The Stock Market Trade: What Happens Behind the Scenes?

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The Stock Market Trade:
What Happens Behind the Scenes?

Usually, a stock market trade will be conducted at an institutional brokerage house. Individuals and companies open these accounts for convenient real-time access to the broker's traders, and to take advantage of their research, proxy and reporting services.

These customers pay the broker a commission to trade either on a stock exchange trading floor (such as NYSE, AMEX or one of the smaller regional exchanges) -- or through a computer connection into an automated quotation system (such as Nasdaq).

What are the types of customer orders? Customers have the option of placing two general types of stock market trade orders:

• Market orders, which are orders to buy or sell a stock at the current price set by the free market; and

• Limit orders, which are orders to buy or sell a stock at a price not greater than (in the case of a buy) or less than (in the case of a sell) a price selected by the customer.

A computer program is used to manage market and limit orders because bids and asks are usually for different numbers of shares, which complicates the matching process.

How are buyers and sellers matched? Regardless of whether the transaction is a market order or a limit order, trades are conducted by matching the highest bid prices with the lowest ask prices until no more matches can be made.

What is a spread? A stock market trade spread exists when there is a line of remaining bidders waiting for a better deal, but the existing line of sellers are asking more for their stock than the bidders are willing to pay.

This standoff only gets resolved when market orders are placed, or when someone adjusts their limit orders so that matches between the buyers and sellers can resume.

Where does the match happen? A stock market trade is rarely done person to person, except in the case of a private stock purchase (brokers will typically only do this for high net worth individuals).

A stock market trade usually occurs through brokerage house intermediaries called specialists (on NYSE/AMEX) or market makers (on Nasdaq), who buy up blocks of stock and sell them out of their own accounts.

What's in it for the specialists and market makers? Specialists and market makers profit by trading stocks in the dual role of buyer and seller in the same transaction. They profit when market orders "cross" a spread between the bid and ask price.

Take, for example, a spread of 100 by 100 ½. That means that $100 is the most that a buyer is willing to pay for a stock, and $100.50 is the least a seller is willing to accept. Specialists are under no obligation to close this spread.

When someone places a market order to buy that stock, a specialist can sell it to the buyer for $100.50. It can then find someone placing a market sale order on that stock, and buy the stock from that person for $100. The specialist just made a profit of $0.50 per share without changing the number of shares in its inventory.

A specialist also profits when it sells shares that it doesn’t own yet, so long as the specialist can buy the shares at a lower price within the time required (short selling).

Despite the rising controversy over investors who sell shares that they don't own, and either can't or won't borrow (naked short selling), specialists and market makers are still subject to far more relaxed short selling rules than are the rest of the investment community.

This is because their role in the community is primarily protective. Specialists and market makers lend stability to the markets by standing ready to buy up or sell blocks of stock to slow down frightening price fluctuations when they occur.