How Trading Stocks on a Stock Exchange Works
Stock markets such as the New York Stock Exchange and NASDAQ are places where corporations and investors trade partial ownership in companies. However, most first time and novice investors are turned off by the complexity of the stock exchanges, their functions and procedures a mystery. The purpose of this article is to identify the major players in the securities trade markets and define the roles they play in making the modern corporation possible. Learn how stock exchanges and trading stocks work.
Corporations are an invention of the late nineteenth century when large companies began selling portions of ownership to multiple buyers. Like today, these investors enjoy the risk-reducing benefits of owning small portions of multiple companies. This situation creates limited liability for the investor because he/she can only lose an amount equal to what was paid for the stock in a company. There is, however, no theoretical limit to how much a stock can be worth so wealth and value creation are limitless.
When an investor wants to buy partial ownership in a corporation, the investor does not knock on the company’s door and ask to buy some shares of stock. Instead, the investor usually contacts a broker. The word broker is thought to come from the Old French word brocheor which means to broach or open a keg of wine. A broker is an individual usually under the employment of an investment firm that helps investors buy and sell stock.
The broker makes money by charging a sales commission. Usually this commission is a percentage of the total trade but in some cases a flat fee may be charged instead. What’s important to understand is that the broker never takes ownership of the stock. He/she simply makes it possible for a seller and an investor to come together and trade shares of stock for money. That’s how a stock exchange works.
In contrast to a broker, a dealer does take ownership of stock. Investors buy and sell shares of stock directly from the dealer who buys and sells stock from his/her own portfolio. When an investor buys shares of stock from a broker, the broker simply arranges the purchase from a holder of the stock willing to sell. This is typically arranged through a stock exchange such as the New York Stock Exchange.
Another player in the purchasing and selling of stock is the Investment Banker. Investment Bankers specialize in the sale of new securities issued by a corporation, such as when a company decides to issue new shares of stock to raise capital. This type of stock sale is known as a seasoned offering in comparison to when a corporation first issues stock to the public which is called an Initial Public Offering, abbreviated IPO. Investment bankers often play a dual role. Sometimes they act as a broker without taking ownership of stock and sometimes they act as a dealer taking ownership of stock before selling it to its final owner, such as an individual investor or financial institution. Occasionally, the investment banker will guarantee a minimum price for the corporation thereby acting as underwriter, a type of dealer. It all depends on which situation is most profitable for the investment banker.
Trading stocks on a stock exchange requires input from a variety of people and professions. Investors rarely deal directly with an exchange but instead pay fees to brokers, dealers, and investment bankers to transact the sale of partial ownership of a company for them. This system creates a highly liquid market where trades can be completed in minutes and trading volumes can reach into the billions. It takes a lot of people for a stock exchange and trading stocks to work. Without the right roles, corporations could never offer ownership to many investors.