The stock market is as vast and complicated as investors want to make it. However, much like everything else, it can be broken down to gain a better understanding of how things work. Even the market itself can be deconstructed into several submarkets, which appears to be the catalyst for one of today’s most interesting debates: the primary vs secondary market. Instead of viewing each market on their own merits, however, it’s more important for investors to learn how they interact with each other, which is why the following outline was created.

What Is The Primary Market?

The primary market isn’t a physical market like we would typically associate with Wall Street. Instead, the term primary market is used to denote when securities (like stocks and bonds) are initially created and sold. It is the primary market where stocks and bonds are publicly traded for the first time. Therefore, investors aren’t buying and selling securities from each other (like on the secondary market), but are instead buying securities directly from the banks which were responsible for underwriting the initial public offering (IPO).

You see, when a company decides to go public, it will generate cash through an IPO. In doing so, the soon-to-be public company will hire several underwriting firms to determine the financial details of the upcoming stock debut, not the least of which includes the issue price. Once the issue price is set, and the company is ready to make its IPO, investors may buy shares of the business from the bank on the primary market.

When all is said and done, the primary market isn’t a place, but rather a catalyst for investors to buy shares of a company for the first time. Similarly, businesses and governments may issue bonds on the primary market to raise capital for their own endeavors. Regardless of which security is being purchased, it is important to note that securities are purchased directly from issuers on the primary market.

What Is The Secondary Market?

To clear up the primary vs secondary market debate, the secondary market is more commonly referred to as the “stock market.” It is the secondary market where investors trade among themselves on all the major indices: the New York Stock Exchange, NASDAQ, S&P 500, and all major exchanges on a global level. That is an important distinction to make, as securities are traded on the secondary market without any involvement on behalf of the issuing companies.

Let’s say, for example, an investor wanted to buy shares of Apple Inc. (AAPL) on the secondary market. Any purchase order would acquire the specified shares from another investor, and not the company itself. At the same time, anyone selling on the secondary market is actually selling their shares to another investor.

It is worth noting, however, that the secondary market can be broken down into two additional subcategories:

• Auction Markets

• Dealer Markets

Auction Market

The New York Stock Exchange (NYSE) is perhaps the most well-known example of an auction market. As their names suggest, auction markets function similarly to the same auctions most of us are familiar with. As part of the secondary market, however, auctions take place between investors who are looking to buy and sell; no businesses are involved. Participants gather to announce the bid and ask prices they are comfortable with. Otherwise known as the prices they are willing to buy and sell at, bid and ask prices eventually start to form a more concrete figure. With everyone declaring their terms,  an efficient market should eventually prevail.

Hypothetically, investors don’t have to seek out the best price on the secondary market. Thanks to auction markets, the unique convergence of buyers and sellers will inherently lead to fair prices for everyone. In a perfect world, buyers and sellers will be submitting competitive offers at the same time. When all of the bids are submitted, the auction market will look at the most a buyer is willing to pay and the lowest price a seller is willing to accept. When bids and offers match, transactions are made, and everyone is happy.  

Dealer Market

While auction markets require a convergence of investors, dealer markets tend to take place electronically through individual markets. In the Nasdaq (the most popular dealer market), for example, dealers maintain an inventory of securities, not the least of which they are ready to trade (buy and sell )with other investors at a moment’s notice. To facilitate dealer markets, dealers announce at what prices they are comfortable buying or selling specific securities. To be clear, the dealers will stake their own capital to provide liquidity for subsequent investors. In return, dealers earn profits based on the spreads each security is bought and sold for.

Dealers exercise complete transparency and display the prices for everyone to see. It is that transparency that acts as the primary mechanism for dealer markets and generates competition. If for nothing else, the concept of the dealer market relies heavily on competition. Competition between dealers, for example, should theoretically provide investors with the best possible prices.

Primary Vs. Secondary Market: Key Differences

While the primary and secondary markets are easy to confuse, it is important to note there are several key differences. Here’s a list of the most important differences investors need to know about before investing in either the primary or secondary market:

• The primary market is where new shares are sold for the very first time, whereas the secondary market allows investors to trade previously issued securities between themselves.

• On the primary market, investors buy securities directly from issuers at the IPO. The secondary market, on the other hand, witnesses investors trade shares with each other on today’s most prominent indices.

• Sometimes the primary market is referenced as the New Issue Market (NIM), and the secondary market defaults to the After Market.

• Securities may nay be sold once on the primary market, but they can be sold an infinite number of times on the secondary market.

• In the primary market, companies (new IPOs) profit the amount on the sale of shares. In the secondary market, investors are made privy to the profits of sales.

• Initial Public Offering underwriters (banks) serve as the intermediaries on the primary market, whereas brokers serve as the intermediaries on the secondary market.

• Sales on the primary market coincide with fixed prices. Sales on the secondary market fluctuate based on several factors.

• Shares can’t trade on the secondary market until they have been issued on the primary market first.

Over-The-Counter Market

The term “market” casts a wide net in the investing world. As we have already discussed, markets can be used to describe several investing environments. The secondary market, for example, consists of several subcategories, two of which we have already talked about: dealer and auction markets. It is worth noting, however, that even these submarkets can be broken up further. The dealer market, for example, is also often referred to as the Over-The-Counter (OTC) Market.

As the name vaguely references, the Over-The-Counter Market consists of stocks that are not listed on an exchange. Instead of trading on major market indices, OTC stocks can be found on the over-the-counter bulletin board (OTCBB) or the pink sheets. Companies found on the OTCBB and pink sheets are generally very small and haven’t gone through the same level of scrutiny as those listed on a stock exchange. As a result, the OTC market tends to offer a lot of value, but the risk is magnified. This is where you will find what investors tend to refer to as “penny stocks.”

Third & Fourth Markets

While the majority of investors will never have to concern themselves with the third and fourth markets, it doesn’t hurt to know what they are. Simply put, the third and fourth markets revolve around transactions made between broker-dealers and large institutions. While the third market consists of OTC transactions between broker-dealers and large institutions, the fourth market consists solely of deals between larger institutions. Generally speaking, these markets have little impact on the daily transactions of regular investors, but their brands can often shed some light on certain situations.

Summary

Wall Street can be an intimidating place for investors, whether they are new to the game or have been trading for decades. The sheer volume of markets alone is enough to intimidate anyone, let alone how they operate independently from one another. That said, there’s no reason to let the complexities of each market stop you from investing. All investors need to do is take a step back and learn about each market at their own pace. Breaking each market down can serve as a strong foundation for each investment portfolio, and investors who mind their due diligence now will be happy they did years down the road. When all is said and done, the primary vs secondary market debate shouldn’t be an issue, but rather an educational experience.