What actually happens when you “buy a stock”?

Due to technology today, and the availability of online brokerages in the form of their own applications, every time we go to Saxo or Robinhood to purchase a stock, it seems very simple, invest a sum of money, and then get the stock (or ownership of the company) in return. But is it really just that? Interestingly not, with there being innumerable microsystems that operate in the span of milliseconds when a trade is entered, with some other nuances to be explored too!

The first, and biggest aspect to be discussed here (which may surprise many) is that upon buying a stock you are not buying from the actual company, but instead another investor in markets such as the NYSE or Nasdaq. To better understand exactly how this works, it is essential to familiarize yourself with the concept of Primary and Secondary markets. Simply put, a primary market is where securities are created or companies sell or float their new stocks to the public for the first time. A common example is an Initial Public Offering (IPO) in which investors purchase securities from the bank involved in the underwriting for a certain company’s stock. And, as the name may imply, a secondary market is a market in which investors trade previously issued securities (from the IPOs, etc.) without the involvement of the issuing entity (which is where the initial statement gets justified). Possibly the most common secondary market where equities are bought is known as the “stock market” (NYSE or Nasdaq in the USA).

Fig.1 NYSE vs Nasdaq, two of the USAs secondary markets

Since secondary markets are what we are normally expected to interact with, it’s worth understanding the two different types- namely Auction markets and Dealer Markets (as a combination of both these concepts is what goes on behind each of our trades). Auction markets (ex. The NYSE) is where buyers and sellers converge together in one location to discuss prices. Traditionally, traders would stand on a floor and shout bids, which would be matched by a specialist. However, this system has now been made electronic, improving the pace at which deals are matched. A dealer market (ex. Nasdaq) is when you trade with dealers (market makers) who are normally big financial firms like Hedge Funds, acting as middlemen that buy from sellers, and sell to buyers. They become profitable from the difference between the bid (buy price) and ask (sell price).

Now, more importantly, how this links to today. In real life, both Nasdaq and the NYSE are mixes of both auction and dealer systems, and the same applies when you go on those brokerage apps (Robinhood, Interactive Brokers, etc.) to purchase a stock. When you place your bid, if it is at a price that can be matched by another investor, the trade takes place following the system of an auction market. However, in the case that it does not match, market makers often step in and complete the trade, following the operation of a dealer market.

But isn’t as simple as that because upon buying a stock it isn’t directly transferred to your account or ownership, even though that’s what the application may reflect. Before the stock is yours, a backend process known as settlement takes place where the buyer pays the required price, and the seller delivers the shares, which is managed by Clearing Houses, who ensure both parties fulfill their side of the trade, making it safer and less prone to defaults. Another misconception which may surprise many is that even after all this, you are only the economic owner of the stock. Shares which are held electronically in custody, are legally registered under your broker, which means that a 3^rd person would see it as- “Broker owns 1 share on behalf of [Your Name]”- and this is because having to individually register each trader is logistically unrealistic and would drastically slow systems down. Regardless of the broker’s representation in terms of ownership, you still have complete access to any dividends, profits and voting rights that come with the purchase of a share.

Fig. 2 Today’s largest brokerage firms

The most important part of buying stock is watching for price changes. Depending on whether you long or short a certain asset, the price going up or down, respectively, is what will benefit you. But what really changes these prices? Unlike any of the other complex mechanisms explained above, price changes are just due to the price at which the last trade was made. Say a trader’s bid price is $100, and another investor’s ask price is $101, there is no price change until either one matches (bid up to $101 or ask down to $100). The same would apply if the sale of a stock brings the price down to $99 (if two investors matched on this price). This is the very reason news around the world affects stocks very closely (especially what controversial politicians like Trump say, which significantly affect markets like the NYSE and Nasdaq) as changing expectations affect the urgency of traders which can lead them to make compromises or jumps, which in turn can cause price to move up or down.

To conclude, buying a stock may seem simple on the surface, however, on the inside it is a complex set of hybrid networks that include multiple different entities in one go- such as traders like yourself, large financial firms, and regulators to ensure that everyone has a safe investing experience.