After a security is sold for the first time in the primary market, it begins trading in the secondary market. At that point, the issuer has already raised capital (money). Now, investors trade the security with other investors at its current market price. The secondary market has its own roles, rules, and pricing dynamics, which we’ll cover in this unit.
In this first chapter, we’ll focus on three major secondary market topics:
Later in this chapter, you’ll learn about the Securities Exchange Act of 1934, a law that governs the secondary market and its participants. For now, there are three key roles to know:
Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. In practice, traders usually don’t speak with or maintain relationships with clients.
For example, many mutual funds employ several (or even dozens of) traders to carry out the fund manager’s strategy. The fund manager sets and adjusts the strategy, and the traders execute it by buying and selling securities for the fund. Traders who work for large portfolios (like mutual funds) generally don’t have relationships with the investors in those portfolios.
Previously in this material, we discussed what a broker-dealer is and what they do. As a reminder, broker-dealers are financial firms in the business of performing securities transactions on behalf of others (broker/agency) or for their own account (dealer/principal). In plain English, broker-dealers help customers trade securities and earn profits by providing that service. They can operate in one of two capacities: agency or principal. We’ll compare those two capacities later in this chapter.
Here’s a list of the 5 largest broker-dealers in 2020:
Traders and broker-dealers can sound similar because both are involved in buying and selling securities. A key difference is that broker-dealers typically maintain client relationships, while traders usually don’t.
If you have an account at a broker-dealer, you’re often offered services like retirement planning, portfolio analysis, and cash management. Relationship management matters because competition is high and moving assets between broker-dealers is relatively quick and easy. Traders, on the other hand, are usually focused solely on executing trades as part of a larger portfolio operation.
Market makers are financial organizations that buy and sell securities on a principal basis (from inventory) with traders, broker-dealers, and public customers. They continuously publish bid and ask prices (explained below), which are the prices they’re willing to trade at. Market makers play an important role because they provide liquidity - making it easier for others to buy and sell.
That definition includes a lot of market terminology, so here’s the same idea in everyday terms. Imagine you have a large inventory of apples. You set up a stand with a sign that says:
I will buy or sell apples with anyone who is willing to do so. You can sell an apple to me for $1, or you can buy an apple from me for $2.
You’re willing to trade apples with anyone at posted prices, which makes you an apple market maker.
Because you’re always available to buy or sell, it becomes easier for people in the neighborhood to trade apples. That’s another way of saying apple liquidity is high. If there are multiple apple market makers in the city, liquidity would be even higher.
Now replace apples with securities. Market makers buy and sell securities with the public and earn profits by buying at one price and selling at a higher price. They post bid and ask prices (covered in more detail below), which both support their profits and add liquidity to the market.
If you place a trade with a broker-dealer*, the firm will often route your order to a market maker, who fills the order. For many publicly traded stocks (especially exchange-listed stocks), there are dozens of market makers quoting and trading the same security. Traders and broker-dealers look for the best available price to maximize results for their clients.
*When investors place trades with broker-dealers, most trades are fulfilled on an agency basis. In this scenario, the broker-dealer connects the investor with a market maker and charges a commission. Broker-dealers have the structure and capacity to act as a principal, usually in one of two ways. First, they can act as market makers and trade with the public on a principal basis. Second, they act as a dealer while taking part in underwriting syndicates.
Financial firms like broker-dealers earn money by participating in secondary market trading. Depending on the security and the firm’s role in the market, a firm may trade on an agency basis or a principal basis.
Assume a customer approaches a financial firm and wants to buy 100 shares of IBM stock. If the firm acts in an agency capacity, it works to match the customer’s order with another participant in the market.
On any given day, thousands of trades occur in IBM, so it’s usually not difficult to find someone willing to sell 100 shares. The trade is completed once the firm finds a seller who meets the customer’s price and other order specifications.
When a firm matches an order on an agency basis, it earns a commission. In this role, the firm is acting as a middleman. This is similar to other agency-based businesses you may already know. For example, real estate brokers match buyers and sellers and earn a commission when a transaction occurs.
Now compare that to a principal trade. If the firm acts in a principal capacity, it sells the shares out of its own inventory. As discussed earlier, market makers always act in a principal capacity. They stand ready to trade with customers:
Firms acting in a principal capacity earn money through mark-ups and mark-downs. This is similar to how dealers work in other markets. For example, a used car dealership buys cars from the public at prices below their market value. When the dealership buys your car below market value, that difference is a mark-down. The dealership then tries to sell the car at or above market value, which is a mark-up. In other words, dealers try to buy low and sell high.
Acting in a principal capacity involves risk because the value of securities held in inventory can fall. If that happens, the firm may have to sell at lower prices and take a loss.
Here’s a video breaking down a practice question on this topic:
Bid & ask spreads are maintained by market makers in the secondary market. The bid and ask are the prices the market maker is willing to trade at.
The bid is the price the firm is willing to pay to buy a security. The term “bid” is from the market maker’s perspective: the firm is bidding for the security, hoping a customer will sell to it. Along with the bid price, the market maker also states how many shares it’s willing to buy at that price.
The ask, sometimes called the “offer,” is the price the firm is willing to accept to sell a security. Again, this term is from the market maker’s perspective: the firm is asking a price, hoping a customer will buy from it. Along with the ask price, the market maker also states how many shares it’s willing to sell at that price.
Here’s an example of a bid/ask:
GM stock
$40 bid / $41 ask
4x7
In this example, a market maker is quoting GM stock.
When a market maker publishes a quote, the share size is stated in round lots. The “4” on the bid side means 4 round lots, or 400 shares.
The difference between the market maker’s buy price ($40) and sell price ($41) is the market maker’s profit opportunity. This difference is called the “spread.” Even small spreads can add up because market makers may execute thousands of trades per day.
A $1 spread is not common for actively traded stocks. In most cases, popular stocks have spreads measured in pennies. In an efficient market, firms can still earn substantial profits because trading volume is high and spreads are small. An efficient market is defined as one with active trading and small spreads.
Every trade has two sides. So far, we’ve described bid and ask from the market maker’s perspective. When a customer trades, the customer takes the opposite side.
Here’s a summary:
Bid
Ask
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