What is a Stock Exchange?

The Concept of a Stock Market

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A stock market is a centralised place where shares are traded between buyers and sellers. Effectively it’s the same as any other type of market that might be found on the street in most towns and cities across the United Kingdom.

Though share prices move for a number of reasons, the function of a stock market is to enable a fair and true valuation of shares to be established. In the final analysis, such a fair price is a direct component of the weight of buyers versus sellers (ie, demand and supply).

There are several elements that form a stock market, the most important of which is the stock exchange.

Introducing the Stock Exchange

Just as any street market needs a governing body to operate successfully, so does a stock market. The stock exchange is often set up as a company with the remit to do exactly that. It produces specific rules that dictate the qualification requirements of companies to be listed, and regulations which govern the way that stock market participants must behave toward each other and customers.

All exchanges used to operate in their own single physical location, called the stock exchange floor, where traders and brokers would meet to buy and sell shares between them either for their own account or for customers. However, with the advent of the internet the majority of stock exchanges now operate a ‘virtual exchange’, where prices, trading, and stock information is displayed on screens in brokers’ and traders’ offices and can even be accessed in real time by anyone with a computer and internet connection.

Stock exchanges are profit making companies, and so charge companies to have their shares listed and traded, as well as charge all the market participants for the privilege of access to the exchange.

Some of the largest exchanges in the world are the Nasdaq (based in America and started as a market for new and emerging technology companies, it was the world’s first virtual exchange, Nasdaq standing for National Association of Securities Dealers’ Automatic Quotations), the London Stock Exchange (LSE), and the Tokyo Stock Exchange. The world’s largest stock exchange by value of trade is the New York Stock Exchange which is the only one of all the major exchanges to continue to trade on a single centralised floor.

Methods of dealing

Shares around the world are dealt in one of three ways.

The first of these is under the market maker system, where stock exchange registered market makers are obliged to offer a two way price at all times of the trading day. This ensures that there is always a price at which an investor can buy or sell shares. Market makers make their profit by buying and selling at different prices, with orders given to them by stockbrokers who are obliged to deal at the very best price for their clients. Stockbrokers make their money by charging the investor a commission to deal.

The second method of dealing on a stock exchange is through order entry, where customer orders are directly entered to the price dissemination system. This means that where there are more buyers than sellers, for example, there may not be a price at which stock can be automatically bought. For this reason, many exchanges operate a hybrid system combining both order entry and market maker to ensure that prices are as competitive as possible with the ability to trade under any trading circumstances.

Brokers

Brokers are companies registered with the stock exchange that are permitted to trade on exchange on behalf of their clients, who can be large investment companies (in the stock market, called institutions) or individual investors (called private clients). They act as middlemen between buyers and sellers, and charge commissions or flat fees per order executed.

While some institutions may be allowed to deal directly on the exchange, most don’t in order to protect their anonymity. Private clients must go through a broker when buying or selling shares, though many brokers now offer an automated platform on which clients can enter their own orders direct to the market.

Stock market traders

Traders come in a variety of guises, from the small day trader sitting in his home office to the mega institutional trader dealing in billions of pounds worth of stock every day.

These traders – including market makers and principal traders dealing with their own company’s money – provide the liquidity that helps ensure a professional market place for investors to operate in.

Stock market indices

Stock indices enable investors to quickly and easily see the performance of the stock market and its listed companies. Most such indices are monitored by independent companies under licence from the stock exchange, and will measure the relative value of a basket of stocks. For ease of reference these indices are then displayed as a points value.

The FTSE 100 is the most commonly quoted UK stock market index, and measures the performance of the top 100 companies in the UK. Similarly the S&P500 Index in the United States measures the share prices of its 500 largest companies, while the Dow Jones Industrial Index has just 30 components – though they are 30 of the largest companies not just in the United States but also the world.

In summary

When wanting to buy or sell shares on a stock exchange, a private client will place an order with his broker. That broker will then send the order to the market, where it will either be matched with an order in the opposite direction or shown to a market maker for execution (providing the price is agreeable). The exchange facilitates this trading activity, and the price dealt directly affects the value of the stock market index of which the company whose shares have been traded is a component.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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