The order-driven market

The New York Stock Exchange (NYSE) is a prime example of an order driven market. When an investor (or a trader) places an order on NYSE, it goes through a specialist who is responsible for making an orderly market in a particular stock. (Large orders can also go through floor brokers who seek to match buys and sales among themselves, or with a specialist.) 

One stock listing is assigned to one specialist at the trading post. A specialist makes a profit by the difference (a spread) in a bid (a price at which stock is sold to the specialist) and an ask (a price at which a stock is sold to the customer). If the quote is $10.05 / $10.10, a specialist will make 5 cents on every share.

However, specialist’s firm takes a risk of the market going against them. If the stock, for example, declines, the specialist may end up holding many shares, which can now be sold at a lower price, resulting in a loss. If the stock goes up, the specialist could end up short and be required to buy back shares at a higher price, also resulting in a loss.

During times of volatility, spreads can increase, even though a specialist is required to provide a fair and orderly market. This is to compensate for increased risk. Moreover, stocks that are less liquid, in general have higher spreads.

When there are more buyers than sellers, a specialist will raise both bid and ask prices. That will make buyers pay more for a stock, while a higher bid means better sale price for sellers. This will make the price of the stock go higher.

On the other hand, when there are more sellers than buyers, bid and ask (and effectively the price) will be lowered to discourage the sellers and to encourage the buyers.

The quote-driven market

The NASDAQ is a good example of a quote-driven market. Instead of a single specialist (plus floor brokers) handling a single stock, the quote-driven market has multiple market makers posting quotes in order to buy and sell securities.

The way prices move is similar to that of an exchange trading. Market makers also expose their firms’ capital to risk, just like the specialists do, in order to make gains on spreads. 

There are various types of quotes posted by the market makers. One is a firm quote where the market maker who posted it is obligated to buy or sell at least 100 shares of a stock, or 10 bonds.

When it comes to a subject quote, the price needs to be confirmed by contacting the market maker. In addition, there are workout quotes, which are ranges within which deals to buy or sell can be made. Usually these apply to thinly traded securities.

Three Levels of NASDAQ Quotation Service

The quote system on NASDAQ can be divided into three levels.

Level 1, which most investors see, displays best bids and offers. 

Level 2 displays every market making firm making bids and offers for securities. This is typically available to professional investors, although some retail customers get access to it.

Finally, Level 3 allows market makers to enter and update their bids and offers.

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Stock markets can be divided into two major kinds: the order-driven and quote-driven markets. 


Order-driven vs. Quote-driven Exchanges

Although most of our readers are already quite familiar with stock markets, there are some details we’d like to point out that may be new to some. ​