How Stock Trading Works
"Trading stocks." You hear that phrase all the time, although it really is wrong. You don’t trade stocks like baseball cards—for example, I’ll trade you 100 IBMs for 100 Intels.
Trade = Buy or Sell
To “trade” in the jargon of the financial markets means to buy and sell. The workings of a system that can accommodate trading of one billion shares in a single day are a mystery to most people. No doubt, our financial markets are marvels of technological efficiency.
Traders and markets must handle an order for 100 shares of Acme Kumquats with the same care and documentation as an order of 100,000 shares of MegaCorp.
You don’t need to know all of the technical details of how to buy and sell stocks, but having a basic understanding of how the markets work is important for an investor.
Two Basic Methods
There are two basic ways exchanges execute a trade:
- On the exchange floor
There is a strong push as of December 2017 to move more trading to the networks and off the trading floors, but this push is meeting with some resistance. Most markets, most notably the NASDAQ, trade stocks electronically. However, the futures markets trade in person on the floor of several exchanges, but that’s a different topic.
Exchange Floor Trades
Trading on the floor of the New York Stock Exchange (NYSE) is the image most people have, thanks to television and movie depictions of how the market works. When the market is open, you see hundreds of people rushing about shouting and gesturing to one another, talking on phones, watching monitors, and entering data into terminals. It looks like chaos.
At the end of the trading day, the floor calms down, but it can take up to three more trading days for a trade to settle, depending on the type of trade. Here is a step-by-step walk-through of the execution of a simple trade on the NYSE.
- You tell your broker to buy 100 shares of Acme Kumquats at market.
- Your broker’s order department sends the order to its floor clerk on the exchange.
- The floor clerk alerts one of the firm’s floor traders, who finds another floor trader willing to sell 100 shares of Acme Kumquats. This is easier than it sounds because the floor trader knows which floor traders make markets in particular stocks.
- The two agree on a price and complete the deal. The notification process goes back up the line and your broker calls you back with the final price. The process may take a few minutes or longer depending on the stock and the market. A few days later, you will receive the confirmation notice in the mail.
Of course, this example was a simple trade; complex trades and large blocks of stocks involve considerably more detail.
In this fast-moving world, some people are wondering how long a human-based system like the NYSE can continue to provide the level of service necessary. The NYSE handles a small percentage of its volume electronically, while its rival NASDAQ is completely electronic.
The electronic markets use vast computer networks to match buyers and sellers, rather than human brokers. While this system lacks the romantic and exciting images of the NYSE floor, it is efficient and fast. Many large institutional traders, such as pension funds, mutual funds, and so forth, prefer this method of trading.
For the individual investor, you frequently can get almost instant confirmations on your trades, if that is important to you. It also facilitates further control of online investing by putting you one step closer to the market.
That said, you still need a broker to handle your trades, as individuals don’t have access to the electronic markets. Your broker accesses the exchange network, and the system finds a buyer or seller depending on your order.
What does this all mean to you? If the system works, and it does most of the time, all of this will be hidden from you. However, if something goes wrong, it’s important to have an idea of what’s going on behind the scenes.
What Else You Need to Know
If you're planning on managing your own investments and making your own trading decisions, you should learn some more about how stock prices are set, how to understand stock quotes, bid & ask prices, and stock orders. It's important to also understand how to use trailing stops to protect stock profits to avoid losing all your gains.