Beginner’s guide to the stock market: part 1 markets vs exchanges

Unless you’re already involved with the stock market, be it through your job, an interest in the markets or you make personal trades on a daily basis, there’s a good chance that you may not really know too much about the world of stock markets.

Speaking from experience, prior to the creation of Trading.co.uk, I personally had (what it turns out to be) little knowledge on the subject.

I knew the stock market existed, I knew its purpose and I knew that people and companies can make a lot of money making smart trades. But what I didn’t really know is the finer details of how its structure worked and how intricate and vast the world of stocks and shares has become.

So, in this series of blog posts, I hope to be able to break down the barrier of uncertainty that many people have and explain more about how stock markets work; so that anyone, especially people interested in taking their first steps into the world of trading will be able to understand the basics.

Note: This article is a beginner’s guide to the world of stock markets and is intended for people new to the financial industry. It will therefore cover only the basics of the financial industry and will not go into the finer details of making trades, or offer any advice on trading.

Clearing up some common mistakes

In this first post, I feel it’s crucial to clarify and clear up some common mistakes I have found while digging into the word of stock markets and making trades. The most common and, frankly, important one I have come across has been the confusion over stock market and stock exchanges.

Stock markets and stock exchanges are not the same

Before we clarify this, people/websites can be forgiven for using the terms “stock market” and “stock exchange” to mean the same thing.

When talking in general conversation about the financial industry in the broadest sense, the terms do become somewhat interchangeable. But this seems to have led to a rather common misconception that the terms are indistinguishable from one another.

They are, however, two very different parts of the rather complex, global financial industry.

Even before working for a company with a financially-focused product, I thought I knew the basic difference between the terms. But the confusion in mixing the terms seems to have become so prevalent in many financial articles I’ve read recently, that I was starting to believe it and use the terms interchangeably myself.

But when you dig a little deeper, you will see and understand the differences.

So let’s define those terms:

Stock market:

In a nutshell: 
The stock market is all stock trading through various avenues. It can refer to the global stock market or more regionally-focused financial markets.

Comprehensive definition: 
A stock market (aka an “equity market”) is often used to describe the broad entity that covers a wide range of market activities and companies; i.e. the organised trading of stocks/shares.

The stock market is not a physical facility or isolated object — it is a loose network of economic transactions; the aggregation of buyers and sellers of stocks, which may include securities listed on a stock exchange as well as those only traded privately.

While it is often used as a general term to describe the world’s financial market, it can also be used to describe a regional area of financial trades and transactions, such as “the UK stock market” — but not being as specific as the “London Stock Exchange” or “FTSE 100” (more on LSE and FTSE in a minute).

A stock market includes stock exchanges, the over-the-counter (OTC) market and electronic trading systems.

Stock exchange:

In a nutshell: Stock exchanges (aka. “bourse”) are separate companies that promote the orderly flow of stock buying and selling.

Comprehensive definition:

Stock exchanges are the location for the majority of stock market activity, they are the infrastructure that facilitate the trading of those equity securities/stocks, debt securities, (e.g. banknotes, bonds and debentures) and derivatives, (e.g. forwards, futures, options and swaps).

Exchanges can be ‘manual’, taking place in physical locations with trading floors, or ‘electronic’/’virtual’, where trading happens via computer.

Stock exchanges are businesses in their own right and make profits from providing a venue for stock buying and selling. The exchanges also provide additional services such as data feeds, dividend payment processing and providing stock indexes.

Still unsure what this all means?

Essentially when you break it down, stock exchanges offer a supervised and structured environment for companies to list shares. But without a stock market, those stock exchanges would have no reason to exist.

OTC (over the counter) trading

While stock exchanges are the most prevalent and, arguably, the most ‘secure’ form of trading, buying and selling shares through stock exchanges is not the only method available to traders.

Also known as ‘off-exchange trading’, OTC trading is an alternative to making trades via stock exchanges.

Unlike trading on an exchange, where companies list their stocks for all to see and trades are supervised by the exchange operator, OTC trading is done directly between two parties.

It is classed as a ‘decentralised’ market — where there is no central, physical location and the two parties communicate directly through various methods of communication, including telephone, email and proprietary electronic trading systems.

An OTC market is made up of all the participants within the market trading among themselves. Possibly most famous example of a decentralised market is the Foreign Exchange Market (FOREX).

In an OTC trade, dealers act as ‘market makers’ by quoting prices at which they will buy and sell shares. A trade can be executed between two participants in an OTC market without others being aware of the price at which the transaction was effected.

In general, OTC markets are less transparent than exchanges and are also subject to fewer regulations. This offers both advantages and disadvantages to trading via a stock exchange:

OTC pros:

Products traded on the exchange are strictly regulated and must hold consistent standard. Exchanged deliverables need to match a narrow range of quantity, quality, and identity — which is defined by the exchange and identical to all transactions of that product.

OTC markets do not have this limitation. The parties may agree on an unusual quantity and the price does not necessarily need to be published to the public — allowing companies and individual traders to maintain a certain amount of privacy when trading.

Also, having no requirement to broadcast prices outside of the two parties, it is possible for traders to secure a better deal for stocks than other traders — whereas through an exchange the price is ‘fixed’ for all traders who want to buy at that moment in time.

OTC trading has lower transaction costs, whereas trading through a stock exchange incurs additional charges, due to regulatory constraints, exchange fees and commissions.

OTC cons:

Due to the lack of transparency and lower level of regulation with OTC trades, the market for these stocks is often associated with uncertainty and seen to have higher risks for both parties involved.

The primary reason being that OTC stocks are typically not listed or traded on any of the major stock exchanges, which are more thoroughly regulated.

That said — the OTC market is used by legitimate businesses and individuals and it remains part of the trading activity that is monitored by the UK regulators.

Ultimately, if you are taking your first steps into trading, you will need to weigh the benefits of both trading OTC or via an exchange — as they both have pros and cons and are suitable in different situations for different people/companies.

That’s it for part one. Hopefully this initial post will have helped you take your first steps into understanding the world of stock markets. In the next post in our series, we will look more at the hierarchical structure of the global stock market — to help get a better understanding of where stock exchanges and OTC markets sit in the financial world.

Want to know more about the stock market? Check out Trading.co.uk to keep up to date with the latest market movements.