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Course 102
The Stock Exchanges

Introduction

When a company decides to issue stock to raise capital, one of the most important things it has to decide is where that stock will be traded. Most stocks are traded on exchanges, which are places where buyers and sellers get together and decide on a price. Some exchanges are physical locations, where buyers and sellers make their transactions on a trading floor; others are virtual locations, consisting of a network of computers. Each of the exchanges is different, and all have evolved over the years.

The New York Stock Exchange

The oldest and most prestigious exchange in the United States (or indeed in the world) is the New York Stock Exchange (NYSE, also known as the "Big Board"), at Broad and Wall Streets near the southern tip of Manhattan. The NYSE traces its beginnings to 1792, when 24 brokers, under a buttonwood tree on Wall Street, signed an agreement to trade securities on a commission basis. One of the first two stocks listed on the NYSE was the Bank of New York BK, which is still traded there. In 1817 the Exchange wrote its first constitution, and in 1903 it moved into its present home at 18 Broad Street.

Trading on the New York Stock Exchange is done on a large trading floor. Orders to buy and sell specific stocks come into brokerage firms that are members of the Exchange, and these firms transmit the orders to floor brokers. A floor broker goes to a designated place on the floor where a specific stock trades (known as a trading post) and executes the order with another broker who specializes in trading that stock. Prices are determined through supply and demand. Once the deal is made, the price and amount are transmitted back to the brokerage firm, which then notifies the person who placed the order.

In order to be listed on the New York Stock Exchange, a company has to meet a rigorous set of standards. Among those standards, its stock has to be worth at least $60 million and the company has to have had at least $2 million in earnings for each of the past two years. There are also cash flow requirements and standards involving minimum number of shareholders and shareholder rights. Companies that cannot meet all the standards can be admitted on a case-by-case basis, but they generally have to be substantially bigger and more established companies to do so.

Even with all this, a company still has to get the stamp of approval of the Exchange, which wants to ensure that the companies it lists are stable. Once it gets approval, the company is assigned a ticker symbol of one to three letters, which is used as its unique identifier in making trades.

Nasdaq

Until recently, all of the biggest public companies in the United States were listed on the NYSE, and only second-tier companies traded elsewhere. Now, however, many of the largest companies in the U.S. trade on Nasdaq (National Association of Securities Dealers Automated Quotation system), an entirely computer-based system, which has become a serious rival to the New York Stock Exchange.

Nasdaq developed out of a network of brokers linked by telephone, which was formalized and linked by computer in 1971. Trading of Nasdaq stocks is done through brokerage firms, much as in the NYSE, but there is no trading floor. Instead, orders are sent out over a distributed network of thousands of computers, where "market makers" give the prices at which they are willing to buy and sell any specific stock. Once a price is agreed upon, the order is completed electronically. The number of shares traded on Nasdaq is now routinely higher than the number traded on the NYSE, which makes sense because Nasdaq has more stocks listed.

There are actually two levels of Nasdaq. The more prestigious of these is the Nasdaq National Market, with around 4,000 stocks. In order to be listed here, companies have to meet listing requirements that are similar to those for the NYSE; in fact, more than a quarter of the Nasdaq National Market stocks would qualify for listing on the NYSE but choose to trade on Nasdaq instead. These stocks include such big technology names as Microsoft MSFT, Intel INTC, and Cisco CSCO.

In addition, there's the Nasdaq SmallCap Market, containing about a third as many stocks as the National Market. As the name implies, this market is for stocks of companies that aren't big enough to meet the listing requirements of the major Nasdaq market, but that still want the prestige and liquidity of trading on a regulated market.

The American Stock Exchange

The third-biggest national stock exchange is the American Stock Exchange, or Amex. Until the 1950s, it was known as the "Curb Exchange," because it originated with brokers meeting on the curb outside the New York Stock Exchange to trade stocks that didn't qualify for the Big Board. Those days are long gone, as Amex now has a trading floor located just up the street from the NYSE, and trading at the two places is done in much the same way. In 1998, the National Association of Securities Dealers, the parent of Nasdaq, bought Amex and combined the two markets into the Nasdaq-Amex Market Group.

The role of Amex has changed over the years. It used to be a major alternative to the NYSE for large U.S. stocks, but Nasdaq now fills that role, and the stocks currently trading on Amex are virtually all small- and mid-cap in size. Most of the trading on Amex these days is in options and other derivatives, whose value depends on the price of some security or index of securities. Since derivatives have become very popular, they have helped Amex to continue thriving.

Regional Exchanges

In addition to the national stock exchanges, there are four regional exchanges: The Boston Stock Exchange, the Chicago Stock Exchange, the Pacific Exchange (in San Francisco and Los Angeles), and the Philadelphia Stock Exchange. There’s also the Cincinnati Stock Exchange, which, despite its name, is a purely electronic market (like Nasdaq) with its headquarters in Chicago.

These regional exchanges started as places for trading the stocks of local companies, which didn’t want to, or couldn’t afford to, be listed on a national exchange. Some such stocks still trade on these exchanges, but the majority of the activity is now in nationally listed stocks, which also trade on one of the major national markets. The Chicago, Pacific, and Philadelphia Stock Exchanges have also followed Amex in becoming major centers for the trading of options and derivatives.

Over-the-Counter (OTC) Stocks

Thousands of stocks not listed on the NYSE, Nasdaq, or Amex are traded on the over-the-counter (OTC) market. This term used to include Nasdaq stocks, since they are not traded on an exchange with a physical trading floor, but now it’s used almost exclusively for small or marginal companies that don’t meet the listing requirements of any of the regulated markets, including Nasdaq. These stocks are sometimes called "pink sheet" stocks, a term left over from the days when lists of over-the-counter stocks were printed on pink paper.

Since they are so small and often financially questionable, OTC stocks tend to be risky and to trade infrequently. However, the very fact that they are so thinly traded means that the chance of finding a bargain price is greater than in stocks traded on an organized market; thus some people like to buy OTC stocks in the hopes of making quick gains. This is made easier by the fact that the share prices of most OTC stocks are low, often under $1.00, but it’s made harder by the fact that information on these stocks is hard to come by and often unreliable. Trading in OTC stocks is a lot like gambling, and it is not something we recommend for beginners.

Quiz 102
There is only one correct answer to each question.

1 Which of the following is a major difference between the New York Stock Exchange (NYSE) and Nasdaq?
a. Stocks of all the largest companies are traded on the NYSE.
b. The NYSE, unlike Nasdaq, has a physical trading floor.
c. Only stocks which don't qualify for listing on the NYSE trade on Nasdaq.
2 Which of the following is not a requirement for a company to be listed on the New York Stock Exchange?
a. Its stock has to be worth at least $60 million.
b. It has to have had at least $2 million in profits the previous two years.
c. It has to have been in existence for at least five years.
3 Currently, the American Stock Exchange (Amex) is:
a. The major alternative to the New York Stock Exchange for large-cap stocks.
b. A major center for trading options and other derivatives.
c. A completely computer-based exchange with no trading floor.
4 Which of the following is not a characteristic of OTC stocks?
a. They are traded on their own separate trading floor.
b. They tend to be smaller companies that can't meet the listing requirements of the major exchanges.
c. Information about them is hard to find and unreliable.
5 Trading at the New York Stock Exchange is completed:
a. On a trading floor with prices dictated by supply and demand.
b. Entirely over a network of computers scattered across the country.
c. By secret ballot.
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