The Exchanges:
Whether we refer to stocks, options, futures, etc… an exchange is a meeting place of sorts for buyers and sellers of an underlying security or investment product. Most people have heard of the New York Stock Exchange. However, there are many other important major exchanges such as the Chicago board of Trade the Chicago Mercantile Exchange, the NASDAQ and the six options exchanges.
Exchanges offer a common ground for buyers and sellers to exchange their products. They save investors the time and resources associated with looking for counter parties to a trade. For example, you may own 1000 shares of Google that you purchased years ago for $200 per share. As you are looking for some extra cash to remodel your pickup truck, you decide to sell your 1000 shares. Uncle Joe would like to buy some Google shares and he offers to buy the shares off of you for $300 per share. While you would net a nice profit, you would be selling your shares well below current market value. Unbeknown to Uncle Joe, there are plenty of people who are willing to pay more for your shares. However, who else do you know that is a willing buyer of 1000 shares of Google?
Thanks to the existence of exchanges, you do not have to go out and find a buyer. You can simply sell your shares in the open market, courtesy of the NASDAQ for around $700 per share. More importantly, you never have to know who the counter party was. It could have been one person, it could have been many people. The important thing is that you were able to successfully sell your shares and collect your money.
The Clearing Houses:
So, you opened up a trading account and you are making money. A common question to ask is, “if I’m making money, is it possible that someone is losing money?” The short answer is, “yes”. In fact, you may know some people who are losing money in the market.
Then, the logical follow-up concern arises. If some people are losing money, what happens if I happen to make a trade with one of those people and they cannot pay? Relax. That is where the Clearing Houses come into play.
A clearing house is the counter party to BOTH sides of every trade! They ensure that both sides of the obligation are met. In the United States the clearing body for options is the Options Clearing Corporation (OCC). It is the largest options clearing house in the world and currently the only one with a AAA credit rating from Standard and Poor. That’s a good thing, since this is the regulating body that makes sure that every winner in the options market place gets paid.
The Market Makers:
When you buy or sell an option or an underlying, you do so at the appropriate exchange in order to receive the benefit of countless buyers and sellers competing to take or to give the best price possible. However, what happens in less liquid markets? Or what about in markets where there is no buyer or seller present at the precise moment that you want to buy or sell your goods? What if there are buyers and sellers, but not for the large quantity that you want to trade? This is where market makers play such an important role.
Market makers literally make the markets when there are no readily available markets. In the US, their responsibility is to make a fair and two-sided market. That is, they have to provide both a bid price and an ask price. Their job is to create competitive markets in order to stimulate liquidity for their products. The more liquid the market the more people will be enticed to trade that market, which will lead to more liquidity and so on.
The Brokers:
Much like a bank teller may assist you with financial transactions at your local bank, brokers are the financial intermediaries that assist you when executing a trade. Just as you need to open a bank account in order to write checks, you need to open a brokerage account in order to place trades.
You cannot simply walk up to a trading pit on an exchange with a wad of cash and demand to buy a security. That process needs to be taken care of by a broker. Hence, the broker acts as a buffer between you and the financial world. This is a good thing. Remember, you do not know the person on the other side of your trade. The broker ensures that the transaction takes place according to standard procedure and in legal fashion.
That said, a broker is not a trader. A broker’s job is to execute your order correctly and to the best of his or her ability. The broker has a fiduciary responsibility to the trader employing him. For his services, a broker is paid a commission.
Many brokers offer investment advice for what is usually a significantly higher commission structure. While all brokers are licensed professionals, many stick to what they do best – execute your orders to the best of their ability. You will have to decide for yourself how involved you would like your broker to be in your trading.