Everything You Wanted To Know About The Stock Exchange But Were Too Shy To Ask

I have been asked by several of my readers to provide an easy to understand introduction to some of the more misunderstood or confusing concepts of stock markets and how they operate.  In this article I will go over an introduction to what a stock exchange is, who can participate in the market and how, what short selling is, and how an IPO works.

What exactly is a stock exchange?

A stock exchange is an organization where buyers and sellers interact with each other in a centralized location to buy and sell stocks in companies who are listed on the exchange.  A stock exchange can have a physical location such as the New York Stock Exchange which maintains their headquarters and a trading floor at 11 Wall Street in New York City.  At this location floor brokers interact with each other to execute orders from clients.  A stock exchange can also operate strictly in the virtual world, like the Nasdaq Exchange where there is no human interaction involved.  The 10 largest stock exchanges in the world according to total dollar value of all companies listed are:

1. New York Stock Exchange (USA)
2. Nasdaq Stock Exchange (USA)
3. Tokyo Stock Exchange (Japan)
4. London Stock Exchange (United Kingdom)
5. Shanghai Stock Exchange (China)
6. Hong Kong Stock Exchange (Hong Kong, China)
7. Toronto Stock Exchange (Canada)
8. BM&F Bovespa (Sao Paulo, Brazil)
9. Australian Securities Exchange (Sydney, Australia)
10. Deutshe Borse (Frankfurt, Germany)

Who can buy and sell stock?

The stock market is open to anyone worldwide (subject to local securities laws and regulations) that has a valid brokerage or trading account at an authorized financial institution.  Most investors are individuals that use discount brokerages such as Etrade, Think or Swim, Interactive Brokers.  Investors place orders themselves either online through a trading platform or can place an order over the phone.  In this case the client is strictly responsible for doing their own research and receive no advice or recommendations from the company.  Trades are cheap often costing less than $5.  Clients that want to purchase stock on recommendations can do so through a financial advisor or stock broker at an investment firm such as Merill Lynch Bank of America or Citi Bank Personal Wealth Management.  High net worth individuals with millions of dollars in investable assets often seek advisory services from the large Wall Street firms such as Goldman Sachs or JP Morgan.   

Other participants include institutions that invest clients money such as a mutual fund (examples: Fidelity Investments, Pimco Funds, JP Morgan Asset Management) and sovereign wealth funds which is a state owned investment fund financed through government activities or sales of resources.  Examples include the Abu Dhabi Investment Authority, China Investment Corporation, Caisse de depot de placement du Quebec.

How do I buy and sell a stock?

Any market participant that wants to buy or sell a stock does so by placing an order with their authorized financial institution by either calling them, or placing an order online.  An order contains unique instructions or terms relating to price, quantity and other conditions which need to be matched for a transaction to occur.  There are two types of orders: a market order and a limit order.

Market order: A market order is an instruction to buy or sell a stock “at the market” which means the best available price at this exact time.  For example, Rebecca calls her stock broker to place a market order and buy 1000 shares of Apple AAPL at market price.  The stock broker will then execute the order and buy as many shares possible up to 1000 at the best available price at the moment.  If there is less than 1000 shares available, the order will be filled as much as possible.  This is known as a ‘partial execution.’  Rebecca has no control over what price she will receive and how many shares will be bought as all these factors are determined by the market.

Limit order: A limit order is an instruction to buy or sell a stock at a specific price.  In this case Rebecca logs on to her online brokerage account and places an order to buy 1000 shares of Apple at $600.00.  The order will only be executed if the price of Apple reaches $600.  The order is considered ‘pending’ (i.e waiting in the system) until it is executed and completed. 

There are other conditions that are included in an order:

• All or None (AON) is a condition that stipulates the order can be executed only if the entire order can be filled.  In Rebecca’s case if there is only 500 shares available the order will not execute because the instructions were for ALL the shares or NONE of the shares to be bought.  The order will remain ‘pending’ until 1000 shares are available or Rebecca cancels the order.
• Good ‘Til Canceled (GTC) is an instruction to keep the order pending until Rebecca decides otherwise.  The order will remain on the system as pending until it is either executed or cancelled by Rebecca at a later time or date.
• Day order is an instruction to keep the order pending until the end of the trading day.  At that point the brokerage firm will automatically cancel the order if it is still pending.

What is short selling?  How does it work?

Short selling involves selling a stock that you do not own with the hopes of repaying the borrowed shares at a lower price thereby earning a profit.  To short a stock you are essentially borrowing shares from someone else and selling it immediately in the market.  You will then be obliged to repay the shares.  It is easier to understand with an example.

Emily wants to short 100 shares of Amazon.com AMZN because she believes the stock trading at $200 is overvalued.  Emily would call her broker and instruct them to do so.  When the order is executed, Emily has sold 100 shares, and to close out the transaction she will have to repay the 100 shares.  If the price were to drop to $190, Emily could buy back the 100 shares and has concluded the short selling process while earning a $10 profit.

To recap:

Step 1: Borrow 100 shares and instantly sell at $200

Step 2: Bought 100 shares at $190

Total profit: 100 shares * ($200-190) = $200

So who exactly does Emily borrow from?  For a short sell to occur there must be someone on the other side willing to lend the shares.  Each broker has what is called a shortable inventory or Box list which contains information regarding every stock and quantity that can be loaned out.  The inventory is updated in real time so the broker on the phone will have up to the second information on how many shares can be loaned to Emily.  The inventory is made up of the brokerage firms customers and other third-parties that have agreed to allow their shares to be loaned.  A stock that is easy to short because the inventory is often full is referred to as “Easy To Borrow” (ETB.) 

It is possible that several days later Amazon.com is no longer shortable because the broker does not have any shares remaining in their inventory, in this case the stock is now “Hard To Borrow” (HTB.)  Since no shares are available for Emily to borrow, it will be impossible to short.  Emily might have the option to request a “locate” which means that her broker will contact other brokers to see if they have any Amazon.com shares in their inventory to lend.  Emily will have to pay an additional for this service.

How come there is always a buyer or seller available?

Many investors are curious why all their orders are executed so quickly.  For an order to be executed someone somewhere has to be willing to take on the other side of your transaction.  It appears to be unlikely or impossible that you will always find someone to take on the other side at the exact same time you place your order.  But sure enough, every time you want to place a transaction it is filled immediately.  There are two possible reasons why:

1. Proprietary traders.  Proprietary traders are individuals that are employed by a trading firm and buy and sell stock all day long with the objective of earning a trading profit.  These are day traders and they account for an extremely large percentage of total.  Many traders make a good percentage of their money through what is known as ‘rebate trading.’  Basically, a trader receives money from the exchange when they place a limit order as an incentive to make the market more liquid, that is easier for others especially retail clients to buy and sell.  These traders are paid by the stock market around $2 per 1000 shares, while the retail client normally pays around $5 per 1000 shares.
2. Market Makers.  A market maker is an individual employed by a financial institution such as a bank that is ready and willing to buy and sell a stock often at the same time throughout the trading day.  They are literally “making a market” for the stock as they are both a buyer and seller.  Market makers places bids, or offers to buy a stock at a lower price than their offer to sell.  This is how a market maker attempts to earn profits.  It is possible that your order is sold to a market maker who has no intention of holding on to the purchase for the long term and will now attempt to sell his newly bought shares at a profit.  Many prop traders fulfill the duties of market makers due to their large volume and short term timeframe that makes them both buyers and sellers. 

What is an IPO?  How does it work?

An IPO stands for Initial Public Offering and is the term used when a company (for the first time ever) begins selling their stock to the general public through an exchange in order to raise money.  A company might need these additional funds to secure new markets, purchase new factories or expand current operations.  It is important to note that the company can and most often do decide to only sell a small percentage of ownership, say 10% to the public. It is possible that the company already sells stock on a primary market which means that the company sells their stock privately to individual investors and not to the general public.  When a company conducts an IPO the shares now trade in the secondary market where investors buy and sell their stock to each other as opposed to directly with the company.  The process of an IPO has several steps:

The first step that takes place is known as the Pre Announcement.  The company decides that they want to raise capital and will hire the services of an investment bank such as Goldman Sachs, Credit Suisse, or Barclays Capital to evaluate the company and derive a strategy towards moving forward.  The bank will calculate what they believe the firm to be worth and will handle the duties of selling the shares and collecting the funds.  It is common that 2-3 different investment banks collaborate and work together (known as underwriters) with one firm taking the lead (known as the lead underwiter). 

The next step occurs when the investment bank conducts a “road show” where it’s sales team and the company’s senior managers will travel and visit large institutions and sell the stock (examples of road show presentations can be seen online at www.retailroadshow.com.  The reason for this is often the banks have billions of dollars of stock to sell so it is logical that they approach institutions that can buy millions if not hundreds of millions of dollars worth of stock in one shot.  This is also the reason why an individual investor is not likely able to participate in the IPO as the ‘average Joe’ does not have the millions of dollars needed and the investment banks are often on tight schedules.  The investment bank will then generate a lot of publicity and hype and the stock will be discussed on business news networks such as CNBC or print journals like The Wall Street Journal.

The following step of an IPO is the public sale.  The company chooses a date for the IPO offering and the stock begins trading after a little ceremony and celebration takes place at the stock market’s headquarters. In this step it is important to discuss what determines the opening price.  The price at which the stock is available to the market is NOT the same price that the investment bankers sold to large investors during the “road show.”  The price that a stock begins trading at is determined by the overall market.  Investors and traders place bids for the stock at different price levels and all this is recorded and evaluated.  The investment bankers will evaluate all this information and determine the morning of the IPO (often a few hours before initial trading) the official opening price which best satisfies the overall market demand.  Trading will begin at a pre-determined time at that price and for the first time ever the stock available to every investor, not just large financial institutions. 

Let’s look at an example of Linkedin.com LNKD and their road to becoming a Nasdaq listed stock.

Linkedin.com a social network site used for professional networking launched in 2003.  Users upload their own personal profile detailing information such as their educational background and job history.  From this users can create and join new groups and search for prospective employees, suppliers, investors, distributors etc. 

After growing steadily for several years, in early 2011 the company enlisted the services of Morgan Stanley & Co to be lead under-writer and on behalf of the company and conduct an IPO to be listed on the Nasdaq Stock Exchange.  Bank of America and JP Morgan acted as under-writers.  Through complex financial analysis Linkedin was valued Linkedin.com at around US$4 billion and the firm was selling 7.84 million shares at $45 each thereby selling approximately 8% of the firm and raising US$350 million. 

Morgan Stanley and the other under-writers turned to their largest clients and institutional funds selling the stock for $45 a share raising billions of dollars from firms such as Sequoia Capital, Greylock Partners.  Both these firms are multi billion dollar private equity and venture capital firms.

An IPO date was then set for May 19, 2011.  On that morning the investment banking firms realized that there is tremendous demand to buy the stock, and for good reason that extends beyond the fact that Linkedin.com has a strong user base and is profitable.  This is the first social media IPO in history and it was impossible to determine demand until investors and traders started placing bids.  It was then determined the opening price of Linkedin to be $80 per share.  Anyone lucky enough to get in on the IPO price of $45 saw their profits almost double overnight.  When trading began there was a buying frenzy which skyrocketed the stock to over $122 per share. 

The success of this IPO has been the catalyst for other social media and online companies to file for their IPO such as Zygna ZNGA and Groupon GRPN 

Conclusion

The stock market is often perceived is confusing however it is fairly straight forward and easy to understand with some basic background.  I feel like I have touched upon the harder to understand topics which gives you a good foundation to explore the stock markets in further detail.  The New York Stock Exchanges website is www.nyse.com and Nasaq is www.nasdaq.com