Firms issue securities to raise the capital necessary to finance their investments. Investment bankers market these securities to the public on the primary market. Investment bankers generally act as underwriters who purchase the securities from the firm and resell them to the public at a markup. Before the securities may be sold to the public, the firm must publish an SEC-approved prospectus that provides information on the firm's prospects.
Already-issued securities are traded on the secondary market, that is, on organized stock exchanges; the over-the-counter market; and for large trades, through direct negotiation. Only members of exchanges may trade on the exchange. Brokerage firms holding seats on the exchange sell their services to individuals, charging commissions for executing trades on their behalf. The NYSE maintains strict listing requirements. Regional exchanges provide listing opportunities for local firms that do not meet the requirements of the national exchanges.
Trading of common stocks on exchanges occurs through specialists. The specialist acts to maintain an orderly market in the shares of one or more firms. The specialist maintains "books" of limit buy and sell orders and matches trades at mutually acceptable prices. Specialists also accept market orders by selling from or buying for their own inventory of stocks when there is an imbalance of buy and sell orders.
The over-the-counter market is not a formal exchange but a network of brokers and dealers who negotiate sales of securities. The Nasdaq system provides online computer quotes offered by dealers in the stock. When an individual wishes to purchase or sell a share, the broker can search the listing of bid and ask prices, contact the dealer with the best quote, and execute the trade.
Block transactions currently accounts for about one-third of trading volume. These trades often are too large to be handled readily by specialists and so have given rise to block houses that specialize in identifying potential trading partners for their clients.
Buying on margin means borrowing money from a broker in order to buy more securities than can be purchased with one's own money alone. By buying securities on a margin, an investor magnifies both the upside potential and the downside risk. If the equity in a margin account falls below the required maintenance level, the investor will get a margin call from the broker.
Short-selling is the practice of selling securities that the seller does not own. The short-seller borrows the securities sold through a broker and may be required to cover the short position at any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the broker usually requires that the short-seller deposit additional cash or securities to serve as margin (collateral) for the short sale.
Securities trading is regulated by the Securities and Exchange Commission, by other government agencies, and through self-regulation of the exchanges. Many of the important regulations have to do with full disclosure of relevant information concerning the securities in question. Insider trading rules also prohibit traders from attempting to profit from inside information.
In addition to providing the basic services of executing buy and sell orders, holding securities for safekeeping, making margin loans, and facilitating short sales, full-service brokers offer investors information, advice, and even investment decisions. Discount brokers offer only the basic brokerage services but usually charge less. Total trading costs consist of commissions, the dealer's bid-ask spread, and price concessions.
