Page 64 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 3: Primary Market and Secondary Market

to obtain the right to trade securities there. The trading that takes place on the floor of the stock Notes
exchange resembles an auction, as members trying to sell a client’s stock strive to obtain the
highest price possible, while those representing the buyer-clients strive to obtain the lowest
price possible. When members announce their intention to buy or sell a certain number of
shares of a certain stock, they receive bids or offers as the case may be from other members.
Sellers accept the highest bid or hold shares until an acceptable bid is offered. A member can act
as buyer or seller.
Only members can transact business at the posts, where securities are traded. The ‘open outcry’
offers a relatively simple method of trade-matching that has been used for centuries, in
commodities markets. In this, buyers and sellers match themselves up directly by calling out
bid and offer price offers in the trading ‘pit’. The physical order matching system is now emulated
by the new screen based exchanges. Trading pits are rapidly losing ground to the electronic
system. The new electronic media is used mainly by market-makers and corporates, to conduct
large-scale transactions.
Online trading systems are gaining popularity at the retail level as well. The more progressive
stock exchanges have electronic quotation systems that provide immediate price quotations.
Companies that wish to have their prices quoted must meet specific requirements on minimum
assets, capital and number of shareholders. Specialists take positions in specific stocks and stand
ready to buy or sell these stocks. They are expected to maintain a fair and orderly market, in the
securities assigned to them. Floor brokers execute stock transactions for their clients.
Transactions are facilitated, by market-makers who stand ready to buy or sell specific stock in
response to customers’ orders made through telecommunications network. Liquidity of the
stock market is enhanced by market-makers, because they are required to make a market at all
times in an effort to stabilise prices. Whereas, brokers on the exchanges match buyers and
sellers, market makers serve not only as brokers, but also as investors. Marketmakers have a
bid/ask spread, to charge for transactions they execute. Consequently, transaction costs become
higher.
The market is created, from the flow of orders to buy or sell each stock. Investors communicate
their orders to brokers by specifying name of the stock, whether to buy or sell it, number of
shares to be bought or sold, and whether the order is a market order i.e. transact at the best
possible price or limit order i.e. limit placed on the price at which a stock can be purchased or
sold. In a limit order, investors may obtain a stock at a lower price but there is no guarantee that
the price will reach that limit. Orders may be placed for a day or longer periods.
Investors can purchase stock on margin (with borrowed funds) by signing up for margin account
with their broker. Investors can sell the stock short or short the stock when they anticipate that
the price will decline. When they sell short, they are essentially borrowing the stock from an
investor to whom they will have to provide it. Short sellers earn the difference between what
they initially sold the stock for and what they pay to obtain the stock. There is also the brokerage
mechanism, which is employed in thin markets for heterogeneous instruments. This is quite
adequate for traders with little immediacy or liquidity requirement, who trade frequently.
Brokers use their knowledge of clientele to find buyers and sellers, or are approached by brokers’
clients, without taking items on to their books. In an extreme case, where the process fails, an
auction may be arranged. Small company shares are usually traded on a ‘matched bargains’
basis, by small regional stockbrokers. Matching methods are used, to make markets in equities
and to determine opening prices for auctions. Client ‘limit orders’ which specify the size of the
trade and an acceptable price range, are collected before the market opens. These buy and sell
orders are then aggregated and the market clearing price is found at the level at which net
demand is close to zero. A market-maker has the option of using this aggregate demand/supply
schedule as an offer curve and can execute these limit orders against his own inventory. Liquidity
in these markets is maintained by dealers in return for privileges, which they receive from the

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