What Is the Trading Mechanism in the Stock Exchange?

Stock exchanges are organized to facilitate trading between buyers and sellers. The New York Stock Exchange and NASDAQ are the two major stock exchanges in the U.S. While they share many features, they use different mechanisms to transact trades. NYSE trading is performed by human beings on the Wall Street trading floor, whereas the NASDAQ is a computer network with no particular physical location.

Definitions

The basic trading mechanism is the auction, where supply and demand dictate prices. The following definitions are fundamental:

  • Bid: The price a buyer is willing to pay to buy shares
  • Ask or Offer: The price a seller demands to sell shares
  • Market Order: An order to buy shares at the best (lowest) current ask or sell shares at the best (highest) current bid
  • Limit Order: An order to buy or sell share at a specified price
  • Stop Order: An order to sell shares at a specified price in order to prevent losses from exceeding a preset amount

In an auction, the difference between the highest bid and lowest ask is the spread. On a market order, the spread is zero and the order is filled immediately because the buyer agrees to pay the best ask, or the seller agrees to take the best bid. The buyer will receive shares and the seller receives cash at the agreed price when the trade settles, which in the U.S. is three business days after the order is filled. A limit order guarantees price but does not guarantee the order will be filled.

The Specialist System

The NYSE uses specialists to transact trades. Each specialist firm is responsible for one or more stocks listed on the exchange, and each stock is assigned to only one specialist. The job of the specialist is to receive and match bids and asks conveyed by brokers on behalf of traders. The specialist maintains an order book that shows all active orders, and attempts to give equal treatment to all orders, big and small. If the bid/ask spread is unusually large, the specialist may intervene and buy or sell shares in order to maintain the market's liquidity -- the ability to buy and sell easily without significantly moving the price. The specialist also sets the opening price of the stock at market open. The NYSE SuperDOT system is used to place orders with specialists electronically.

Market Makers

The NASDAQ system uses market makers rather than specialists. Several market makers may handle the same stock. Each market maker maintains a continuous bid/ask spread within a specified percentage range, and attempts to buy or sell its own shares or find buyers or sellers to fill orders that fall within its spread. All orders and transactions are conveyed electronically among traders, brokers and market makers. The NASDAQ uses the Small Order Execution System to automatically transact orders up to 1,000 shares. Market makers must fill SOES orders as long as they fall within their published spread.

Alternative Trading Systems

Alternative trading systems compete with stock exchanges. They allow traders to buy and sell securities away from the stock exchange, on electronic communications network, dark pools, matching networks and other mechanisms that cut the middleman out of the transaction process.