How Does the Stock Market Work

Introduction to the stock market

The thought of investing is never an easy-to-digest for most people with little experience in the financial markets. Many have been tricked by so-called experts who have promised huge returns on stocks that ended up not moving at all while others did it themselves without initially learning the ropes and ended up struggling to make profits or build sustainability.

Investing in the stock market is a risky endeavor but there’s a certain approach, one that involves education, practice, and continuous research which could make a difference for the average investor. It’s worth noting that the majority of wealthy individuals and families have large investments in the stock market.

What is a stock?

A stock also referred to as a share, is a product that represents ownership in a company (Figure 1). In other words, if you own a stock, you’re technically a part-owner, and most likely a very small one if the company has many shares in the market. For example, if a company has one million shares outstanding and you own 100,000 of them, this implies a 10% ownership in that company.

Figure 1 - Daily Facebook Chart (Ticker: FB)

Preferred and Common stocks

There are two types of stocks: Common and Preferred. As the names imply, common stocks are the more available ones and carry voting rights that enable holders to vote during special events and corporate meetings. On the other hand, preferred shares do not usually carry voting rights, but they maintain priority in receiving dividends and assets in the event of liquidation. 

Common stocks can be broken down further into stocks that hold more voting rights than others and are usually referred to as Class A and Class B shares.

Why companies issue stocks

Many of the bigger corporations we see and hear about every day had humble beginnings. Successful ideas saw sudden and strong growth which can only be leveraged further by making sure enough cash is available for new offices, employees, raw materials, and other aspects needed for the business. While companies have two methods of raising cash, startups and smaller firms will choose the shares path as the debt financing may provide difficulty with minimum assets. In turn, they may see banks turning them down for lack of a safety net.

Companies listing their shares

As companies grow, they may need access to more money, and one of the main ways to accomplish this is through an initial public offering or IPO. An IPO changes the company from a privately held one where a few investors hold the majority of shares to a public one, which allows the general masses to acquire the outstanding shares. 

As soon as the listing is done, the stock becomes available for stock trading and the price begins to fluctuate as traders begin positioning respective to their view of the company.

Stock Exchanges

Stock exchanges are known as secondary markets. It’s the place where current owners of shares potentially transact with future buyers. Secondary markets are where most of the trading occurs as the corporation itself is not buying or selling there, aside from the occasional buyback or the issuance of new shares. In other words, when you buy shares in a specific stock, you are buying them from an investor or a general owner holding them, and vice versa when you are selling your holdings.

History of stock exchanges

It all started in Europe a few hundred years ago when the first stock markets began showing up in trading hubs such as Amsterdam and London. The focus back then was on bond issuing and not equity so investors buying bonds would effectively be loaning those companies money for new and future activities.

Just before the 19th century, stock markets began their journey in the US with the Philadelphia stock exchange as the first and oldest in the country. The exchange still stands today and was founded in 1792. On the other hand, the notable New York Stock Exchange began when the Buttonwood Agreement was signed. Before that, brokers and traders would meet under a buttonwood tree on Wall Street to transact in shares.

The 20th century’s technological advances created more modern stock markets and brought upon regulatory changes that would ensure fairness and transparency for all market participants. In other words, enhanced trust was born with traders having no issues buying and selling. Furthermore, exchanges became linked electronically, meaning more facilitated trades across continents and major hubs and a large-scale increase in liquidity.

At the same time, many other less-regulated exchanges were born, usually referred to as over-the-counter exchanges. They feature riskier stocks that could not make it on the more stringent major exchanges. Some of these requirements include a company needing to be operational for x amount of years.

How share prices are determined

Auctions are the most common way of setting the prices of a share, although other methods exist but are less popular. In the auction model, buyers and sellers place bids and offers across a range of prices which determines something similar to a starting point for a stock.

This goes beyond a few traders placing bids and offers across different prices based on their expectations of the stock. It’s millions of traders, some short-term day traders, and others long-term investors placing their trades and speculating according to their unique trading signals and styles.

Supply and Demand

The idea of placing trades is what sets and determines the price, but supply and demand are truly what moves the market. The stock market offers a prime example of that. Every transaction includes a buyer and a seller so, in simple terms, more buyers and fewer sellers mean higher demand and higher future prices, and vice versa.

Further to the idea of matching trades and supply and demand, a large number of bids and offers are placed by so-called specialists, with their main role being to place trades to provide liquidity for market participants. Their profit is usually generated from the spread.

The spread is the difference between the bids and offers. A market with many trades is said to have good depth and usually features easier execution and tighter spreads.

In the old days, matching of buyers and sellers (Figure 2) was done manually and face-to-face through a process called ‘open outcry’, where traders verbally communicate and use hand gestures to initiate trades. This disappeared not too long ago when electronic trading became a much more efficient way of matching traders and executing their trades.

Figure 2 - Daily Microsoft Chart showing Volume on every bar (Ticker: MSFT)

Benefits of an exchange listing

Having your company listed on one of the most prestigious exchanges such as the New York Stock Exchange or the Nasdaq was the goal of every business owner or entrepreneur. The benefits are clear and encouraging, including:

• Abundant liquidity during the initial stage and through continuous trading.
• Issuing more shares is easy and allows for an easy method of raising additional money.
• Ease of setting up stock options plans for employees, a feat that many companies use to encourage and keep team members happy.
• Being listed means more attention, analyst coverage, article coverage, and institutional interest.
• Listed shares can be used to acquire other companies or part of them. Effectively, they act as currencies.

However, some disadvantages do exist when looking to get listed on an exchange:

• Costs associated such as listing fees and more compliance and reporting fees.
• Increased scrutiny and regulation possibly preventing a company from accomplishing all its goals.
• The dilemma of focusing on the short term to please day traders and others speculating over a short period versus taking a long term trading approach to accomplish the overall mission and vision of the company.

Investing in Stocks

The stock market has always proven to be a rather profitable investment through studies done over time and for anyone who invested money over the past 50-100 years. This makes it a very attractive, low risk and low-maintenance investment which many people can get into with some research. Returns on stocks are made up of capital gains, which is the idea of selling a stock at a price higher than where it was initially bought. 

Dividends also make up a decent part of overall returns. Dividends are profits distributed by companies that are making profits as a way to compensate their shareholders. Since the middle of the 20th century, dividends have made up an increasingly larger share of total returns when investing in stocks.

Stock investing is not a get rich quick method. While some stocks have made stellar returns during short periods, most stocks will not grow at a rapid pace. A stable yet growing company that pays dividends is a much better holding than investing in a company that carries higher volatility and is prone to extreme ups and downs.

Market cap of companies

Market cap is the market value of the outstanding shares of a company. Multiplying outstanding shares by the current market price will generate the market cap of a company. Stocks are usually categorized according to market cap size, with large caps being companies valued at over $10 billion while mid-cap ranges between $2 billion and $10 billion. The small-cap ranges between $300 million and $2 billion. Microcaps and smaller companies are ones valued at below $300 million.

Stock sectors

MSCI and S&P Dow Jones Indices developed the currently used categorization of stocks into 11 sectors and 24 industries in 1999.

These sectors are:

• Energy
• Materials
• Industrials
• Consumer discretionary
• Consumer Staples
• Health Care
• Financials
• Information Technology
• Communication Services
• Utilities
• Real Estate

This classification helps investors better allocate stocks across their portfolios and would be able to quickly select which sector needs more or less weight, especially with the availability of other products such as ETF’s which can cover an entire sector by only purchasing one product instead of a multitude of stocks.

Technology, financials, and energy have historically been more aggressive sectors that tend to gain during positive periods of growth. Meanwhile, consumer staples, health care, and utilities may help build a steadier portfolio that builds income and is not prone to excessive volatility.

Indices

Stock market indices are aggregated prices of several different stocks which can reflect the health of a sector, market, or even an entire economy. One of the most popular indices is the Dow Jones Industrial Average, abbreviated as DJIA, which represents 30 large American corporations. It’s not the most accurate indicator of the health of the stock market as it only shows 30 large companies. However, it tracks closely to the S&P 500 and the Nasdaq. In turn, this reflects the health of the economy to a certain extent.

The S&P 500 is another major one and is a market-cap-weighted index, meaning companies with a bigger market cap have more presence and weight. Since it is 500 of the largest companies in the US, this index is a much better reflection of the current state of the economy.

Most countries around the world have indices that represent the stocks on the stock market or across different sectors or industries, depending on how involved their financial markets are. Indices are traded through exchange-traded funds, futures, options, or simply building all the components of an index with individual stocks, which is a very difficult task to accomplish and maintain.