How the Stock Market Works
By David S. Chang
The stock market is where buyers and sellers meet to decide on the price to buy or sell securities, usually with the assistance of a broker. Let’s take a closer look at what you need to know about how stocks are traded and how the stock market works.
Public companies are a key part of the American economy. They play a major role in the savings, investment, and retirement plans of many Americans. If you have a pension plan or own a mutual fund, chances are that the plan or mutual fund owns stock in public companies. Like millions of Americans, you may also invest directly in public companies.
What Is a Public Company?
The term “public company” can be defined in various ways. There are two commonly understood ways in which a company is considered public: first, the company’s securities trade on public markets; and second, the company discloses certain business and financial information regularly to the public.
In general, we use the term to refer to a company that has public reporting obligations. Companies are subject to public reporting requirements if they:
- Sell securities in a public offering (such as an initial public offering, orIPO;
- Allow their investor base to reach a certain size, which triggers public reporting obligations; OR
- Voluntarily register with us.
A private company also can become subject to public reporting requirements by merging with a public shell company. This process is called a reverse merger. As with any investment, investors should proceed with caution when considering whether to invest in reverse merger companies.
As mentioned, we view companies as public if they are subject to public reporting obligations. There are instances, however, where the securities of a company that does not regularly report business and financial information to the public are nonetheless traded on smaller public markets. Investing in these companies is riskier as there can be little public information to allow investors to make an informed investment decision.
Transparency and Continuing Disclosures
A public company’s disclosure obligations begin with the initial registration statement that it files with the SEC. But the disclosure requirements don’t end there. Public companies must continue to keep their shareholders informed on a regular basis by filing periodic reports and other materials with the SEC. The SEC makes these documents publicly available without charge on its EDGAR website. The filed documents are subject to review by SEC staff for compliance with federal securities laws.
Following are some of the reports that may be filed by U.S.-based public companies. Foreign companies that file reports with the SEC may file different types of reports.
- Annual Reports on Form 10-K. This report includes the company’s audited annual financial statements and a discussion of the company’s business results. For suggestions on making your way through an annual report, you may be interested in our How to Read a 10-K andBeginner’s Guide to Financial Statements.
- Quarterly Reports on Form 10-Q. Public companies must file this report for each of the first three quarters of their fiscal year. (After the fourth quarter, public companies file an annual report instead of a quarterly report.) The quarterly report includes unaudited financial statements and information about the company’s business and results for the previous three months and for the year to date. The quarterly report compares the company’s performance in the current quarter and year to date to the same periods in the previous year.
- Current Reports on Form 8-K. Companies file this report with the SEC to announce major events that shareholders should know about, including bankruptcy proceedings, a change in corporate leadership (such as a new director or high-level officer), and preliminary earnings announcements. For more, see our How to Read an 8-K.
- Proxy Statements. Shareholder voting constitutes one of the key rights of shareholders. They may elect members of the board of directors, cast non-binding votes on executive compensation, approve or reject proposed mergers and acquisitions, or vote on other important topics. Proxy statements describe the matters to be voted upon and often disclose information on the company’s executive compensation policies and practices.
- Additional Disclosures. Other federal securities laws and SEC rules require disclosures about a variety of events affecting the company. These include proposed mergers, acquisitions and tender offers; securities transactions by company insiders, and beneficial ownership by a person or group that reaches or exceeds five percent of the company’s outstanding shares.
Public Disclosures Protect Investors
Our federal securities laws are based on public disclosure by companies of meaningful business, financial and other information. Public disclosure by companies serves to advance the mission of the SEC.
Part of the mission of the SEC is “to maintain standards for fair, orderly, and efficient markets.” To do this, the SEC regulates a number of securities market participants. These include:
- Broker-Dealers – Broker-dealers charge a fee to handle trades between the buyers and sellers of securities. A broker-dealer may buy securities from their customer who is selling or sell from their own inventory to its customer who is buying.
- Clearing Agencies – Clearing Agencies are Self-Regulatory Organizations (SROs)thatare required to register with the SEC.LikeallSROs, they are responsible for writing and enforcing their rules and disciplining members. There are two types of clearing agencies– clearing corporations and depositories.
- Clearing corporations, such as the National Securities Clearing Corporation (NSCC) and the Fixed Income Clearing Corporation (FICC), compare member transactions, clear those trades and prepare instructions for automated settlement of those trades. Clearing corporations often act as intermediaries in making securities settlements.
- Depositories, namely The Depository Trust Company (DTC), hold securities certificates for their participants, transfer positions between participants, and maintain ownership records.
- Credit Rating Agencies – Credit Rating Agencies provide opinions on the creditworthiness of a company or security. They indicate the credit quality by means of a grade. Generally, credit ratings distinguish between investment grade and non-investment grade. For example, a credit rating agency may assign a “triple A” credit rating as its top “investment grade” rating, and a “double B” credit rating or below for “non-investment grade” or “high-yield” corporate bonds. Credit rating agencies registered as such with the SEC are known as “Nationally Recognized Statistical Rating Organizations.”
- ECNs/ATSs – Electronic Communications Networks, or ECNs, are electronic trading systems that automatically match buy and sell orders at specified prices for users of the system. ECNs register with the SEC as broker-dealers and are subject to Regulation ATS. ATSs are Alternative Trading Systems. This term encompasses all systems that perform securities exchange functions and are not registered with the Commission as exchanges.
- Investment Advisers – Investment advisers are persons or firms that are in the business of providing investment advice to investors or issuing reports or analyses regarding securities. They do these activities for compensation.
- Securities Exchanges – Securities exchanges are markets where securities are bought and sold. Currently, there are fifteen securities exchanges registered with the SEC as national securities exchanges, including NYSE Euronext, NASDAQ, The Chicago Board Options Exchange, and BATS Exchange. Securities Exchanges are also SROs.
- Self-Regulatory Organizations (SROs) – An SRO manages its industry through the adoption of rules governing the conduct of its members. SROs also enforce the rules they adopt and discipline members for violating SRO rules. Two well-known SROs are the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB). FINRA is the largest SRO in the securities industry. It is the frontline regulator of broker-dealers. MSRB makes rules regulating dealers of municipal securities. The SEC oversees both FINRA and the MSRB. Other SROs include clearing agencies and securities exchanges.
- Transfer Agents -Transfer agents record changes of security ownership, maintain the issuer’s security holder records, cancel and issue certificates, and distribute dividends. Transfer agents stand between issuing companies and security holders. Transfer agents are required to be registered with the SEC, or if the transfer agent is a bank, with a bank regulatory agency. There is no SRO that governs transfer agents. The SEC has announced rules and regulations for all registered transfer agents. The intent is to facilitate the prompt and accurate clearance and settlement of securities transactions and assure the safeguarding of securities and funds.
For more technical information on Market Participants, go to http://www.sec.gov/divisions/marketreg/mrclearing.shtml.
Types of Orders
The most common types of orders are market orders, limit orders, and stop-loss orders.
- A market order is an order to buy or sell a security immediately. This type of order guarantees that the order will be executed, but does not guarantee the execution price. A market order generally will execute at or near the current bid (for a sell order) or ask (for a buy order) price. However, it is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed.
- A limit order is an order to buy or sell a security at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. Example: An investor wants to purchase shares of ABC stock for no more than $10. The investor could submit a limit order for this amount and this order will only execute if the price of ABC stock is $10 or lower.
- A stop order, also referred to as a stop-loss order is an order to buy or sell a stock once the price of the stock reaches the specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order.
- A buy stop order is entered at a stop price above the current market price. Investors generally use a buy stop order to limit a loss or protect a profit on a stock that they have sold short. A sell stop order is entered at a stop price below the current market price. Investors generally use a sell stop order to limit a loss or protect a profit on a stock they own.
Types of Brokerage Accounts
A cash account is a type of brokerage account in which the investor must pay the full amount for securities purchased. In a cash account, you are not allowed to borrow funds from your broker to pay for transactions in the account.
A margin account is a type of brokerage account in which your brokerage firm can lend you money to buy securities, with the securities in your portfolio serving as collateral for the loan. As with any other loan, you will incur interest costs when you buy securities on margin.
There are risks involved in purchasing securities on margin. For example, if you buy on margin and the value of your securities declines, your brokerage firm can require you to deposit cash or securities to your account immediately. It can also sell any of the securities in your account to cover any shortfall, without informing you in advance. The brokerage firm decides which of your securities to sell. Even if the brokerage firm notifies you that you have a certain number of days to cover the shortfall, it still may sell your securities before then. A brokerage firm may at any time change the threshold at which customers are subject to a margin call.
Stock Purchases: Long and Short
Having a “long” position in a security means that you own the security. Investors maintain “long” security positions in the expectation that the stock will rise in value in the future. The opposite of a “long” position is a “short” position.
A “short” position is generally the sale of a stock you do not own. Investors who sell short believe the price of the stock will decrease in value. If the price drops, you can buy the stock at the lower price and make a profit. If the price of the stock rises and you buy it back later at the higher price, you will incur a loss. Short selling is for the experienced investor.
A short sale is the sale of a stock that an investor does not own or a sale which is consummated by the delivery of a stock borrowed by, or for the account of, the investor. Short sales are normally settled by the delivery of a security borrowed by or on behalf of the investor. The investor later closes out the position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market.
Investors who sell stock short typically believe the price of the stock will fall and hope to buy the stock at the lower price and make a profit. Short selling is also used by market makers and others to provide liquidity in response to unanticipated demand, or to hedge the risk of an economic long position in the same security or in a related security. If the price of the stock rises, short sellers who buy it at the higher price will incur a loss.
Brokerage firms typically lend stock to customers who engage in short sales, using the firm’s own inventory, the margin account of another of the firm’s customers, or another lender. As with buying stock on margin, short sellers are subject to the margin rules and other fees and charges may apply (including interest on the stock loan). If the borrowed stock pays a dividend, the short seller is responsible for paying the dividend to the person or firm making the loan.
Executing an Order
When you place an order to buy or sell stock, you might not think about where or how your broker will execute the trade. But where and how your order is executed can impact the overall cost of the transaction, including the price you pay for the stock. Here’s what you should know about trade execution:
Trade Execution Isn’t Instantaneous
Many investors who trade through online brokerage accounts assume they have a direct connection to the securities markets, but they don’t. When you push that enter key, your order is sent over the Internet to your broker — who in turn decides which market to send it to for execution. A similar process occurs when you call your broker to place a trade.
While trade execution is usually seamless and quick, it does take time. And prices can change quickly, especially in fast-moving markets. Because price quotes are only for a specific number of shares, investors may not always receive the price they saw on their screen or the price their broker quoted over the phone. By the time your order reaches the market, the price of the stock could be slightly — or very — different.
SEC regulations do not require a trade to be executed within a set period of time. But if firms advertise their speed of execution, they must not exaggerate or fail to tell investors about the possibility of significant delays.
Your Broker Has Options for Executing Your Trade
Just as you have a choice of brokers, your broker generally has a choice of markets to execute your trade.
- For a stock that is listed on an exchange, your broker may direct the order to that exchange, to another exchange, or to a firm called a “market maker.”
- A “market maker” is a firm that stands ready to buy or sell a stock listed on an exchange at publicly quoted prices. As a way to attract orders from brokers, some market makers will pay your broker for routing your order to them — perhaps a penny or more per share. This is called “payment for order flow.”
- For a stock that trades in an over-the-counter (OTC) market, your broker may send the order to an “OTC market maker.” Many OTC market makers also pay brokers for order flow.
- Your broker may route your order — especially a limit order — to an electronic communications network (ECN) that automatically matches buy and sell orders at specified prices.
- Your broker may decide to send your order to another division of your broker’s firm to be filled out of the firm’s own inventory. This is called “internalization.” In this way, your broker’s firm may make money on the “spread” — which is the difference between the price the firm paid for the security and the price at which the firm sells it to you.
Your Broker Has a Duty of “Best Execution”
Many firms use automated systems to handle the orders they receive from their customers. In deciding how to execute orders, your broker has a duty to seek the best execution that is reasonably available for its customers’ orders. That means your broker must evaluate the orders it receives from all customers in the aggregate and periodically assess which competing markets, market makers, or ECNs offer the most favorable terms of execution.
The opportunity for “price improvement” is an important factor a broker should consider in executing its customers’ orders. “Price improvement” is the opportunity, but not the guarantee, for an order to be executed at a better price than the current quote.
Of course, the additional time it takes some markets to execute orders may result in your getting a worse price than the current quote – especially in a fast-moving market. So, your broker is required to consider whether there is a trade-off between providing its customers’ orders with the possibility, but not the guarantee, of better prices and the extra time it may take to do so.
You Have Options for Directing Trades
If for any reason you want to direct your trade to a particular exchange, market maker, or ECN, you may be able to call your broker and ask him or her to do this. But some brokers may charge for that service. Some brokers offer active traders the ability to direct orders to the market maker or ECN of their choice.
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