What is a Primary Market?
The primary market is where companies and governments first sell stocks, bonds, and other securities to the public through an initial public offering (IPO). Another term used for the primary market is the New Issue Market (NIM).
It is not a physical location but rather a market where new securities are created and sold by the issuer, with the help of investment banks who set an initial price range for the securities and oversee the sale process.
Once all the securities are sold in the primary market, they start trading on the secondary market, where investors can buy and sell them from each other. But in the primary market, investors buy securities directly from the banks underwriting the IPOs.
For example, a new company called XYZ Inc. wants to raise money to expand its business. They may decide to sell stocks for the first time through an IPO on the primary market. Investors can then buy these stocks directly from the bank underwriting the IPO. After the IPO is complete, these stocks start trading on the secondary market.
A primary market is an excellent place for investors to buy stocks and bonds because studies have shown that the average IPO outperforms the broader stock market. However, investors must be careful and do their due diligence before investing in IPOs, as not all IPOs will perform well.
Types of Primary Markets:
- Initial Public Offering (IPO): When a company offers shares of stock to the public for the first time in order to raise money.
- Rights Issue/Offering: When a company offers its existing stockholders the opportunity to purchase new shares at a discounted price in order to raise more money.
- Private Placement: When a company sells its shares to a select group of investors or individuals instead of issuing them in the public market.
- Preferential Allotment: When a particular group is offered shares at a special or lower price than the publicly traded share price.
What is a Secondary Market?
In the secondary market, investors buy and sell securities that have already been issued, like stocks and bonds. Another term used for the secondary market is the After Issue Market (AIM).
When investors trade in the secondary market, they do it among themselves, without the involvement of the issuing company.
For example, if you want to buy Berkshire Hathaway (NYSE: BRK.A) stock, you will buy it from another investor who owns shares in Berkshire Hathaway, not from Berkshire Hathaway itself.
The secondary market is important because it provides liquidity for investors to buy and sell securities at a market-determined price. For instance, bondholders can sell their bonds on the secondary market to other investors at a higher price if interest rates have decreased since the bond’s issuance. This can result in a tidy profit for the seller as the bond becomes more valuable due to its higher coupon rate.
Types of Secondary Markets:
The secondary market is divided into two types: auction markets and dealer markets.
- In an auction market, buyers and sellers come together in one place to announce the prices at which they are willing to buy and sell securities. The New York Stock Exchange (NYSE) is an example of an auction market.
- In contrast, a dealer market doesn’t require buyers and sellers to be in the same place. Dealers hold an inventory of securities and offer firm prices at which they are willing to buy and sell them through electronic networks. The Nasdaq (NASDAQ) is an example of a dealer market. The idea is that competition between dealers will lead to the best possible price for investors.
Differences Between Primary Market and Secondary Market
| Criteria | Primary Market | Secondary Market |
| Type of Shares | Fresh shares issued by the company | Already issued or existing shares traded |
| Market Name | New Issue Market | After Issue Market |
| Purpose | Company receives funds for business expansion | Company does not receive funds |
| Exchange | Securities issued by companies to investors | Securities exchanged between buyers and sellers |
| Price | Securities issued at one price for all investors | Securities exchanged at the market price |
| Liquidity | Does not provide liquidity | Provides liquidity |
| Intermediary | Underwriters | Brokers |
| Number of Sales | Security can be sold only once | Securities can be sold innumerable times |
The OTC Market
When people talk about the OTC market, they refer to a type of market where trading happens through dealer networks instead of on a physical stock exchange like the NYSE or Nasdaq. This term originally meant a system where stocks were sold “over-the-counter” in stock shops rather than being listed on an exchange.
Today, the term OTC usually refers to stocks that are not listed on a major exchange, like the NYSE or Nasdaq. Instead, these stocks are traded on networks like the over-the-counter bulletin board (OTCBB) or the pink sheets. These networks provide pricing information for securities, but they are not actual exchanges and have fewer regulations than traditional stock exchanges.
However, it’s important to note that the Nasdaq, created initially as a dealer network, has since evolved into a major exchange. So while it technically falls under the OTC umbrella, it is inaccurate to say that it trades in unlisted securities. Most stocks on the OTC market are penny stocks or from small companies.
What are the Third and Fourth Markets?
The third market is where broker-dealers and big institutions trade stocks with each other, while the fourth market is where only big institutions trade with each other. These markets aren’t very interesting to regular individual investors because they involve trading large volumes of shares at once.
While most everyday investors won’t need to worry about the third and fourth markets, it’s good to know what they are. These markets don’t really impact the stock market activities of individual investors, but their names can sometimes help explain what’s happening in the financial world.
Key Takeaways
- The primary market is where companies and governments first sell stocks, bonds, and other securities to the public through an initial public offering (IPO).
- The primary market is where investors buy securities directly from the banks underwriting the IPOs, while in the secondary market, investors buy and sell securities from each other.
- In the secondary market, investors buy and sell securities that have already been issued, like stocks and bonds.
- The secondary market is divided into two types: auction markets and dealer markets.
- The OTC market refers to a type of market where trading happens through dealer networks instead of on a physical stock exchange like the NYSE or Nasdaq.
- The third market is where broker-dealers and big institutions trade stocks with each other, while the fourth market is where only big institutions trade with each other. These markets aren’t very interesting to regular individual investors because they involve trading large volumes of shares at once.
