The ChoosaBroker Trading Academy
6.3. Primary and Secondary Markets
The term “market” has broad connotations. In stock trading parlance, it can denote both the primary market and the secondary market. Knowing how each of these distinct markets operates is essential to understanding how stocks and other related securities are traded. Without this basic knowledge, the stock market would be much more difficult to negotiate, and consequently much less profitable.
WHAT IS A PRIMARY MARKET?
A primary market is the market where new securities are directly issued and sold by the issuer to the investors. In the primary market, business corporations raise capital through the sale of new stock. This process is generally undertaken through three methods:
- Initial Public Offer (IPO) – An IPO is the very first sale of a company’s stock to the public. Prior to an IPO, the company is deemed to be private, with a relatively small number of shareholders consisting primarily of founders and their family, as well as early investors such as venture capitalists and angel investors. Post the IPO, the stock is typically listed on a secondary market like a stock exchange.
- Rights Issue –It is the process by which already listed companies often opt to raise additional funds. However, instead of going to the general public, these companies grants their existing stockholders the “right” to subscribe to the newly issued securities in proportion to their respective holdings.
- Preferential Issue – It is the procedure by which a listed company allots shares to a select group of individuals, which may include promoters, strategic investors, employees and other such people. Preferential issue is amongst the fastest routes through which a company can raise capital.
FEATURES OF PRIMARY MARKET
The following are the key features of the primary market:
- The market is an important source of long term capital for companies.
- The company receives the money and in return issues new share certificates to the investors.
- Proceeds from primary market issues are predominantly used by companies to either expand their existing operations, or venture in to new businesses.
- The primary market performs the critical function of facilitating capital formation within an economy.
WHAT IS A SECONDARY MARKET?
It is the marketplace where already listed securities are bought and sold. The stock exchange is the most common example of a secondary market. An investor has to engage a broker to transact on the secondary market. The broker charges a fee or a commission for the services rendered. The price of a stock fluctuates on the secondary market depending on the underlying demand-supply scenario for the security. The volume of securities traded also varies from day to day.
FEATURES OF SECONDARY MARKET
An efficient secondary market exhibits the following characteristic:
- As has been stated above, an initial public offering is a leading example of a primary market. IPOs are brought to the open market by one or more underwriting investment banks, which assist the issuing company by soliciting potential investors. The underwriting firms also help the issuing company to decide on the price at which shares of its stock are to be offered to investors.
EXAMPLES OF PRIMARY MARKET AND SECONDARY MARKET
Let us next look at primary market and secondary market examples to get an overview of how each of them operates.
As has been stated above, an initial public offering is a leading example of a primary market. IPOs are brought to the open market by one or more underwriting investment banks, which assist the issuing company by soliciting potential investors. The underwriting firms also help the issuing company to decide on the price at which shares of its stock are to be offered to investors.
Chinese e-commerce giant Alibaba decided to go public in the United States in 2014. Six of the world’s biggest investment banks were selected as lead underwriters. The list included Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Citigroup. Shares debuted on the New York Stock Exchange (NYSE) on September 18, 2014, in what became the largest IPO in history, raising approximately $25 billion for the company. Alibaba shares surged as much as 34.00% from its IPO price of $68 per share during its first day of trading.
The defining characteristic of a secondary market is that investors’ trade previously issued securities among themselves, without the issuing companies’ involvement. Major stock exchanges like the NYSE, NASDAQ and London Stock Exchange are the most visible examples of secondary markets. For example, if you go to purchase Apple (AAPL) stock on the NASDAQ, you are dealing with another investor who holds shares in Apple. The iPhone maker is no way directly involved with the trade. The price at which Apple shares trade at any given point of time is a factor of the demand-supply for the stock. Since in a secondary market, securities are transferred from one investor to another, it becomes important that they be highly liquid. As a general rule, the greater the number of investors in a stock exchange, the better is the price discovery in that market.
PRIMARY MARKET vs. SECONDARY MARKET
Issue of Securities
hares of a company are issued for the firm time
Deals in already issued shares
There is no fixed location
Usually the financial capital of a country
Only buying of securities take place
Both buying and selling of securities can take place
Price of a security is determined by the issuing company
Prices are determined by factors that affect the demand-supply of the security
Securities are transferred from the issuing company to investors
Securities are transferred from one investor to another
The way in which shares are brought to the open market and subsequently traded on various stock exchanges is central to the capital market’s function. The importance of markets and the ability to buy and sell shares is often taken for granted. But just imagine if a structured and regulated primary and secondary market did not exist. Investors would have to personally hunt down other investors every time they wanted to buy or sell a stock.