The Basics Of How The Stock Market Works

Oct 6, 2020 04:50 PM ET
The Basics Of How The Stock Market Works

Overview

The instrument of stocks is traceable as far ago as the late 15th century. Aside from the clear technological leaps that have succeeded, the definition of a stock has remained intact. To understand the stock market is first to grasp the idea of what a stock is.

A stock represents a fractional share of ownership in a company, mutual fund, or even a real estate investment trust (REIT). Nowadays, we most often affiliate stocks with companies as these are the most popular worldwide.

Through acquiring a stock, the shareholder technically has some ownership in the invested company and can expect their stock to increase or decrease in value depending upon the performance of the corporation as well as technical and fundamental factors. For example, if a brand offers 1 000 shares and you buy 100 of them, you technically own 10% of the provided shares. You can keep the stock for as long as desired, continue buying more or sell in line with how you believe the asset will perform over a particular time frame.

The most known way of earning an income from stocks is through the appreciation or depreciation of the asset, as stated above. While not as prevalent due to a few prerequisites, many high-growth and value stocks pay dividends on a predetermined basis. Dividends would be additional earnings to shareholders given by corporations as a distribution of their profits.

Inner workings of the stock market and exchanges

Inner workings of the stock market and exchanges

Like any large marketplace, there needs to be an intermediary to handle trade. To facilitate these transactions, a stockbroker acts as a middleman between the shareholders and stock exchanges. When we refer to the stock market, we are talking broadly about the numerous stock exchanges worldwide where companies have listed their stocks. 

A stock exchange is merely an establishment that enables stock trading transactions. While these exchanges are physical offices, they have occupied fewer people who do actual trading due to the advancement of electronic communication networks (ECNs), making trading many financial markets more digital. This digital revolution allows for faster trade execution and low transaction costs or fees overall.

Nonetheless, exchanges help categorize stocks. Typically, most countries have a stock exchange based in its capital city. The largest and most-followed exchange is the New York Stock Exchange (NYSE) based in the United States, which boasts an incredible market capitalization of around $23 trillion.

With such a high figure, it’s only natural to wonder about the calculation and where the money comes from when trading stocks. Analysts calculate the market capitalization by taking the share price of a company multiplied by the number of shares offered. 

Initial Public Offering (IPO)

The process in which shares are made public is known as an Initial Public Offering (IPO). Any listed company would have once had to go through an IPO. For a corporation to reach this privileged stage, historically, they would need to have revenues above a few hundred millions for some years. Before the shares go public, elite investors can invest in these new shares once underwriters have calculated the share price. If we combine these investments and those of the public once the share is made public, we can see how this creates liquidity. Multiplying these investments by the millions of investors produces all the money available to trade.

The increasing or decreasing fluctuations of the share price can either diminish or expand the liquidity. Every market participant speculates on these prices daily, also known as trading. What drives prices up and down regularly is based on almost countless factors that involve technical, fundamental, and sentimental analysis.

The main reason why companies go public is for capital expansion. Instead of taking bank loans, stocks allow them to achieve capital expansion, but then at the expense of surrendering pieces of their equity to shareholders.

The significance of stock markets 

A well-known joke states, ‘’Stock markets have predicted 10 out of the last three recessions.’’ 

Technically, the performance of stock markets is not like-for-like correlated to the economy. However, the most basic premise is that when stocks are doing well, companies become more valuable. When companies become more valuable, people spend more money with them. When people spend money, that boosts economic activity, and the cycle continues. 

The opposite is true, especially in times of recessions, such as the one experienced in 2020. Recessions have typically preceded so-called crashes. Aside from recessions, anytime there is a decline in a country’s primary indicators, economists tend to look at the stock and indices markets for clues.

Some basic terminology in stock markets

  • Bid/ask prices: highest price someone is willing to buy a stock/lowest price someone s willing to sell a stock.

  • Bull and bear markets: general increase (bull) or decrease (bear) of price for a particular stock.

  • Diversification: keeping different shares to spread or minimize risk.

  • ‘Going long’ or ‘going short’: To buy (long) or sell (short) a stock.

  • Hedge: a position taken on one instrument to offset the potential loss of another.

  • Index: a diversified basket of underlying stocks to form one separate instrument.

  • Leverage: also known as margin, this refers to utilizing bigger positions through a broker by putting down a proportionally smaller deposit.

  • Portfolio: a collection of different stocks.

  • Ticker symbol: a unique one to five-letter abbreviation used to identify a stock.

  • Trend: the overall direction of a stock’s price.

Conclusion

It’s incredible to think that stocks have been around for several centuries now, with a few world-recognized exchanges existing since the 1600s. The stock market is one of the speculated financial markets due to its long-standing heritage. Aside from the potential of increasing your wealth with stocks, understanding this market also helps with better understanding the world of business, economics, finance, investing and the companies involved. 


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