How Do Stocks Trade?

You hear the phrase all the time: trading stocks. But you know what? It's wrong. You don't trade stocks like you do, say, marbles or baseball cards ("I'll trade you 10 of my Googles for 10 of your Dells"). Even the term "stock exchange" is misleading in the sense that you're not exchanging one stock

How a system can effectively accommodate the trading of over 1 billion shares a day is a mystery to most people, and for good reason. Luckily, you don't need to know all the technical ins and outs of how stocks are bought and sold. But you should have a basic understanding of how the various markets work.

To begin, it's important to understand the difference between the "primary" market and the "secondary" market. In the primary market securities are created by means of an initial public offering (IPO), while in the secondary market investors trade already-issued securities. When people refer to the stock market they're really referring to the secondary market.

Stock trades are executed in one of two ways:

• On the exchange floor
• Electronically

On the Exchange Floor

Thanks to television and the movies, the floor of the New York Stock Exchange (NYSE) is the image most people have when they think about trading stocks — people in gray coats wildly throwing up their arms, waving, yelling, signaling to each other. It appears chaotic, but come the end of the day the markets manage to execute all the trades and get ready for the next day.

What follows is the process of a simple trade on an exchange floor:

1. You direct your broker to purchase 100 shares of Acme Pinwheels at market.
2. Your broker complements you on your decision (or not), passes the message to his order department, and they in turn relay it on to their clerk on the exchange floor.
3. The floor clerk then alerts the firm's floor trader, who seeks out different firms' floor traders willing to sell 100 shares of Acme Pinwheels. (This is where the wild gesturing and signaling come in.)
4. The two agree on a price and the deal is done.
5. A short time later your broker calls you back with the final price.

Electronically

With the amount of technological innovation we've experienced in the last decade alone, many wonder how long a human-based system like the NYSE will last. It's a good question. Only a very small percentage of the NYSE's volume is handled electronically, while the rival NASDAQ is completely electronic.

Instead of human brokers, electronic markets employ vast computer networks to match buyers and sellers. While this system may lack the romanticism of the NYSE floor, it is efficient and fast, and that's a good combination when you're talking money. Many large institutional traders such as pension and mutual funds far prefer this method of trading. It also works extremely well for small individual investors because it provides nearly instant trade confirmations and facilitates further control of online investing by putting you one step closer to the market.

That said, individuals don't have point-of-access to the electronic markets and still need brokers to handle their trades. Brokers access the exchange network and the system finds a buyer or seller.

If you're new to investing online, refuse the impulse to put your entire life savings into an online account, no matter how attractive it seems. Instead, start with a smaller sum, which will be easier to handle and keep track of.

Also understand that spreading risk is critical to long-term success. If you invested all of your money in one company and that company's stock falls by 50 percent, you've just lost half your savings in one go. If you invest in four companies and one of the company's stock falls by 20 percent, you only lose in one area. Spreading risk across differents stocks assures you that if one stock goes down, you have others to balance your situation.