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American flags with Wall Street sign in the foregroundStocks can be an important part of a diversified investment portfolio. Individual stock shares are bought and sold on a stock exchange. There are multiple exchanges where stocks and other securities can be traded. If you’re new to investing, you may not understand how these exchanges work or why they’re important. While you may conduct all of your stock trades through an online brokerage account, it’s helpful to know what role the exchanges play in those transactions. A trusted financial advisor can also help you understand the mechanics of stock exchanges and which ones your holdings are a part of.

Stock Exchange, Definition

In simple terms, a stock exchange is a type of marketplace where different securities can be bought and sold. While the name implies that only stocks are traded, you can also buy and sell other securities such as mutual funds, exchange-traded funds, bonds and commodities.

A stock exchange allows companies to raise capital by selling shares to individual and institutional investors. From an investor perspective, buying and selling stocks is a way to potentially build wealth through investment returns. This is different from growing your money through savings, which typically involves leaving your money in a deposit account at a bank and earning interest.

Electronic Trading vs. Auction-Based Stock Exchanges

Stock exchanges can take one of two forms: electronic exchanges or auction-based exchanges with a physical location.

The New York Stock Exchange (NYSE) is a prime example of an auction-based stock exchange with a physical location. There’s a trading floor where individuals known as specialists or market makers facilitate trades of stock shares with floor traders, who buy and sell them on behalf of their customers.

In auction-based trading, buyers have a bid price that they’re willing to pay for stock shares while the ask price is what sellers are willing to accept for those shares. Specialists study bid and ask prices to execute trades when the two match. Companies have to meet specific regulatory criteria to have shares of stock listed on the NYSE.

Electronic stock exchanges, on the other hand, don’t have a physical location. All trading is done electronically, which means you can trade stocks from virtually anywhere. The Nasdaq is one of the most well-known examples of an electronic stock exchange.

Similar to the NYSE, companies have to meet certain requirements to be listed on the Nasdaq. In place of specialists, individuals known as dealers buy and sell shares to facilitate trades for investors. Electronic stock exchanges are often considered to be more streamlined and efficient for stock trading, compared to physical auction-based exchanges.

In terms of whether one is better than the other between the NYSE and the Nasdaq, it depends on what you’re seeking as an investor. The NYSE tends to feature more established, stable companies while the Nasdaq can offer more opportunities to invest in stocks that experience rapid movements in pricing. Investing in stocks on both exchanges is one way to capitalize on both when creating a diversified portfolio.

Primary vs. Secondary Markets and Stock Exchanges

bull and bear modelsStock exchanges exist for a very important reason: to allow everyday investors access to stocks and other securities.

The primary market is where new securities are issued and made available for sale to the public. The best example of this is an initial public offering, in which a company goes public for the first time.

In this scenario, you’re buying shares of stock directly from the issuer. The secondary market, on the other hand, is where shares issued on the primary market can be bought and sold.

This is where a stock exchange comes in. If you’re an investor buying shares of stock on the Nasdaq, for example, you may execute a trade to buy 100 shares. Those shares are bought from a seller with the stock exchange acting as the middleman. This is what allows you to build a portfolio of publicly traded stocks as an individual investor.

Over the Counter Stock Trading

As mentioned already, the NYSE and Nasdaq both have specific guidelines that companies need to meet for their shares to be able to trade on either exchange. Those guidelines include:

  • Generating a minimum amount of pretax income for a consecutive number of years
  • Having a minimum threshold market capitalization
  • Having a minimum number of publicly held shares

Share prices must also reach a minimum dollar amount to be listed on either exchange. If a company fails to meet those requirements their shares can be sold through over the counter markets (OTC) instead.

In an OTC market, investments are bought and sold without having to go through a broker or central stock exchange. Trading is done electronically and you also have dealers who are responsible for setting bid and ask prices for a particular stock or security. For example, you can also find foreign currencies or derivatives being traded through an OTC market.

OTC markets are subject to less regulation than the NYSE or Nasdaq, which means they can offer more liquidity to investors. But less regulation and sometimes limited transparency can increase the potential for risk when trading stock shares through an OTC market.

Foreign Stock Exchanges

While the NYSE may be the most well-known stock exchange, other countries have their own exchanges for trading securities as well as currencies and commodities. These exchanges operate using their own regulatory guidelines and some are physical exchanges while others are electronic.

Examples of foreign stock exchanges include:

  • Shanghai Stock Exchange
  • London Stock Exchange
  • Hong Kong Exchanges and Clearing
  • Tokyo Stock Exchange
  • National Stock Exchange of India
  • SIX Swiss Exchange

It’s important to remember not to confuse stock exchanges with stock indexes. For example, the Tokyo Stock Exchange is the actual exchange platform for stock trading in Japan. But the Nikkei is a price-weighted index that tracks the performance of 225 large-cap publicly traded companies in Japan that are traded on the Tokyo Stock Exchange. This is comparable to the S&P 500, which is an index that tracks the 500 largest publicly traded companies in the U.S.

The Bottom Line

Stock trader at his deskStock exchanges serve an important purpose in the U.S. financial system and in the financial systems of countries around the world. They make it possible for you to buy and sell shares of publicly traded companies along with other investments such as bonds and commodities. The activity that occurs on stock exchanges can also have broader implications for the economy since they’re one of the ways in which companies raise capital.

Tips for Investing

  • Consider talking to a financial advisor about your investment strategy to make sure you’re diversified enough to manage risk while meeting your goals. If you don’t have an advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool can help. If you’re ready, get started now.
  • An online brokerage account may be the easiest and cost-effective way to buy and sell shares of stock or other securities on an exchange. When comparing online brokerage account options, consider the range of investments offered, the investment minimums required and what you’ll pay in trading commissions and fees. If you’re buying mutual fund or ETF shares through an online brokerage account, also pay attention to the individual expense ratio of each fund since this directly affects your investment costs.

Photo credit: ©iStock.com/Chaay_Tee, ©iStock.com/peterschreiber.media, ©iStock.com/LanaStock

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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