How Stock Market Exchanges Work
Stocks are either listed on a particular exchange or are traded “over-the-counter” (OTC). The phrase over the counter is used when a stock is traded through a dealer network, rather than formally through a centralized exchange. Over the counter also refers to debt instruments, such as bonds and other financial instruments. One example of "other" financial instruments are derivatives which are traded via a dealer network.
The NASDAQ operates as a dealer network and is run by the National Association of Securities Dealers. However, NASDAQ stocks are not considered OTC, because it is considered a stock exchange.
OTC stocks are usually unlisted securities of small companies. Traders and investors should be wary of many OTC stocks. Penny stocks are a good example of an OTC security. Although you will find examples where large sums of money have been made in these stocks, much more has been lost. You get what you pay for also applies in the financial markets.
In the NYSE, there are specialists who are members of the exchange and act as the market maker to facilitate the trading of certain stocks. A specialist holds an inventory of stock, posts a bid and ask price, manages limit orders and executes trades. They also trade their own accounts. They are required by the exchange to maintain an orderly market in the stock they represent. In many instances, you are in competition with the specialist.
On the NASDAQ you will find Broker-dealer firms that act as market makers. They function in a fashion similar to a specialist in that they supply a market for particular stocks by holding an inventory of those stocks. There are over 500 member firms acting as market makers on the NASDAQ.
Both Market Makers and specialists draw a majority of their income from the difference between the bid and ask price on any given security. This difference is called the "spread". It is important to understand the spread is an additional cost of the transaction to your portfolio. It is in your best interest to always obtain the best possible entry and exit price.