The Mechanism of Trading in Stock Exchanges

Stock exchanges are used by millions of investors every business day to trade shares of ownership in public corporations, either as long-term investments in the company's growth or short-term speculation on movement in the shares' price. The mechanism of trading differs from one exchange to another, and some limits are placed on how they operate by government. The mechanism of trading that an exchange uses is important to investors because different mechanisms lend themselves to different trading volume limitations and pricing behaviors.

A stock exchange, according to the Business Dictionary, is an "organized and regulated financial market where securities (bonds, notes, shares) are bought and sold at prices governed by the forces of demand and supply." Exchanges facilitate capital markets liquidity by providing a place where buyers may meet and exchange cash for shares of equity in companies, called securities. They enable a more open and transparent system of exchange through well-defined trading mechanisms. Stock exchanges have existed in some form since the 17th century, according to finance scholar Lodewijk Petram.

Stock exchanges like the New York Stock Exchange and the Hong Kong Exchange are primarily auction markets. They use a system of bidding and asking prices executed through a specialist who matches buyers with sellers at a equilibrium price — the buyer's highest bid and the seller's lowest asking price. On an auction market, traders compete for the best price for their side of the transaction, and orders are only executed when the buyer's price and the seller's price are successfully matched. In modern markets, this process usually takes place electronically.

To match prices at this auction, specialists popularly known as "market makers" maintain a limit order book, which essentially is a list of all of the unexecuted orders and their limit prices. The limit price for buyers is the highest price they're willing to pay; for sellers it is the lowest price at which they're willing to sell. On the NYSE, the vast majority of trades are executed at auction with a limit order book. However, auction markets like the NYSE often use a different mechanism of trading called a dealer market for large orders, because of the practical difficulty of executing a large trade at auction.

Dealer markets, such as the London Stock Exchange and — traditionally — the NASDAQ, operate a little differently than auction markets. Instead of matching buyers' bids with sellers' asking prices, orders are placed directly with dealers of shares, who offer quotes to purchasers. Quotes are usually "take it or leave it" on a dealer market, according to Joel Hasbrouck of New York University, though purchasers may try to negotiate prices with dealers. Large trades on the NYSE are often executed in a dealer market, according to researchers at Duke University.