What Is the Stock Market and How Does It Work?

It’s common knowledge that investing in the stock market can be very financially rewarding. But it can be equally catastrophic to your net worth if you don’t know how to do it.

The first step is to gain a basic understanding of how the stock market works. This will allow you to have an easier time analyzing opportunities and be successful. And that’s why we created this guide; to give you the fundamentals that all types of traders and investors need to know before they buy their first stock.

A stock is a security (financial instrument) that a company uses to raise capital and it represents ownership in a business.

More specifically, when you buy stock in a company you become a partial owner of its business and you have a partial claim on its profits and assets.

In the pre-internet era, stocks were in the form of paper which made its holder the owner of an underlying business. Today, they are mostly stored as entries on digital ledgers.

You might hear someone refer to stocks as shares. Though the terms are used interchangeably, shares are the ownership “slices” of a stock. You could say that stock consists of shares. The number of shares is basically the way that the company structures its stock.

For instance, let’s assume that a company wants to raise $100 million. It could do so by offering stock to the public and slicing it to 10 million shares at $10 per share. It could also divide its stock to 5 million shares at $20 per share. While the structure of the company’s stock changes, the amount that is raised is the same.

Lastly, when you look at the price of a stock, that is actually the price of one share (or slice) of that stock.

When a company wants to grow, it needs capital to finance that growth (buy new factories, or invest in research and development projects.

Selling stocks to the public is one of the two main financing means (though there are more) that a corporation has at its disposal to grow its business. Another is debt; it can borrow money from banks or sell bonds to the public to finance a new project.

A company may choose to sell stock instead of getting into debt for the following reasons:

• It can’t or doesn’t want to pay interest on a loan/bond
• It doesn’t have enough physical assets to post as collateral
• It doesn’t want to burden itself with the obligation to pay back the amount it raised

Stocks are sold generally via a stock exchange.

A stock exchange is an organized market where brokers and traders can transact stocks with each other. Corporations that need to sell stocks need to “list” them on a stock exchange so they become easily available to the public.

In the pre-internet era, a stock exchange was a physical location where you could go and trade stocks with others. Today, stock exchanges have been digitized and consist of large rooms filled with servers where trading is done electronically.

Some small countries may have only one stock exchange and we would say that it basically is that country’s stock market.

Some others like the United States have multiple exchanges like the New York Stock Exchange, Nasdaq, Boston Stock Exchange, etc. In this instance, we would say that all of the US stock exchanges constitute the country’s stock market.

So the stock market in general is the sum of all of the stock exchanges around the world. It’s where stock listing/trading happens, be it trading floors or server computers.

Although the stock market consists of stock exchanges, you often hear people say things like “the market is down today” or “the market’s condition has been deteriorating”. In this instance, they don’t talk about exchanges, but a stock market index.

A stock market index is basically a tool that is used to measure a certain number of stocks’ performance. The stocks that belong to a stock market index are selected as the fittest to represent a country’s stock market’s performance.

For instance, the S&P 500 is a US stock index that tracks the US stock market’s performance via the largest 500 US companies that best represent the US economy. The DJIA does the same thing with a smaller sample of the 30 largest US corporations.

While the stock market consists of stock exchanges, its performance is measured by stock indices. That’s why the terms are often interchangeable.

Now, what drives the stock prices up and down?

Put simply, the law of supply and demand. If there are more buyers than sellers for a particular stock, its price will gradually move upwards. If the opposite is true (more sellers than buyers), trading activity will drive the price downwards.

Imagine the stock market as an auction, where bids (the highest price a buyer is willing to pay) and asks (the lowest price a seller is willing to accept) are placed.

The more demand a stock has, the easier it is for a seller to sell the stock at an attractive price and the harder it is for the buyer to buy at an attractive price. If a stock has more sellers (supply) than it has buyers (demand), then the opposite happens.

A step further, the supply/demand forces are caused by market sentiment which simply is the general attitude of the public towards a stock. That’s why in the short-term, a stock’s price movement reflects the fear and greed of the public, while in the long-term, it reflects its appreciation (or lack thereof) of the underlying business.

Note: The short-term price fluctuations can be predicted via technical analysis while the long-term performance through fundamental analysis.

Market makers are professional traders that serve as intermediaries between buyers and sellers to ensure liquidity in the market.

In other words, the reason that traders can buy and sell stocks so fast is that market makers are always available during market hours to take the other side of a transaction. Without them, you would have to place an order through your broker and wait for someone to agree to the price you want to buy or sell. That would cause a huge liquidity problem in the market.

Sometimes a market maker is your broker. But they’re usually banks and other financial institutions. The incentive is always the same, however. They intend to profit from the difference of the bid and ask price (called spread); i.e. they buy the stock that you want at a low price and sell it to you at a higher one.

Stock brokers are the institutions that allow you to buy and sell stocks.

To trade in the stock market, you need to first open a brokerage account. After you fund it, you will be able to place an order to buy a stock.

When you place a buy order, you basically tell your broker how many shares you want to buy and at what price. That order will be “filled” as soon as there is a market maker who can provide you with the number of shares at the price you want.

After your order is filled, the broker will deliver the shares to your account. The process involves a digital ledger entry; simply put, the broker will electronically store the information that you own a certain portion of the company to track your ownership.

Now that you understand what the stock market is and how it works, the next step is to choose your investment style.

At the same time, you need to choose the broker that will best fit that style you go with. That’s why we created a tool that will help you do just that.

Our broker comparison app will find the best broker based on the country of your residence, what you value most in a broker (fees, ease of use, etc.), deposit preferences, and more. Start your investment journey with a broker that best aligns with your needs today!