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The word "market" can have many different meanings, but it is used most often as a catch-all term to denote both the primary market and the secondary market. In fact, "primary market" and "secondary market" are both distinct terms; the primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors. Knowing how the primary and secondary markets work is key to understanding how stocks trade. Without them, the stock market would be much harder to navigate and much less profitable. We'll help you understand how these markets work and how they relate to individual investors.

Primary Market

The primary market is where securities are created. It's in this market that firms sell (float) new stocks and bonds to the public for the first time. For our purposes, you can think of the primary market as the market where an initial public offering (IPO) takes place. Simply put, an IPO occurs when a private company sells stocks to the public for the first time. The primary market is also the market where governments or public sector institutions raise money through bond offerings.

The important thing to understand about the primary market is that securities are purchased directly from an issuing company.

Secondary Market

The secondary market commonly referred to as the "stock market." This includes the New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the world. The defining characteristic of the secondary market is that investors trade among themselves. That is, in the secondary market, investors trade previously issued securities without the issuing companies' involvement. For example, if you go to buy Microsoft stock, you are dealing only with another investor who owns shares in Microsoft. Microsoft is not directly involved with the transaction.

The secondary market can be further broken down into two specialized categories: auction market and dealer market.

In the auction market, all individuals and institutions that want to trade securities congregate in one area and announce the prices at which they are willing to buy and sell. These are referred to as bid and ask prices. The idea is that an efficient market should prevail by bringing together all parties and having them publicly declare their prices. Thus, theoretically, the best price of a good need not be sought out because the convergence of buyers and sellers will cause mutually-agreeable prices to emerge. The best example of an auction market is the New York Stock Exchange (NYSE).

In contrast, a dealer market does not require parties to converge in a central location. Rather, participants in the market are joined through electronic networks (from low-tech telephones or fax machines to complicated order-matching systems). The dealers hold an inventory of a security, then stand ready to buy or sell with market participants. These dealers earn profits through the spread between the prices at which they buy and sell securities. An example of a dealer market is the Nasdaq, in which the dealers, who are known as market makers, provide firm bid and ask prices at which they are willing to buy and sell a security. The theory is that competition between dealers will provide the best possible price for investors.

The OTC Market

Sometimes you'll hear a dealer market referred to as an over-the-counter (OTC) market. The term originally meant a relatively unorganized system where trading did not occur at a physical place, as we described above, but rather through dealer networks. The term was most likely derived from the off-Wall Street trading that boomed during the great bull market of the 1920's, in which shares were sold "over-the-counter" in stock shops. In other words, the stocks were not listed on a stock exchange - they were "unlisted".

Over time, however, the meaning of OTC began to change. The Nasdaq was created in 1971 by the National Association of Securities Dealers (NASD) to bring liquidity to the companies that were trading through dealer networks. At the time, few regulations were placed on shares trading over-the-counter - something the NASD sought to improve. As the Nasdaq has evolved over time to become a major exchange, the meaning of over-the-counter has become fuzzier. Today, the Nasdaq is still considered a dealer market and, technically, an OTC. However, today's Nasdaq is a stock exchange and, therefore, it is inaccurate to say that it trades in unlisted securities.

Nowadays, the term "over-the-counter" refers to stocks that are not trading on a stock exchange such as the Nasdaq, NYSE or American Stock Exchange (AMEX). This generally means that the stock trades either on the over-the-counter bulletin board (OTCBB) or the pink sheets. Neither of these networks is an exchange; in fact, they describe themselves as providers of pricing information for securities. OTCBB and pink sheet companies have far fewer regulations to comply with than those that trade shares on a stock exchange. Most securities that trade this way are penny stocks or are from very small companies.

Third and Fourth Markets

You might also hear the terms "third" and "fourth" markets. These don't concern individual investors because they involve significant volumes of shares to be transacted per trade. These markets deal with transactions between broker-dealers and large institutions through over-the-counter electronic networks. The third market comprises OTC transactions between broker-dealers and large institutions. The fourth market is made up of transactions that take place between large institutions. The main reason these third- and fourth-market transactions occur is to avoid placing these orders through the main exchange, which could greatly affect the price of the security. Because access to the third and fourth markets is limited, their activities have little effect on the average investor.

Bottom Line

Although not all of the activities that take place in the markets we have discussed affect individual investors, it's good to have a general understanding of the market's structure. The way in which securities are brought to the market and traded on various exchanges is central to the market's function. Just imagine if organized secondary markets did not exist - you'd have to personally track down other investors just to buy or sell a stock, which would not be an easy task.

In fact, many investment scams revolve around securities that have no secondary market, because unsuspecting investors can be swindled into buying them. The importance of markets and the ability to sell a security (liquidity) is often taken for granted, but without a market, investors have few options and can get stuck with big losses. When it comes to the markets, therefore, what you don't know can hurt you, and in the long run, a little education might just save you some money.

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