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How the Market Works

One of the distinguishing characteristics of stocks is the ease with which they can be bought and sold within the marketplace. When you invest in shares of stock, you can sell them at any time at their current market price, which can fluctuate on a daily basis. Part of becoming an informed investor in stocks, therefore, is understanding how the stock market works.

In the United States, the Securities and Exchange Commission (SEC), a federal agency, regulates the stock market. The SEC was formed in the 1930s when, after the collapse of the stock market in 1929, the need for regulation of the securities market became apparent. To protect investors and ensure the market remains fair and continuous, the SEC monitors new stock offerings, trading and the registration of brokers and dealers.

The stock market is comprised of the primary market, where new offerings of stock originate, and the secondary market where trading occurs. When a company decides to make a public offering of stock, or “go public,” the SEC requires that it file a registration statement which includes a detailed prospectus. All potential investors are provided with this prospectus to help them decide whether or not to purchase the new issue of stock.

After originating on the primary market, shares of stock may be bought or sold on the secondary market through the various stock exchanges or the over-the-counter (OTC) market. Listed stocks are bought or sold on one of the stock exchanges. Unlisted stocks are bought or sold over-the-counter. In general, the more actively traded and widely held stocks are listed on an exchange.

The largest of these, the New York Stock Exchange (NYSE), and the second largest, the American Stock Exchange (AMEX), are located in New York City. NYSE companies tend to be larger and more established than those listed on the AMEX.

A stock exchange is an incorporated association of members that includes brokers, specialists and floor traders who act as agents for the public in buying and selling shares of stocks listed on the exchange. To become a member, a firm must purchase a “seat” on the exchange. To list shares of its stock for trading on an exchange, a company must also meet strict criteria. The NYSE, for example, requires specific levels of profit margins, tangible assets, market value of shares, number of publicly held shares, and number of stockholders for an initial listing.

Instead of buying and selling stocks on the floor of a stock exchange, participants in the over-the-counter market trade stocks using telephones and computers. Traditionally, dealers in the OTC market have bought and sold securities for their own inventory, marking prices up or down as any wholesale merchant would do. These dealers are said to “make a market” by continually quoting a price at which they are willing to buy a security (bid) and higher price at which they are willing to sell (ask price). They profit from the “spread,” which is the difference between the bid and the asked price.

Today, most OTC market trading occurs through an electronic market, known as the NASDAQ Stock Market, which links participants to each other and with other national and foreign markets. Formed in the early 1970s by the National Association of Securities Dealers (NASD), a self-regulating organization of securities dealers, the NASDAQ Stock Market has grown enormously since its inception.