How Does the Stock Market Work

Introduction to the stock market 

Newbie investors who are, well, beginners in the game of investing usually find stock investments a challenge, especially on a deeper level. Most of them are scammed by self-claimed experts who promise huge and unrealistic returns ultimately end up losing all their money, only to never invest again. 

Investing in the stock market comes with its risks but with the right strategy, months of practice, and continuous learning any investor can transform from a beginner to advanced trader. Not to forget, majority of the top billionaires and the richest families in the world have invested 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. 

A stock, also known as a share or equity, is an asset that give investors ownership rights in the company. That means if you buy a stock, you become a partial owner of the company. You gain profit when the value of the company rises and shares loss if its value falls.  

Figure 1 - Daily Facebook Chart (Ticker: FB) 

Types of Stocks 

There are two types of stocks, common and preferred. 

Common stocks 

Common stocks, as the name suggests, are most common and easily available stocks for trading. They give voting rights to stock owners during company meetings. Common stocks are further divided into stocks that hold more voting rights than others.  

Preferred stocks 

Preferred stocks generally do not carry voting rights, but preferred stockholders are given higher priority than common stockholders when receiving the dividends. In other words, they are paid first and have a higher claim on company’s assets before common stockholders. Hence, the name “preferred”. 

Why companies issue stocks 

Mostly companies start small and when they reach success at some point and finally see growth, then they need to generate cash to scale up their business, either to expand or get more resources. Startups and small businesses often choose equity financing because getting loans can be hard without enough assets. Banks may also turn them down if they don’t have a strong safety net. 

Companies listing their shares 

As companies grow, they may need more cash and one of the main ways to generate more money is through listing their shares on the stock market by issuing an initial public offering or IPO. When the IPO is launched, the privately held company is changed into a public company, shifting ownership from a few investors who previously held most of the shares to the public acquiring the outstanding shares. 

As soon as the IPO is listed, the stock becomes available for the public and the price begins to shift as traders take positions. 

Stock Exchanges 

Stock exchanges are known as secondary markets. It is the place where current owners trade with potential buyers.  

History of stock exchanges 

It all started in Europe a few hundred years ago when Amsterdam and London became trading hubs for the first stock markets. It started with the bonds, investors buying bonds would loan those companies money for their businesses. 

In 1792, US launched its stock market with Philadelphia stock exchange as the first stock exchange, which still stands today. The famous New York Stock Exchange began when the Buttonwood Agreement was signed. Before that, brokers and traders would meet in Wall Street under a buttonwood tree to trade shares. With advancements in technology, exchanges became electronically linked, making trades convenient across continents and increasing liquidity on a huge scale. 

How share prices are determined 

The most common way of determining the stock price is through “Auctions” where buyers and sellers place bids and price offers to determine a starting point for a 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 investment objectives. 

Supply and Demand 

Supply and demand move the market, and the stock market offers a classic example of that. Every transaction includes a buyer and a seller, so more buyers and fewer sellers mean higher demand and higher future prices, and vice versa. 

Many bids and offers are placed by so-called experts, with the goal to provide liquidity for traders. They usually earn profit generated from the spread, which is the difference between the bids and the 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 when electronic trading became a much more efficient way of executing and matching 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 used to be every company’s vision. The benefits are clear and encouraging, including: 

Liquidity during early stages and through continuous trading. 

Issuing more shares and raising additional money is easy. 

Ease of setting up stock options plans for employees to boost their morale and loyalty. 

Being listed means more attention, analyst coverage, article coverage, and institutional interest. 

Listed shares can be used to acquire other companies or their shares. 

Effectively, they act as currencies. 

However, there are some disadvantages of getting listed on an exchange 

High costs associated such as listing fees and more compliance and reporting fees. 

Increased scrutiny and regulation potentially limiting a company from accomplishing all its goals. 

The challenge of choosing short term gains to please speculators or day traders or the long-term trading approach to accomplish company's vision and future objectives. 

Investing in Stocks 

History has proved that stock investment has been one of the most profitable investments of all time, making it attractive, low risk and low-maintenance investment. Returns on stocks are made up of capital gains, which means selling a stock at a price higher than when it was initially bought.  

Dividends are also part of returns. Dividends or yields are profits distributed by companies to compensate their shareholders. Stock investing is not a quick rich method. While some stocks have made impressive returns in short periods, most of them follow slow growth. Investing in a stable, growing company that pays dividends is often better than choosing a high-volatility stock with unstable price movements.  

Market cap of companies 

Market cap is the market value of the outstanding shares of a company. Multiplying outstanding shares with the current market price calculates the market cap of a company. Stocks are usually divided 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 diversify their portfolio better by allocating them in sectors according to their weight. With the availability of other products such as ETF’s can help traders invest in entire sector by only purchasing in a pool of stocks with one investment. 

Technology, finance, and energy have historically been more aggressive sectors that tend to grow and have higher returns. Meanwhile, consumer staples, health care, and utilities may help build a stable low volatile portfolio to grow wealth over time. 

Indices 

Stock market indices are collective prices of several different stocks within a specific market or sector. The S&P 500 is a major stock index including top 500 US companies with a bigger market cap. It reflects the entire US economy. Another major index is Dow Jones Industrial Average, it speculates the price movements of top 30 big, renowned brands of the US.  

Indices are traded through exchange-traded funds, futures, options, or simply building all the components of an index with individual stocks, making them hard to maintain.