What Is the NASDAQ?

Founded in 1971, the National Association of Securities Dealers Automated Quotations system was the first computerized stock market and is still the largest. The NASDAQ is also a stock index, which means it only measures OTC stocks, or stocks traded over the counter.

The computer network of the NASDAQ provides instant information to NASD members about securities and prices in the OTC market and other negotiated trades. More than a half million computer terminals worldwide are connected to the NASDAQ network. In this way, NASDAQ quotations provide some of the same immediate market feedback that traders on an exchange floor get from outcry auctioning.

Throughout much of the 1970s and ‘80s the NASDAQ was of little interest to the general investing public, mostly because when a company grew large its management would pull its company’s stock from the NASDAQ in favor of a large exchange, such as the New York Stock Exchange. That changed a number of years ago when many of America's newest growth companies bucked trend by remaining with the NASDAQ even after they had become big. Today many of the world's largest companies, including Microsoft, Dell Computer, Intel, and Cisco, are on the NASDAQ, which as a result represents much of the investor wealth in the world.

The NASDAQ is what’s known as a weighted index, meaning that stocks with larger market values influence it more than smaller companies with smaller market values. Today less than 1 percent of NASDAQ companies represent more than 50 percent of the weighting. Of that big 1 percent, each is a technology stock.

This disparity is perhaps best illustrated by the performance of the index in the year 1999 when the NASDAQ rose an astonishing 86 percent, even though more than half the stocks in the index were down for the year. The lesson here is that when the NASDAQ surges or dips sharply, it’s usually a result of only a handful of companies.

How NASDAQ Securities Are Traded

Securities trading in the NASDAQ system is based on “market makers”’ activities. Market makers are NASD member firms that act as dealers, that is, they own securities inventories that they can sell to or buy from the public. At this time there are more than 400 market makers in the NASDAQ system and it’s their quotations on securities issues that make the NASDAQ work.

Although the market maker system is supposed to provide more competitive pricing than exchange auctioning, it’s the market makers themselves that decide whether to buy or sell a given security at a given time. It’s also up to them what the actual trading price will be.

A NASDAQ market maker quotation lists two prices for any given security: the bid price and the asked price. The bid price is the highest price the firm is willing to pay for a unit of a particular security, while the asked price is the lowest price it is willing to sell for. It’s important to note that dealers don’t always pay the bid price or get the asked price. This is to say that bid prices and asked prices don’t define the price at which a dealer is currently buying or selling a security. What they do define is a price range known as the “spread,” in which the actual buying or selling price is negotiated between buyers and sellers.

The NASDAQ vs. Exchanges

There are some significant differences between the NASDAQ and exchange trading. For starters, instead of a few specialist dealers who use their accounts to control trading in a particular security at an exchange, the system of many market makers issuing quotations is supposed to make the NASDAQ more competitive. But while quotations are very public, the actual transaction is still negotiated in private between the dealer and the buyer or seller.

Research has shown, and many investors believe, that auction bidding still provides more immediate market impact on changes in securities prices, which results in prices that more consistently reflect actual market conditions. And while the NASD does provide some of the same regulatory functions as an exchange board, NASDAQ listings and trading aren’t as tightly controlled as they are at a major exchange.