How Does the Stock Market Work?
By: Mike Mc Mahon | Updated: October 31, 2019
There are many different strategies for investing, but the basic function of the stock market comes down to investors purchasing and selling previously existing shares on the New York Stock Exchange (NYSE), Nasdaq, or other stock exchanges.
Let’s take a closer look at how the stock market works, and how you can make it work to your advantage as a trader or investor.
History of Trade On The Stock Market
Before we dive into how the stock market works, let's talk about how and why the stock market came into being in the first place.
The Merchants of Venice were credited with trading government securities as early as the 13th century, but the first genuine stock trading markets didn’t arrive until the 1500s.
As is usually the case, necessity was the mother of invention in the formation of the stock market. The East India Company, who holds the distinction of being the first publicly traded company, allowed for investors to invest in multiple ships. So, instead of financing one ship and risking total loss due to pirates, disease and storms, they allowed investors to purchase shares in multiple ships so if one was lost, all was not lost. Their success led to similar charters being granted to other businesses in England, France, Belgium and the Netherlands. Coffee shops were their trading floor, where stocks were handwritten on sheets of paper and traded.
Antwerp was the commercial center of Belgium, and it is generally accepted that they had the world’s first stock market system. Eventually, the first U.S. stock exchange was opened in 1791 in Philadelphia.
Read more about the history of the stock market.
How Do Stocks Work?
Understanding how stocks works is fairly simple. Companies sell shares of their company to investors, who then sell those shares back to other investors. Owning shares in a company makes the investors part owners of the company. If investors sell shares at higher prices than they bought them, the value is said to go up, and if they sell for less than they paid, the value is said to go down.
Initial Public Offerings
When a company wants to raise money for expansion, it goes public by making an initial public offering (IPO) of common stock. What this means is that they are offering shares of their company’s stock (ownership in the company) to investors.
This is a familiar process if you’ve followed the high-profile IPOs of Facebook (ticker: FB), Twitter (ticker: TWTR) and other tech companies. Typically, the amount of the company that is sold is only a fraction of its total ownership, so the price set for the stock (as determined by open bidding once it goes public) determines the value of the entire company by extension.
Working with an underwriter (a Wall Street bank), the firm tries to guess an appropriate valuation (since that’s what actually goes into the pockets of its executives and private investors) but their valuation is usually off the mark in one direction or the other, sometimes by quite a bit. For example, the day it opened TWTR quickly doubled from its offering price.
How Does the Stock Market Work?
For the stock market to work there must be buyers and sellers. These buyers and sellers trade existing, previously issued shares which are offered by one investor and bought by another. The fact that they are previously existing shares means that most trading on the stock market has no direct impact on the company being traded. The buyer can place a market order to purchase at the current price, or a limit order to purchase if the stock reaches a certain price (which can be lower or higher, depending on the trading strategy). That order is matched up with a seller who has put shares up for sale.
The picture Wall Street likes to paint of an opening bell followed by frantic trading in a huge room full of buyers and sellers is pretty much a historical fiction. Stock trading today is done electronically and the prevailing sound is silence, other than the fans that cool the huge supercomputers used by the exchanges and institutional traders. This is good news for the savvy trader and investor because it means a more efficient and predictable marketplace with much less left to chance and randomness.
What Are the Different Types of Stocks?
Basically, there are two types of stock issue. There are Common stock shares and Preferred stock shares.
Common Stock Shares
Common stock shares are, well, the most common when referring to buying and selling stocks. The ownership of a share represents a claim on the profits of the company and offers the owner voting rights to aid in the direction of the company’s management. Common stock was created to offer gains through capital growth.
Preferred stock functions much like a corporate bond and generally do not offer any voting rights. However, preferred stock typically offers stable dividends, unlike common stock where the dividend can be variable, withdrawn or not even offered. Another protection that is offered to preferred stock owners is they are paid before common stockholders in the case of the company’s liquidation.
Custom Stock Classes
Preferred and Common stock are the two major styles of stock. However, it is also possible for companies to customize different classes of stock to fit the needs of their investors. One of the reasons for creating share classes is so the company can keep voting power concentrated within a certain group of owners. These different classes are often designated in their trading symbols by adding the letter A or B at the end of the symbol.
Additionally, some stocks are sold and placed under Warrant. A warrant typically is placed on the insiders or initial investors that own more than 10% of the company’s shares. The warrant typically states that the shares cannot be sold for 3 to 5 years. Other kinds of warrants allow the insiders to purchase more stock after a given length of time.
To sum it all up, most stocks are issued as common. Common stock can receive variable dividends and have voting rights. Preferred stock typically costs more to buy, but has a dividend fixed in perpetuity with higher creditor rights than the common share owner. Both face the risk of company failure.
What Determines Stock Price?
Once the initial public offering is completed, the stock price can move independently of the actual company’s success; a current example is the sky-high stock price for Tesla (ticker: TSLA), a company that may be years from profitability.
So, what makes stock prices go up or down? The simple answer is, supply and demand. Price changes reflect supply and demand, so when a stock is deemed desirable due to recent success of the company, a strong industry sector, or just plain faddishness and popularity — then its price goes up. If investors are unwilling to buy a stock due to the company faltering, a weak industry sector or the price being simply too high, that lack of demand will cause price to drop. At some point price will move low enough that investors are again willing to buy and the cycle will start all over again. Value investors, like Warren Buffett, specialize in finding unpopular stocks in forgotten industries that still have strong earnings and a solid future, buying them (or buying the entire company, as Buffett often does) and waiting for the price to rise.
What Are the Benefits of Trading On The Stock Market?
The most obvious benefit of buying or selling stocks is investment gains. It is the potential to grow wealth through value appreciation of assets (stocks) that initially draws most to invest in the stock market in an effort to secure their financial future.
Some stocks also offer the opportunity to earn dividends. Dividends can be a great way to earn short-term investment income, and who doesn’t want another income stream?
Let’s not forget about diversification, which is another important benefit of investing in the stock market that is overlooked by many. A properly diversified investment portfolio allows losses in one sector of the market to be offset by gains in another, meaning the portfolio has the potential to be profitable overall.
Buying shares of stock gives investors ownership in the company. Shareholders receive annual reports so they can learn more about the company, and they can vote on corporate board members and other business decisions. Some shareholder meetings are lots of fun, like Berkshire Hathaway’s in Omaha where Warren Buffet shares special offers on products from the companies he owns. Others can be tension provoking, if an activist shareholder (with far more shares than you) makes a move against the current management.
At Online Trading Academy, we teach strategies for short-term income, long-term wealth or both, depending on a student's individual goals. We also teach techniques to diversify investments and take advantage of opportunities in all asset classes.
Strategies For Stock Market Trading
Having said all that, here’s how trading on the stock market works for savvy traders and investors who have been educated at Online Trading Academy. Our patented supply and demand trading strategy allows us to anticipate market moves with a high degree of accuracy by identifying supply and demand zones. Once price enters one of these zones it typically changes direction, often dramatically. The catalyst of that move may be an earnings surprise, or a natural disaster affecting its market sector. But the price move itself is caused by the herd behavior of novice investors who have been conditioned to sell and buy at the worst possible time.
To invest or trade on the stock market successfully with our strategy, price is always the single most important factor. Let’s say a stock is trading in the mid-twenties and a trader wants it to decline to $20 because they know, based on their analysis, that there are a huge number of unfilled buy orders at that level. They might wait for it to drop below $20, then return to that level and buy. (This is a hypothetical example of one of several entry strategies.) If it continues to rise, then they may be on their way to significant profits. And that’s how the stock market really works.
About the Author
Mike Mc Mahon
Mike Mc Mahon was a co-founder of Online Trading Academy in 1997 and was Director of Education for 13 years, charged with recruiting top flight traders and training and guiding them in the methodology of OTA’s Core Strategy. He officially retired in 2009 but still contributes as Content Editor and contributor for all things digital with an emphasis on educational articles and videos.
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