1792 and the National Association of Securities Dealers Automated Quotations (Nasdaq) founded in 1971. They are the biggest in the world based on market capitalization (the value of the stocks multiplied by the amount of outstanding shares) and have the highest trade volume.  But there are also smaller exchanges like the CME group out of Chicago, which specializes in options and futures contracts.

Keep in mind these exchanges are just meeting places for buyers and sellers. The exchanges themselves don’t own any stock. They monitor the orders for each stock and set the stock according to its supply and demand.  

You’ve likely heard the terms bid and ask price. The bid price is what an investor is willing to pay for a stock, say $50. The ask price is what an investor will sell the stock for, let’s say $52. The $2 difference between is the bid-ask spread.

Each exchange has its own requirements and regulations in order to be listed on the exchange.  Most of the trades now are done electronically and held in electronic form. The Nasdaq itself, for example, is a completely electronic market. But some exchanges like the NYSE still have face-to-face trading on the floor.  (Those pictures you see of people yelling and waiving pieces of paper.)

Now that you understand what the market is, on Tuesday I’ll explain how it’s tracked and what those numbers in the Dow and S&P represent.