The term " stock market" can have many different meanings. One usage of the term denotes the "primary" stock market and the "secondary" stock market. These two "markets" distinguish between the market where securities are created and the market where they are traded among investors. Their function is key in understanding how stocks trade.
Primary Stock Market
The primary stock market is where securities are created. It's in this market that firms sell (float) new stocks and bonds to the public for the first time. For our purposes, you can think of the primary stock market as being synonymous with an initial public offering (IPO). Simply put, an IPO occurs when a private company sells stocks to the public for the first time.
IPOs can be very complicated because many different rules and regulations dictate the processes of institutions; however, they all follow a general pattern:
A company contacts an underwriting firm in order to decide upon the legal and financial details regarding the offering of securities.
A preliminary registration statement, which details the company's interests and prospects and the particularities of the issue, is filed to the appropriate authorities. Known as a preliminary prospectus or red herring, this document is not finalized and not a solicitation by the company issuing the new shares. It is rather an information pamphlet and a letter describing the intent of the company.
Governing bodies must approve the finalized statement and then a final prospectus, detailing the issue's price, restrictions and benefits, is issued by the company. This final prospectus is legally binding for the company.
The important thing to understand about the primary stock market is that you are buying securities directly from an issuing company.
Secondary Stock Market
The secondary stock market is what people refer to when they talk about "the stock market." This includes the NYSE, Nasdaq, and all major exchanges around the world. The defining characteristic of the secondary stock market is that investors trade among themselves. That is, in the secondary market, investors trade previously-issued securities without the involvement of the issuing companies. For example, if you go to buy Microsoft stock, you are dealing only with another investor who owns shares in Microsoft. Microsoft (the company) is in no way involved with the transaction.
The secondary stock market can be further broken down into two specialized categories: auction market and dealer market.
In the auction market, all individuals and institutions wishing to trade securities will congregate into one area and announce the prices at which they are willing to buy and sell (bid and ask offers). The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. Thus, theoretically, the best price of a good need not be searched for because the convergence of buyers and sellers will cause mutually-agreeable prices to emerge. The best example of an auction market is the largest stock exchange in the world, the NYSE.
In contrast, a dealer market does not require parties to converge. Individuals or institutions will specialize in specific securities or commodities and then buy and sell according to the demand of the stock market. These "dealers" then earn profits through differences in the posted bidding and asking prices for their specific securities. The rationale behind a dealer market is convenience: investors aren't required to wait for other participants before a transaction can occur. Thus, many over-the-counter markets are classified as dealer markets since the demand and supply for particular stocks is not always enough to meet the requirements of different investors, allowing the specialist to intervene by buying and selling out of personal inventories. Most bonds are traded in dealer markets, and the Nasdaq stock exchange can also be classified as this type.
Third and Fourth Stock Markets
Third and fourth stock markets, as they involve significant volumes of shares to be transacted per trade, aren't for regular investors. The third market began as a rogue over-the-counter market for large institutional investors not wishing to pay the set commissions determined by the NYSE. This third stock market has slowly been phased out of use since many of the commission schedules set by the NYSE have been removed. The fourth stock market is very similar to the third market except for the fact that no brokers are involved in the transaction. An example is a direct trade between two large institutions.
Why Is This Important?
First off, it's good to have a general understanding of the structure of the stock market. If you understand how securities are brought to market and then traded on various exchanges, you will know what is central to the markets functioning properly. Just imagine if organized secondary markets did not exist--you'd have to personally track down other investors to engage in buying/selling stock. Not an easy task.
In fact, many investment scams revolve around securities that have no secondary stock market. The ability to sell a security (liquidity) is often taken for granted. If a security doesn't have a market, you can get stuck with a big loss and no options. As this is so often the case, a little education might save you some money in the long run.