Unlike over the counter forex market, most stocks are traded on an exchange. While this may not seem like information that is relevant to the individual trader, an understanding of the role an exchange plays in the market is essential to understanding how the different exchanges operate, and therefore how to place stock trades.
At its very core, a stock exchange provides 1 central place where all the buyers and sellers for a particular stock send their orders. This brings about several key features include:
1. Price Transparency – all trades for a stock flow through one exchange, this means that everyone sees and has the opportunity to execute on the same exact price as everyone else.
2. A central method of clearing trades – In an exchange traded market, there is what is known as a clearing firm, which is normally a triple A rated institution that is the counterparty to all trades. What this means is that while you may be buying 100 shares of Microsoft from Joe in Indiana who is selling 100 shares of Microsoft, the counterparty to both your buy order, and Joe’s sell order, is the clearing house. This is probably the biggest differentiator between over the counter markets and exchange traded markets, as this essentially eliminates the worry that the person on the other side of your trade will not deliver on their obligations.
3. Regulatory Framework – the exchanges provide a standardized regulatory framework that all participants must adhere to, and a method for resolving disputes should they arise. This makes people more comfortable and more likely to trade, which increases liquidity.
4. Liquidity – Liquidity is basically how much of a particular instrument can be traded without affecting its price which is directly related to the volume or number of buyers and sellers transacting at anyone time. Providing the deepest liquidity is a primary goal of all financial markets, and all of the features of an exchange that we have just discussed are in place to increase liquidity. Because exchanges provide one place for all traders who are interested in trading a particular stock or other security to trade, this makes it much easier for companies to raise money through a public offering then it would otherwise be, and drives costs down for traders and everyone else involved as well.