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September 01 2008| Filed Under 401K, Entrepreneur, ETFs, Investing Basics,
Options
A stock exchange does not own shares. Instead, it acts as a sort of high-tech
flea market where buyers connect with sellers. Every public stock trades on one
of several possible exchanges such as the New York Stock Exchange (NYSE) or
American Stock Exchange (AMEX). Although you will most likely trade stocks
through a broker, it is important to understand the relationship between
exchanges and companies and the ways in which the requirements of different
exchanges provide protection to investors.
How Does It All Start?
The primary function of an exchange is to provide liquidity; in other words, to
give sellers a place to "liquidate" their share holdings.
Stocks first become available on an exchange after a company conducts its
initial public offering (IPO). In an IPO, a company sells shares to an initial
set of public shareholders (the primary market). After the IPO "floats" shares
into the hands of public shareholders, these shares can be sold and purchased
on an exchange (the secondary market).
The exchange tracks the flow of orders for each stock, and this flow of supply
and demand sets the price of the stock. Depending on the type of brokerage
account you have, you may be able to view this flow of price action. For
example, if you see that the "bid price" on a stock is $40, this means somebody
is telling the exchange that he or she is willing to buy the stock for $40. At
the same time you might see that the "ask price" is $41, which means somebody
else is willing to sell the stock for $41. The difference between the two is
the bid-ask spread.
Auction Exchanges - NYSE and Amex
The NYSE and AMEX are both primarily auction-based, which means specialists are
physically present on the exchanges trading floors. Each specialist
"specializes" in a particular stock, buying and selling the stock in a verbal
auction. These specialists are under competitive threat by electronic-only
exchanges that claim to be more efficient (that is, execute faster trades and
exhibit smaller bid-ask spreads) by eliminating human intermediaries.
The NYSE is the largest and most prestigious exchange. Collectively, as of
December 31, 2007, its listed companies represent about $30.5 trillion in
market capitalization.
Listing on the NYSE affords companies great credibility because they must meet
initial listing requirements and also comply annually with maintenance
requirements. For example, to remain listed, NYSE companies must keep their
price above $1 and their market capitalization (number of shares x price) above
$50 million.
Furthermore, investors trading on the NYSE benefit from a set of minimum
protections. Among several of the requirements that the NYSE has enacted, the
following two are especially significant:
Companies must get shareholder approval for any equity incentive plan (for
example, stock option plan or restricted stock plan). In the past, companies
were allowed to sidestep shareholder approval if an equity incentive plan met
certain criteria; this, however, prevented shareholders from knowing how many
stock options were available for future grant.
A majority of the members of the board of directors must be independent.
However, each company has some discretion over the definition of "independent",
which has caused controversy. Furthermore, the compensation committee must be
entirely composed of independent directors, and the audit committee must
include at least one person who possesses "accounting or financial expertise".
AMEX is a smaller but quite prestigious exchange. AMEX also has a history of
innovating: it pioneered the concept of exchange-traded funds (ETFs) and it has
the second largest options trading market.
Nasdaq (an Electronic Exchange)
The Nasdaq, an electronic exchange, is sometimes called "screen-based" because
buyers and sellers are connected only by computers over a telecommunications
network. Market makers, also known as dealers, carry their own inventory of
stock. They stand ready to buy and sell Nasdaq stocks, and they are required to
post their bid and ask prices. Among several high-technology sections, Nasdaq
lists the most companies. Although the NYSE has a far greater total market
capitalization, Nasdaq has surpassed the NYSE in the number of both listed
companies and shares traded.
Nasdaq has listing and governance requirements that are similar but slightly
less stringent than those of the NYSE. For example, a stock must maintain a
price of $1 and the value of the public float (number of traded shares
multiplied by stock price) must be at least $1.1 million. If a company does not
maintain these requirements, it can be delisted to one of the OTC markets
discussed below.
Nasdaq Small Cap
Nasdaq has a separate "tier" for small capitalization companies; the average
market cap of the 685 companies listed in this tier at the end of 2003 was
about $60. This is an excellent exchange for investors interested in smaller
companies because the Nasdaq Small Cap also has listing and governance
requirements.
Electronic Communication Networks (ECNs)
ECNs are part of a class of exchange called alternative trading systems (ATS).
ECNs trade Nasdaq-listed stocks, but they connect buyers and sellers directly.
Because they allow for direct connection, ECNs bypass the market makers. You
can think of them as an alternative means to trade stocks listed on the Nasdaq
and, increasingly, other exchanges as well (such as the NYSE or foreign
exchanges).
There are several innovative and entrepreneurial ECNs, and they are generally
good for customers because they pose a competitive threat to traditional
exchanges, and therefore push down transaction costs. Currently, ECNs do not
really serve individual investors; they are mostly of interest to institutional
investors.
There are several ECNs, including INET (the result of an early 2004
consolidation between the Instinet ECN and Island ECN) and Archipelago (one of
the four original ECNs that launched in 1997).
Over-the-Counter (OTC)
Over-the-counter (OTC) refers to markets other than the organized exchanges
described above. OTC markets generally list small companies, and often (but not
always) these companies have "fallen off" to the OTC market because they were
de-listed from Nasdaq.
Some individual investors will not even consider buying OTC stocks due to the
extra risks involved. On the other hand, some strong companies trade on the
OTC. In fact, several strong companies have deliberately switched to OTC
markets to avoid the administrative burden and costly fees that accompany
regulatory oversight laws such as the Sarbanes-Oxley Act. On balance, you
should be careful when investing in the OTC if you do not have experience.
There are two OTC markets:
Over-the-Counter Bulletin Board (OTCBB) is an electronic community of market
makers. Companies that fall off the Nasdaq often end up here. On the OTCBB,
there are no "quantitative minimums" (no minimum annual sales or assets
required to list).
Companies that list on the Pink Sheets (i.e. less than 300 shareholders) are
not required to register with the SEC. Liquidity is often minimal. Also, keep
in mind that these companies are not required to submit quarterly 10Qs.
Summary
To be traded, every stock must list on an exchange, a central "flea market"
where buyers and sellers meet. The two big U.S. exchanges are the esteemed NYSE
and the fast-growing Nasdaq; companies listed on either of these exchanges must
meet various minimum requirements and baseline rules concerning the
"independence" of their boards. But these are by no means the only legitimate
exchanges. Electronic communication networks are relatively new, but they are
sure to grab a bigger slice of the transaction pie in the future. Finally, the
OTC market is a fine place for experienced investors with an itch to speculate
and the know-how to conduct a little extra due diligence.
by David Harper
In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder
of The Bionic Turtle, a site that trains professionals in advanced and
career-related finance, including financial certification. David was a founding
co-editor of the Investopedia Advisor, where his original portfolios (core,
growth and technology value) led to superior outperformance (+35% in the first
year) with minimal risk and helped to successfully launch Advisor.
He is the principal of Investor Alternatives, a firm that conducts quantitative
research, consulting (derivatives valuation), litigation support and financial
education.