How the Stock Market Works

Updated: September 20, 2018

The stock market works as investors buy shares (making them part owners) in publicly traded companies and then sell those shares back (relinquishing their part ownership). 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.

Learn how the stock market works

What Are Stocks?

When a company wants to raise money for expansion, it “goes public” by making an initial public offering (IPO) of common stock. In its most basic form, this process is how the stock market works for trading in most companies.

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 is usually off the mark, sometimes by quite a bit. (The day it opened TWTR quickly doubled from its offering price.)

What Determines Stock Price?

Part of know how the stock market works is knowing what determines price

Once the offering is completed, the stock price can move independent 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. Price changes reflect supply and demand, so when a stock is deemed desirable for whatever reason — recent success, a strong industry sector, or just plain faddishness and popularity — then its price goes up. At the other end of the spectrum, “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.

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 stock trading 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.

But it’s fact, not fiction, that as a shareholder you are a part owner in the company. You will receive proxy materials before stockholder meetings and you have the right to vote on officers and policy. Some 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.

Having said all that, here’s how the stock market works for savvy traders and investors who have been educated at Online Trading Academy: pretty much like any other asset class. Our patent-pending 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. These are the people we trade against at Online Trading Academy.

Strategies For Buying Stocks

Once you know how stock markets work you can learn the best trading entry and exit strategies

To trade or invest successfully with our strategy, price is always the single most important factor. Let’s say a stock is trading in the mid-twenties and you want it to decline to $20 because you know, based on your analysis, that there are a huge number of unfilled buy orders at that level. You 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 you may be on your way to significant profits. And that’s how the stock market really works.

Over 100,000 Lessons from the Pros readers. Check out last week's issue.

Free Class