Breaking Down the Stock Market: Trading Strategy & Stock Market Operations (part three)

This is part three of a three-part series, see part one and part two here.

To close out our ‘Breaking Down the Stock Market’ series, let’s talk about how the market operates in modern times. What happens when you press buy? How do we piece together IPOs, market participants and investment products to paint a cohesive picture of how the market functions?

The feeling of amazement when an Amazon package arrives on my doorstep the day after I ordered it on the website is hard to replicate. Although the stock market doesn’t generate that same warm and fuzzy feeling, there are similar, extremely complex networks behind making it all happen. First let’s break down the two types of market transactions. The primary market is when you buy that mango directly from the vendor. It occurs during IPOs, direct listings, SPACs as well as when a company buys back their own shares (called a repurchase or repo) or even when a company goes from public back to private. More on this later.

The secondary market, in contrast, is when shares are exchanged from market participant to market participant. Aka when you buy a mango from anyone other than the original vendor. In the stock market, dissimilar to a typical market, almost all buys and sells take place on the secondary market. Imagine buying or selling mangos to the guy behind you looking at strawberries. That means every time you want to buy stock there has to be someone else willing to sell it and vice versa. In today’s world, brokerage firms have built trading systems that connect to exchanges to find the opposite sides of a trade. Think of it as an app on your phone that could tell you the best price available to buy a mango. Once you press buy, it sets off a whole new chain of events.

Buying or selling stock is also called order execution, think of it as a sale. After this sale, similar to an Amazon order, the ‘goods’ then need to be delivered to you. Instead of mailing you a stock certificate, there is a separate party called a custodian that holds these shares in your name. You can imagine a giant warehouse next to the market that puts your mango on a shelf along with a sticky note with your name on it. The time between order execution and the custodian having that stock in your name is called settlement (typically 2 days for most transactions).

If for some reason that mango doesn’t make it to the warehouse in two days, the security is considered a ‘fail’. Brokers work to resolve these fails. If 30 full days pass from the end of the settlement period without resolving them, the broker is required to hold cash in a separate account for the value of those shares. This ensures that the cash value of your mango is always protected.

Bored yet? Securities operations doesn’t excite everyone… let’s dive into trading strategies.

  • Trading on margin: What if you wanted to buy a $100 mango (it must be delicious) but you only had $75. You might want to borrow the other $25. Your broker would give you a margin loan for this amount and then monitor the value of that mango. If all the sudden that mango was now worth $50 the broker would make you put more money in your account, fearing that you may not be able to pay off the $25 plus interest that you owe them.

  • Short selling: you decide that mangos are going to be displaced by pineapples in the next year, aka the value is going to decline. Short selling is a way of capturing the decline by committing to buy the mango at some price in the future. You start by borrowing the mango from someone else, agreeing to pay interest every day that you have it. You then sell it immediately. You are committed to buying it back at some future date. Say the mangos value goes down all the sudden. You then buy it back and return it to the original owner. If the difference in value exceeds the interest you paid, you make money.

  • Passive investing: this is a strategy whereby you believe in the long-term growth of a stock. Regardless of day-to-day fluctuations, you think over time it will increase in value.

  • Active investing: also called day trading, active trading means trying to capture the day-to-day ups and downs of a stock. Here you are less invested in the long-term value of mangos and instead focus on day-to-day scuttlebutt about its perceived value.

  • Over the counter (OTC): let’s say there is a person selling blue mangos. They don’t have enough money to have an official stand, but they want to trade at the market. They would be traded over the counter. These companies are often called pink sheets or penny stocks. Other types of over-the-counter trades are the ones made famous by the movie The Big Short. Imagine if you knew all the mangos were going to taste terrible. You might make a side agreement for a really ‘big short’ (formally called a swap). Similar to a traditional short, you pay interest every day the contract is open, hoping that the decline in value far outweighs that interest amount (those better be some really nasty mangos). Now you know why Christian Bale spent so much time psychotically drumming in that movie (stressing as the interest piled up).

All in all, hopefully this series was educational on how the stock market works. If nothing less, I know you are going to go purchase some mangos. Stay tuned for more stock market content.