We have talked about the importance of investing and saving for the long term, but many people have never learned how to execute a trade or how an exchange works. In Chapter 5 of our flagship course, we introduce you to the concept of a market, and how it consists of buyers - those who demand products - and sellers - those who supply products. There are many kinds of markets that are tailored to buying and selling specific types of products. We can differentiate these markets into four specific types:
- Direct Search Markets
- Brokered Markets
- Dealer Markets
- Auction Markets
Direct Search Markets are the least organized by nature. This type of market consists of individuals actively seeking out other individuals to buy a specific product. You may recognize a Direct search market such as Kijiji, Craigslist, or Marketplace.
Brokered Markets are considered the next step up in terms of organization of a market. A Brokered Market consists of brokers who look for goods or services on behalf of a buyer, or look for buyers on behalf of a seller. Brokered Markets are typically used to buy or sell goods and services that have a high value. This is because the broker’s fee is typically small (generally less than 2%) of the total purchase. You may be familiar with one of the most common brokered markets: Real Estate. Brokers in particular markets develop specialized knowledge on valuing assets that are traded in their specific market. There is another large brokered market that most people outside of the finance world are not very familiar with, and it is called the primary investment market.
The primary investment market is where new issues of securities are offered to the public. This is better known as an initial public offering, or an IPO. The brokers in the primary investment market are known as investment bankers. Investment bankers seek investors to purchase securities, such as shares of a company, directly from the issuing corporation.
Sometimes trading activity, or volume of a particular type of asset can become very high relative to other types of assets. When this occurs, a dealer market typically follows. A dealer is an individual that specializes in various assets, and then purchases these assets to sell at a higher price from their inventory. This is similar to how you may find antique furniture. An antiques dealer would buy various antiques from multiple individual sellers, and then feature the antiques in their own store to sell and make a profit. The money the dealer makes is from the spread (or difference) between what the dealer offers an individual seller (known as the bid) and what the dealer is willing to sell the product for (known as the ask). Generally, lots of market activity is required for dealers to make an attractive profit. In the financial world, most bonds trade in over-the-counter (OTC) dealer markets.
The largest type of market where buyers and sellers converge is known as an auction market. The concept of an auction market is simpler than some of the other markets discussed above. In any auction, there is a seller that has an asset, and is willing to sell the asset for the highest offered price. In the financial world, an auction market is where traders converge to one place in order to buy and sell financial securities, most notably stocks. An example of an auction market would be the New York Stock Exchange (NYSE). One advantage of an auction market over a dealer market is that an individual does not need to search across several dealers to find the best price of an asset. There is such a high volume of interaction (what used to be physically but is now electronically) between individual traders that participants can mutually agree on the best price to buy and sell an asset based on supply and demand.
There are two types of auction markets: periodic and continuous. Periodic auctions are those that happen infrequently, such as an art auction. Continuous auction markets are those that happen continuously, such as a stock exchange. In a continuous market, you may place a bid and acquire a stock to the lowest seller, and the next moment you could place an ask and sell the stock to the highest buyer.
Now continuous auction markets require an immense amount of trading activity to cover the expenses of maintaining the market. Continuous auction markets such as the NYSE or the Nasdaq exchange limit the stocks that are traded on their exchanges to firms that have sufficient trading interest.
When it comes to stock exchanges, one should understand that these are secondary investment markets. Once the stocks are being traded on an exchange, each company listed on the stock exchange does not receive any proceeds from its stock being traded amongst investors. Similar to how a used item being sold on Kijiji such as an Ikea table, the resale to a new buyer will provide no profits towards Ikea. This is the same idea for secondary markets such as stock exchanges.
Now that we have an understanding of the purpose of a stock exchange, let’s dive into the two types of ways you can execute a trade:
- Market Orders
- Price-Contingent Orders
Market Orders are buy or sell orders that are to be executed immediately, at the current market price. For example, you as an investor may want to buy shares of a company such as Microsoft. When you see the price on your computer or on your phone, that is considered to be the current “market price.” If you were to place a market order to buy Microsoft shares immediately, your intuition may suggest that you will get as many shares as you please at that price displayed on your screen; however, you may be surprised to see that you paid a higher average price than you anticipated. This is because the current market price may change as you proceed to buy more shares.
If Microsoft had a current market price of $220 per share, and you ordered 30 shares, you may expect to pay $6,600 for the total. But what if only the first 10 shares of your 30 were available for $220? What if the next 10 were being offered for $221? And the next 10 for $222? That would mean your average price per share that you purchased is actually $221, and your total order is $6,630. Now $30 may not seem like much, but what if the stock price was far lower to begin with? Or if you were to buy hundreds of shares instead of tens of shares? More importantly, what if you did not have a sufficient amount of cash to pay for the 30 shares because you miscalculated their true cost?
Typically the market order will be fairly similar to the price that you see displayed, but in extreme cases, one can drastically underestimate how much they will pay for shares. The same goes for when you may want to sell the shares. You could accidentally sell many shares for far lower value than you anticipated. These are the reasons why any experienced and knowledgeable investor or trader will not execute market orders. They will execute a Price-Contingent Order.
An investor can place a buy or sell order that specifies the price at which the order can be made. A limit buy order will only be executed at or below the specified share price. Conversely, a limit sell order will only be executed at or above the specified share price. In our example with Microsoft, you could choose to make a limit order.
Say you did not want to pay more than $220 per share. You can make a limit buy order for 30 shares, with a limit of $220 per share. The brokerage system that you use (whether be a bank or other trading service) will only buy 10 shares instead of 30 shares, because any shares that would cost more than $220 cannot be bought - as per your instructions. Limit orders are a great way to reduce the potential risk of buying or selling a security for greater than or less than you intended.
Setting limit orders will protect you from very volatile stocks (when stocks go up and down very rapidly) and from other investors who place what is known as a “stink bid.” A stink bid is when somebody places a limit buy order for much less than the current market price, or a limit sell order from much higher than the current market price. These stink bids can be executed if then become the next available offering in a large market order. So just remember, when executing a trade, limit orders are your friend.
Understanding what markets are and how orders are made is an important step towards building your wealth. Before you perform orders for stocks and exchange traded funds (ETFs), you need to learn the basics of evaluating a company, or a set of companies. Improve your financial literacy with The Finance You Need To Know, or get started with our free intro course.
Interested in what it takes to build a company? Check out our Zack’s interviews with CEO of TuskHub, Katie McLean, VP of Operations at AeroShield, Aaron Baskerville-Bridges, and CEO of VizWorX, Jeff LaFrenz.