Anyone who has even a slight interest in financial investing has likely heard the term “market” at some point or another. Whether it’s in the context of stocks or within the context of real estate conditions, investors should always seek awareness of these financial terms to have a firm grasp of their monetary options down the line. 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 better understand 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: primary vs. secondary markets. Instead of viewing primary and secondary markets on their own merits, it’s more important for investors to learn how they interact with each other, which is why the following outline was created. With FortuneBuilders’ helpful guide to understanding primary and secondary markets, new and old investors can ensure they have a strong working knowledge of financial markets.
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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 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.
According to Robert R. Johnson, Professor of Finance at Creighton University, Omaha, Nebraska, the primary market is a great place for investors to acquire stocks. “Studies have shown that the average Initial Public Offering outperforms the broader stock market,” according to Johnson.
However, Johnson notes that investors shouldn’t get too excited without minding due diligence. “Before you go rushing into buying every IPO you can get your hands on, understand how those returns are achieved. While the average return earned by IPOs may outpace the broader market, the average is driven by a few superior performers. The median IPO return (that is, the IPO where exactly half of the IPOs return more and exactly have the IPOs return less) is lower than the broader market,” says Johnson.
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.
Raising Money From The Primary Market
There are a few different ways a company can raise money from the primary market: a public issue, rights issue, and preferential allotment. Depending on the needs and stage of the company, each of these three options may be utilized. The most common example of raising money through the primary market is a public issue, where securities are listed on the stock exchange through an IPO.
Companies can also raise funds through a rights issue, where existing shareholders are given a discounted price for socks. This is sued to raise money from existing shareholders. Finally, a preferential allotment allows is used when companies designate shares to a few individuals using a special price. The share price is not determined by the market value during a preferential allotment.
Different Types Of Primary Offerings
The different ways a company can raise money from the primary market translate into three different primary offerings for investors. These include public issues, rights issues, and preferential allotment. With a public issue, investors can buy shares directly from the stock exchange. In a rights issue, current investors are offered new shares at discounted rates (determined by the shares they already have).
In a preferential allotment, select investors are offered shares at a discounted price — which would not be found in a public issue. This is somewhat similar to another type of primary offering called a private placement. In private placements, hedge funds and banks are given an exclusive opportunity to invest in a company.
Yet another primary offering available to investors is short or long-term bonds, which can also be issued on the primary market. These are used by businesses hoping to raise debt capital, and give investors the opportunity to buy at a specific rate.
Primary Market Benefits
As we touched on previously, neither the primary or secondary markets should be seen as better than one or the other. It’s more important to understand the advantages of both markets to know how to properly navigate each and use them to your investing benefit. As far as the primary market, here are some of it’s unique benefits:
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Companies can raise capital at low costs
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Great way to reduce risk with diversification
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Lack of market fluctuations
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Primary market is highly liquid because securities can be sold immediately
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This market can lead to direct foreign investors
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Lower price manipulation
What Is The Secondary Market?
To clear up the primary vs. secondary market debate, the secondary market definition 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 globally. That is an important distinction to make, as securities are traded on the secondary market without any involvement on behalf of the issuing companies. So while the primary market is the origin of securities, bonds, and stocks for purchase, the secondary market is where these securities can be traded freely amongst initial and new investors.
Let’s say, for example, an investor wanted to buy shares of Apple Inc. (NASDAQ: AAPL) on the secondary market. Any purchase order would acquire the specified shares from another investor, 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:
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Auction Markets
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Dealer Markets
When most people think about financial markets, they most often think about the stock market. We’ll explore each subcategory of the secondary market shortly.
Secondary Market Benefits
When considering primary markets vs. secondary markets, it’s important to consider the unique advantages of each respective financial space. The most obvious secondary market benefit is the ability to access it for newer investors. Some of the most stand-out advantages of the secondary market include, but are not limited to:
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Secondary market trading doesn’t require a surplus of capital or funds, so it’s accessible
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Investors can make great gains in a shorter period of time
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Analyzing a company’s relevance and performance is easy by evaluating stock prices
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Investors can sell and buy stocks easily, ensuring liquidity
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This is the market that offers consumers insight into a company’s financial health
Types Of Secondary Markets
While we understand the key features of both primary and secondary markets, secondary markets tend to be a bit more expansive than the primary market. This is partially due to its wide accessibility, with more potential investors the market is bound to be broken up to be better understood. As we covered, the two main subcategories of the secondary market include auction markets and 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 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 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 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 are a 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. That transparency acts as the primary mechanism for dealer markets and generates competition. If for nothing else, the concept of the dealer market relies heavily on the competition. Competition between dealers, for example, should theoretically provide investors with the best possible prices.
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Primary vs. Secondary Markets: The Differences
While the primary and secondary markets are easy to confuse, it is important to note 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:
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Relation to Shares: The primary market is where new shares are sold for the first time, whereas the secondary market allows investors to trade previously issued securities between themselves.
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Nature of Transaction: On the primary market, investors buy securities directly from issuers at the IPO. On the other hand, the secondary market witnesses investors trade shares with each other on today’s most prominent indices.
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Verbage: Sometimes the primary market is referenced as the New Issue Market (NIM), and the secondary market defaults to the After Market.
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Security Sale Rate: Securities may nay be sold once on the primary market, but they can be sold an infinite number of times on the secondary market.
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Payment Party: 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.
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Price Fluctuation: Initial Public Offering underwriters (banks) serve as the intermediaries on the primary market, whereas brokers serve as the intermediaries on the secondary market.
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Related Parties: Sales on the primary market coincide with fixed prices. Sales in the secondary market fluctuate based on several factors.
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Share Path: 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. However, it is worth noting 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 not listed on an exchange. OTC stocks can be found on the over-the-counter bulletin board (OTCBB) or the pink sheets instead of trading on major market indices. 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 most 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 primary vs. secondary markets. 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.
The primary vs. secondary markets debate shouldn’t be an issue but rather an educational experience when all is said and done. With FortuneBuilders’ helpful guide for primary and secondary markets, investors can take steps toward each market with stronger confidence and educated decision making.
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