2-01 What Are Stock Exchanges?

In the last lesson, we used a simple example of 10 buyers and 10 sellers who got together in the same room to make trades of one company’s stock.

In the real world, there are hundreds of millions of people and companies trading trillions of shares of millions of company’s stocks – getting everyone in the same room would be completely impossible.

This is where stock exchanges come into play.

How Stock Exchanges Work

Stock exchanges are needed to set the rules for trading. Namely:

What companies can be traded?

Stock exchanges put very strict rules on the companies that put their stock for sale on their exchanges. This is to protect investors – companies that list their shares for sale need to have extremely good information available to potential investors about how they operate, what their cash flow and sales look like, and many other aspects of a business.

This lets investors compare different companies apples-to-apples, because the stock exchange makes sure that all companies are sharing the same kind of information with investors. We will discuss this further in our chapter on Fundamental Analysis – where we show how to find and use this information to compare companies.

There are also some “Over the Counter” stock trades, where buyers and sellers trade stocks not normally allowed by the “main” stock exchange. This can include penny stocks, stocks on foreign exchanges (like our Nintendo example from chapter 1), or even shares of stocks that were de-listed from the main exchanges for breaking the rules. “Over the Counter” stocks are considered riskier than stocks listed on a main exchange simply because they don’t need to follow the same rules as everyone else.

Master Order Book

The stock exchange’s main function for the average person hoping to make a trade is to log the orders that come in. All buyers send in their “bid” prices and quantities, and all sellers send in their “ask” prices and quantities – and makes sure the buyer has the cash they are promising, and the seller actually owns the stock they are selling.

The stock market matches the buyers and sellers (almost) instantly, and keeps a public record of how many shares were sold at what prices so all other investors can see what is going on.

In the United States, the largest stock exchange is the New York Stock Exchange, which is on Wall Street, downtown New York.