How Markets Work

Exchanges and Brokers

An exchange is just a regulated place for buyers and sellers to meet. In the U.S. that mostly means the NYSE (founded 1792 — older than the country's currency) and the NASDAQ (1971, the first fully electronic one).

You don't trade on an exchange directly. You go through a broker — Fidelity, Schwab, Robinhood, whoever's app is on your phone. Submit an order there and it gets routed to an exchange or a market maker who finds someone to take the other side. Most retail brokers charge $0 commission now, which sounds generous until you learn they're often paid instead by the market makers they route your order to — a practice called payment for order flow. Nobody's doing this for free; you're just not the one paying directly.

The Bid-Ask Spread

A stock never has just one price. At any instant it has two:

• Bid — the highest price any buyer is currently offering
• Ask (or offer) — the lowest price any seller will accept

The gap between them is the spread, and it's effectively the toll you pay for trading right now instead of waiting. On something liquid like Apple, that toll might be a single cent. On a thinly-traded small-cap, it can run fifty cents or more.

Buy with a market order and you pay the ask. Sell with one and you get the bid. Whoever's on the other side — usually a market maker — pockets the difference as payment for standing ready to trade with you at any moment.

Order Types

Most costly beginner mistakes come down to using the wrong order type:

• Market order — fill it now, at whatever the going price is. Guarantees you get filled, not what you pay. Dangerous on anything illiquid.
• Limit order — fill it only at your price or better. A buy limit at $100 fills only if someone's selling at $100 or less. Guarantees your price, not that you'll get filled at all.
• Stop order — sits dormant until the price hits your trigger, then converts to a market order. "Sell if it drops to $90" is a stop order.
• Stop-limit order — same trigger, but converts to a limit order instead, so you don't get blindsided by a price that gapped straight through your stop overnight.

For anything you're not in a screaming hurry to trade, a limit order is almost always the better call.

The Order Book

Every exchange keeps a running list of every outstanding limit order — the order book. Whatever sits at the very top, the best bid and best ask across every exchange at once, is called the NBBO.

Below the best bid sit lower bids from buyers willing to pay less; above the best ask sit higher asks from sellers wanting more. Stack it all up and you get a picture of liquidity — how much you could actually buy or sell before you started moving the price yourself.

High-frequency trading firms live in this order book at microsecond timescales, constantly posting and pulling orders to catch the spread and react to news faster than any person possibly could.

Price Impact

A big enough order doesn't just fill at the current price — it eats through the book, level by level, pushing the price as it goes. That's called market impact. Your $5,000 Apple purchase is a rounding error against a $3 trillion company; a hedge fund buying $500 million in a day will absolutely move it. That's why big desks break large orders into thousands of small ones (algorithms with names like VWAP and TWAP) instead of just slamming one giant market order through.

Indices

An index takes hundreds or thousands of individual stock prices and boils them down to a single number you can watch:

• S&P 500 — 500 large U.S. companies, weighted by market cap. The default benchmark for "the market."
• Dow Jones (DJIA) — just 30 companies, and oddly weighted by raw share price rather than size. Famous, but a weaker read on the actual economy than the S&P 500.
• NASDAQ-100 — the 100 biggest non-financial NASDAQ names, tilted hard toward tech.
• Russell 2000 — 2,000 small-cap companies, a better gauge of how smaller businesses are actually doing.

Index funds and ETFs simply hold everything in a given index, which is how you end up owning a slice of 500 companies for a few dollars instead of picking one and hoping.