Published on December 23rd, 2020 at 10:25 am
First-time investors often find themselves asking “how does the stock market work?”
Never fear, in this article our experts explain the when, what, how and why of one of the world’s most intimidating, yet profitable, institutions.
Introduction
For those people with little or no experience in the big, bad world of finance, the idea of stepping in to the stock market can be absolutely terrifying.
For some, even the answer to a question as simple as “how does the stock market work?” can feel complex and scary. We know; we’ve been there. Everyone at some stage in their financial journey started out as a beginner, and we’re here to help you make the first step towards diversifying, building or even beginning your portfolio.
While we’ve all heard the horror-stories of people losing 50% of their capital in the matter of hours, or those poor investors who poured in their life savings just before the Global Financial Crisis in 2009, overwhelmingly the evidence shows that branching out in to the purchase of stocks is a safe long-term decision.
Before you get started, though, it’s essential you understand what the stock actually is and how it operates.
The Basics
At its most macro of levels, the stock market is a way of bringing together the buyers and sellers of financial instruments from all over the world and enabling them to exchange what are known as “securities”.
Figure 1: the stock market connects traders all over the world
A “security” is the name for any product which can be invested in, for example shares (stocks), investment trusts, bonds and exchange traded funds (ETFs).
These securities are then listed on a stock exchange – such as the Australian Securities Exchange (“ASX”) or the New York Stock Exchange (“NYSE”) in the United States – and can be bought, sold and traded across the world.
While some stock exchanges – including the NYSE – still have a physical trading floor, for the most part the buying and selling of securities occurs electronically. This takes away much of the stress of trading on the stock market; instead of physically having to find someone willing to buy your securities, the internet does it for you.
Figure 2: a trader on the floor of the NYSE
Any individual (“retail investor”) or entity can be a trader on the stock market, whether that’s you reading at home or an enormous institutional investor like a hedge fund, insurance company or bank.
What Are Stocks?
People can often become confused as to what the difference is between a “stock” and a “security”, but the answer is actually very simple; a stock is a type of security.
The term “security” is used to describe any tradable financial asset and can be split in to three separate categories:
Equity Securities (Stocks);
Debt Securities (Bonds); and
Derivative Securities
Stocks, along with things like bonds, notes, mineral royalties, options, futures contracts etc., are just one type of security.
To own a stock means to take partial ownership of the company whose stock you purchased. Anyone who owns stock in a company can generally buy or sell their holdings in order to make profit, receive money directly from the company in the form of dividends, vote in shareholder meetings and otherwise act like they own a piece of that company.
A “share”, meanwhile, is generally the unit in which stocks are sold, representing the fact that an investor owns a share of the company whose stocks they are buying.
When a company’s worth goes up, your stock in that company is worth more; when it goes down, your stock is worth less. In essence, owning a company’s stock means that you own a slice of that company which is held as a proportion of that company’s total outstanding shares.
Figure 3: the worth of a company’s stocks will move up and down over time
Buying and Selling Securities
Just like any market you’ve ever seen anywhere in the world – even the local farmers market just down the road – the stock market consists of buyers and sellers who are all looking to do exactly as their name suggests; buy and sell.
Unlike your local market, however, the stock market is also made up of third parties, called brokers, whose role in the financial ecosystem is to match trading orders and find the best possible prices for all parties.
The way this works in practice is fairly simple; let’s say you want to buy shares in a company at a certain price, which is known as the bid price.
Your offer will be provided to a broker (usually just an electronic system) which will attempt to find a counterparty for your proposed transaction who is willing to sell their shares at the price you offered. The price that the seller is willing to sell at is known as the offer price.
Once the broker finds a willing counterparty, you’re set to go! The shares are yours, and you officially own stock in a company.
It is worth noting too that there are more than one stock exchanges operating in Australia alone – and countless across the world – so it’s expected that your chosen broker will peruse those exchanges in order to find the best available bid/offer price for your needs.
There are multiple stock exchanges operating in Australia and brokers will scan those exchanges in order to find you the best available price.
Why Are Stock Markets so Important?
There are a plethora of reasons why stock markets are so essential to the financial system, but perhaps the most fundamental is that they enable businesses, governments and, really, any organisation to raise capital, which in turn stimulates the growth of the entire economy.
If individuals or larger trading firms invest money in a company (or a government) in exchange for securities, that company now has the financial support it needs in order to grow, expand and become more financially successful.
When a company decides that it wants to increase its capital and allow its shares to be traded on the stock exchange, it begins by selling shares to investors in what is known as an initial public offering (IPO). Once those initial shares are sold, the company then begins trading publicly on the stock exchange and its shares can be bought and sold like any other security.
Stock markets are also important because they allow investors to liquidise their assets quickly. Because there are so many participants in the stock market across the world, anyone who wishes to can generally buy and sell financial instruments whenever they want to.
How the Prices of Securities Are Set
This is potentially a complicated question, but the simplest answer is that the market dictates prices.
Generally, the stock market operates through an auction-style process, where millions of buyers and sellers make bids and accept offers simultaneously across the world.
The price of a given security is thus determined by the cheapest, or highest offer that your broker can find across the world’s stock exchanges. of course, though, the laws of supply and demand apply; if more people are looking to buy a stock its price will rise, while if everyone is selling a security then its price will plummet.
Figure 4: when everyone sells a stock, its price falls
Make sure you keep checking back to TradeTheDay.com so you never miss out on any of our education pieces, trading advice and news items.
