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Most of this book covers stock trading, so we obviously concentrate on how the key exchanges – NYSE and NASDAQ – operate and how these operations impact your trading activity.

New York Stock Exchange (NYSE: ICE)

The U.S. stock market actually dates back to May 17, 1792, when 24 brokers signed an agreement under a buttonwood tree at what today is 58 Wall Street. The 24 brokers specifically agreed to sell shares of companies among themselves, charging a commission or fee to buy and sell shares for others who wanted to invest in a company. Yup, the first American stockbrokers were born that day.

A formalized exchange didn’t come into existence until March 8, 1817, when the brokers adopted a formal constitution and named their new entity the New York Stock & Exchange Board. Brokers actually operated outdoors until 1860, when the operations finally were moved inside. The first stock ticker was introduced in 1867, but it wasn’t until 1869 that the NYSE started requiring the registration of securities for companies that wanted to have their stock traded on the exchange. Registration began as a means of preventing the over‐issuance (selling too many shares) of a company’s stock.

From these meager beginnings, the NYSE built itself into the largest stock exchange in the world, with many of the largest companies listed on the exchange. Trading occurs on the floor of the exchange, with specialists and floor traders running the show. Today these specialists and floor traders work electronically, which first became possible when the exchange introduced electronic capabilities for trading in 2004. For traders, the new electronic‐trading capabilities are a more popular tool than working with specialists and floor traders. Electronic‐trading capabilities were enhanced when the NYSE merged with Archipelago Holdings in 2006. The exchange expanded its global trading capabilities after a merger with Euronext in 2007, which made trading in European stocks much easier. NYSE Euronext was bought by Intercontinental Exchange (ICE) in 2013.

You may not realize just how much the concept of supply and demand influences the trading price of a stock. Price swings of a stock are caused by shifts in the supply of shares available for sale and the demand created by the number of buyers wanting to purchase available shares.

The designated market makers

Designated market makers buffer dramatic swings by providing liquidity when needed, such as when news about a company breaks. If news that has a major impact on a stock’s price breaks, designated market makers buy shares or sell the ones they hold in a company to make the trend toward a higher or lower stock price more orderly. For example, if good news breaks, creating more demand for the stock and overwhelming existing supply, the designated market maker becomes a seller of the stock to minimize the impact of a major price increase by increasing supply. The same is true when bad news strikes, creating a situation in which having more sellers than buyers drives the stock price down. In that situation, the designated market maker becomes a buyer of the stock, easing the impact of the drop in price. Designated market makers operate both manually and electronically to facilitate stock trading during market openings, closings, and periods of substantial trading imbalances or instability.

The floor brokers

The guys you see on the floor of the stock exchange, waving their hands wildly to make trades, are the floor brokers. They’re actually members of the NYSE who trade exclusively for their own accounts. Floor brokers also can act as floor brokers for others and sell their services. But over 82 percent of trades take place electronically, so floor trading today is used primarily to trade a small group of extremely high‐priced stocks not traded electronically.

Supplemental Liquidity Providers

In order to handle the volume of today’s international marketplace, the NYSE established a new class of market participants called Supplemental Liquidity Providers (SLPs). These high‐volume members of the exchange add liquidity to the marketplace. Each SLP is assigned securities for which he or she is obligated to maintain active trading of at least 10 percent in a trading day. SLPs must average 10 million shares exchanged in a day. They help generate more quoting activity to improve pricing and liquidity for stocks.

NASDAQ

NASDAQ, which stands for the National Association of Securities Dealers Automated Quotations, was formed after an SEC study in the early 1960s concluded that the sale of over‐the‐counter (OTC) securities – in other words, securities that aren’t traded on the existing stock exchanges – was fragmented and obscure. The report called for the automation of the OTC market and gave the responsibility for implementing that system to the National Association of Securities Dealers (NASD).

The NASD began construction of the NASDAQ system in 1968, and its first trades were made beginning February 8, 1971, when NASDAQ became the world’s first electronic stock market. In 2007, NASDAQ combined forces with the Scandinavian exchange group OMX. Together, NASDAQ OMX operates 25 securities markets. It also provides trading technology to 70 exchanges in 50 countries.

Market makers

NASDAQ market makers compete with each other to buy and sell the stocks they choose to represent. Nearly 300 member firms act as market makers for NASDAQ. Each uses its own capital, research, and system resources to represent a stock and compete with other market makers.

Market makers compete for customers’ orders by displaying buy and sell quotations on an electronic exchange for a guaranteed number of shares at a specific price. After market makers receive orders, they immediately purchase or sell stock from their own inventories or seek out the other side of the trades so they can be executed, usually in a matter of seconds. The four types of market makers are

❯❯ Retail market makers: They serve institutional and individual investors through brokerage networks that provide a continuous flow of orders and sales opportunities.

❯❯ Wholesale market makers: They serve primarily institutional clients and other brokers or dealers who aren’t registered market makers in a particular company’s stock but who need to execute orders for their customers.

❯❯ Institutional market makers: They execute large block orders for institutional investors, such as pension funds, mutual funds, insurance companies, and asset‐management companies.

❯❯ Regional market makers: They serve companies and individuals of a particular region. By focusing regionally, these market makers offer their customers more extensive coverage of the stocks and investors in a particular area of the country.

NASDAQ continues to be the leader in electronic trading. Its system, called the NASDAQ Crossing Network, enables fully anonymous trade execution to minimize the market impact of trading.

Over‐the‐counter and bulletin‐board stocks

Stocks that do not meet the minimum requirements to be listed on NASDAQ are traded as over‐the‐counter or bulletin‐board stocks (OTCBB). The OTCBB is a regulated quotation service that displays real‐time quotes, last‐sale prices, and volume information for the stocks traded OTCBB. These stocks generally don’t meet the listing qualifications for NASDAQ or other national securities exchanges, and fewer than two (and sometimes zero) market makers trade in these stocks, making buying and selling them more difficult.

Amex (now NYSE MKT LLC)

When the NYSE moved indoors, some stocks still weren’t good enough to be sold on the exchange. Those stocks were called curb traders and ultimately made up what became known as the American Stock Exchange (Amex), which moved indoors in 1921. Amex lists stocks that are smaller in size than those on the NYSE yet still have a national following. Many firms that first list on Amex work to meet the listing requirements of the NYSE and then switch over.

The Amex trading system was integrated into the NYSE trading system after the merger with the NYSE was completed in 2008, and its named changed to the NYSE Alternext. Then in 2009, the name was changed to NYSE Amex Equities. In May 2012, the name changed again to NYSE MKT LLC.

LISTING REQUIREMENTS

NASDAQ has the easiest minimum listing requirements of all the broad‐market exchanges. The New York Stock Exchange (NYSE) has the toughest requirements to meet for companies to be listed. In addition to listing requirements, companies on the exchanges must conform to certain rules, including publishing quarterly reports, soliciting proxies, and publicly announcing developments that may affect the value of the securities.

Electronic communications networks (ECNs)

Many traders look for ways to get around dealing with a traditional broker. Instead they access trades using a direct‐access broker. We talk more about the differences in Chapter 3. A new system of electronic trading that is developing is called the electronic communications network (ECN).

ECNs enable buyers and sellers to meet electronically to execute trades. The trades are entered into the ECN systems by market makers at one of the exchanges or by an OTC market maker. Transactions are completed without a broker‐dealer, saving users the cost of commissions normally charged for more traditional forms of trading.

Subscribers to ECNs include retail investors, institutional investors, market makers, and broker‐dealers. ECNs are accessed through a custom terminal or by direct Internet connection. Orders are posted by the ECN for subscribers to view. The ECN then matches orders for execution. In most cases, buyers and sellers maintain their anonymity and do not list identifiable information in their buy or sell orders.

In the last few years, ECNs have gone through consolidation. Inet was acquired by NASDAQ. Archipelago now operates under the NYSE umbrella as NYSE Arca Options. Instinet, which serves primarily institutional traders, has an agreement for after‐hours trading with E*Trade.