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How to buy shares

The idea of this article is to explain the process of buying shares for beginners – its aim is to simplify everything about Stock Markets and in particular the London Stock Exchange (LSE) and Investing for beginners by using non-technical jargon and the aid of my not inconsiderable experience. I say non-technical but no doubt I will need to use some jargon, but I will explain this in layman’s terms.

My first task is to help you understand what the Stock Exchange or Stock Market is and what is its purpose(s).

I won’t go into the history of the Stock Exchange as you all probably know it started with a few merchants who met in an open courtyard in Exchange Alley and then the nearby coffee houses-especially Jonathan’s (hence the reason why the attendants at the Stock Exchange were called waiters).

Although the Stock Exchange was created for private means and to promote the common interests of its members, the profession of stock-dealing which it served grew up spontaneously to meet a public need, especially that of the Government. This need was to raise money.

This leads us nicely to the two main functions of the Stock Market.

One is the Primary market and the other the Secondary market.

The Primary market is where funds are raised for Governments (through Gilts or Govt. bonds), for Local Authorities  or for corporations  (shares). The bulk of the money raised goes directly to the companies and in exchange they issue shares which can then be traded in the market. The secondary market is where these shares are traded between individuals and institutions and where the money passes between the buyers and sellers rather than the issuing companies (or governments etc.)

So, that’s the stock market!

The process of buying shares for beginners

In its basic form the trading of shares can be broken down into a few simple processes.

You have buyers and sellers of shares (just like any other market) You have a settlement system:  a fool-proof way of moving money from the buyers to the sellers and of moving the shares from the sellers to the buyers. That’s it!

Ok, so you have dividends (and other corporate actions) that have to be paid to the right person (the buyer or the seller).

Buying and selling shares

Prior to ‘Big Bang’ in 1987 buying and selling shares was initially effected only through one process.

This was through Stockbrokers (who were partnerships of Stock Exchange Members) and Stock Jobbers, or Jobbers (who had the same set up). The Brokers were like retailers in the fact that they were the contact for the members of the public (and institutions) who wanted to trade. The Brokers were the only people to have contact with the Jobbers who made markets in particular shares. The trading between the Brokers and the Jobbers, on behalf of the public (the Brokers clients) was done on the Stock Exchange ‘floor’.

This changed after ‘Big Bang’ or the allowing of dual-capacity when Broker-Dealers were allowed. For example Barclays Bank could be a stockbroker with clients and also make markets in shares as a jobber.

The stock exchange ‘floor’ disappeared and all the pricing etc. became screen based. Now we have two systems which can be described as quote driven and order driven (also a hybrid of the two).

Quote driven is like the old system where Jobbers (now known as Market Makers) run a share ‘book’ and decide themselves what the prices are going to be.

Order driven is an electronic ‘book’ where the orders themselves are put into the system and make the price levels. Don’t worry this will become clear.

The beginner is usually under the misconception that there is a ‘price’ for each and every share. In fact there are two prices; one for buying and one for selling. From these two prices one can work out a ‘middle’ price and this is the price that you may see in the financial press or on TV and the price that the uninitiated think is the buying and selling price.

It may be worthwhile explaining how the dealing process works and I will explain this by referring back to the old Stockbroker/Jobber method. This is still very relevant as a lot of trading, especially in the smaller shares, is still done in this way. If you go into your local bank and buy or sell shares I suspect a young clerk will go to the screen, press the relevant buttons and deal electronically with what is known as ‘best ex’ or Best Execution. This will be the best price available on the screens, but, of course may not be the best price available with a bit of banter.

So, back to the ‘old’ system. The client gives his order to the Broker; “Buy 1000 shares in British Telecom at the best price.”

The broker contacts one of the many Jobbers making a market in BT. Probably he will ‘phone the one he knows gives him the best prices, or with whom he has a good relationship.

The broker asks the Jobber to give him a price in BT. That’s it. No buy or sell clues or any ‘size’ (amount).

The Jobber will respond with his price and size. Let’s say 105/7 in fifty, penny out in a hundred. What does that mean I hear you cry.

It means he is prepared to sell up to 50000 (every one assumes it is thousands so if you actually wanted to buy 50 shares you would have to say 50 shares only, or 50 pieces!) BT shares at 107 pence (all UK shares are always quoted in pence) or buy up to 50000 shares at 105 pence. (Jobbers usually leave out the ‘big figure’ of the price and might say 5/7 in fifty). If the ‘size’ was larger than 50000, and up to, say, 100000 one of the prices would be 1p different. So it could be either 104 to 107 or 105 to 108.

In this case the broker would probably say, “I’ll buy 1000 (at 107).

If the order was for ten thousand the Broker would probably say “ I am a buyer at 106 and a half”, or “ I am limited at 106 and a half. If the Jobber says “OK, 10 at a half “

Then the broker has just ‘saved’ his client £50.

If the order was for 200000 shares then there would be further negotiation. So far we have prices for 100000. The broker might ask “any larger?” or words to that effect. The jobber might quote 2p out in half a million, but at some point someone has got to ‘open’. The broker might ‘open’ by saying “ I am a buyer of 200, any good?” If the Jobber is a seller (he has enough or too many shares on his book) he may be pleased to sell shares at ‘the price’ (107) but if it doesn’t suit him he will say “109”. In which case the broker may decide to politely close the conversation and try another Jobber.

The newer, order driven system is a bit different.

This is known as SETS (Stock Exchange Trading System).

It is an electronic trading book.

As orders enter the system they are either matched instantaneously if possible or remain on the order book until matched.

Taking the above example of BT there may be potential buyers at 105p and lower together with potential sellers at 106p and higher. The orders specify the number of shares wanting to be bought or sold. The order book can be very large (order depth) but to simplify here is a very minimised order book:

ASK (Sell)                                                             BID (Buy)

Number of shares (Volume)

500 106p                                                              500 105p

900 107p                                                              1100 104p

These are limit orders so someone wants to buy 500 shares at 105p but the nearest ASK (or OFFER) is 106p so they will not match. The other orders do not match either.

Now let’s say someone wants to buy 300 shares and is willing to pay 106p. You can see that 300 shares will match (and therefore trade) partially with the 500 shares on offer. If this happens then the order book will become:

200 106p                                                              500 105p

900 107p                                                           1100 104p

And so on.

On this system (called Level 2) you will also see the Last Trade.

In this case the LT will be 300 @ 106p

Of course there maybe 1000’s of orders entering the order book and many matching all in real time and in milliseconds.

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