Stock Market: What is it? How Does it Work?

Asset classes

The stock market is a platform to do extensive trading in financial instruments like shares, bonds, futures, etc. In more simple words, it is a place that brings buyers and sellers together to trade those financial instruments of listed companies. Currently, stock markets have become an indispensable part of a country’s commerce and the overall economy. 

  • Stock markets exist in almost all global financial centers all across the globe.
  • Companies can be either public or private but both have stock shares.
  • Only public companies are listed on stock markets and only listed companies can sell their stocks.
  • Stock markets are financial enterprises where traders and investors buy and sell financial like shares.

Stock markets exist in almost all global financial centers all across the globe. Those financial centers regulate stock markets. They also run indices to enable traders and investors to monitor capital growth on their position’s growth. Shares and equities are investible because of the function of stock markets. 

All serious traders and investors looking to gain reasonable returns need to understand thoroughly how stock markets work and what are the factors that determine market prices. Learning how the stock markets work and their behavior is also crucial because this knowledge opens doors to identify more profitable opportunities. It also makes it relatively easy to identify trends and directions of the underlying market movements. Thus, those who are familiar with stock markets and how it works have always a better shot on identifying profitable trades.

The origin of the stock market

The stock market is not a new phenomenon in the modern world. It dates back to almost five hundred years ago. Back in the 1600s, European explorers used to sell shares in their company’s ventures to raise money. Investors used to buy those shares to profit from that company’s adventures. For example, the pursuit of Europeans to bring spices from Asia and sell them in European markets. The Dutch East Indian Company was among the pioneers who used to sell their shares on Amsterdam’s stock market in exchange for future profits. The practice continued and gradual transformation led to modern-day stock markets. 

Why companies sell stocks?

Companies can be either public or private but both have stock shares. Only public companies are listed on stock markets and only listed companies can sell their stocks. Companies sell their stocks in order to raise capital for expanding and modernizing the existing businesses. The capital raised through selling stocks is interest-free. This is the main advantage of selling shares on stock markets. 

How does the stock market work?

As we know that stock markets allow trading financial instruments of listed companies only. All the listed or public companies heavily rely on the stock markets to raise capital. They also look at the stock prices to evaluate and assess what investors think about their company, its business, and prospects. On the other hand, investors also rely on stock markets to invest their capital in viable financial instruments.

Understanding how does the stock market work is very easy. The principle of the stock market’s working is to align all participants in the whole ecosystem. It connects public companies, investors, brokers, and exchanges. In fact, stock markets allow and encourage investors to participate in the development and growth of different enterprises from different sectors of the economy. 

Stock markets are a kind of auction platform where buyers can place bids and sellers offer their asking prices for the financial instruments, especially stocks. A trade happens once the bid equals the asking price. This is what happens on stock markets in the most simplistic terms. More liquid securities are easy to buy and sell as the bid-ask spread is usually very minimal. A bid-ask spread means the difference between the bid price and the asking price. Conversely, less liquid securities are always difficult to trade because of a higher bid-ask spread. 

Forces of supply and demand are among the most powerful factors that hold stock markets. Shares come with an inherent demand and share prices react perfectly to the competition between supplies and demands. That is the reason that prices continue to phase through highs and lows. In simple words, a share’s price will automatically fall when the supply is high as that share is easily available and easy to acquire. Conversely, when demand is high, share prices also rise as it gets more and more difficult to acquire those stocks. Those forces of supply and demand on stock markets allow investors and sellers to trade shares throughout their price cycles. 

Types of stocks traded on the stock market

Basically, there are two main types of stock shares traded on the stock markets, Common stocks and Preferred stocks.

Common stock shares

Common stock shares are the most common type of stock shares traded on the stock market. Shareholders of common stock have shares in the profit of the company. They also have voting rights when it comes to set the directions of that company’s management. Companies offer their common stock shares to raise capital.

Preferred stock shares

Preferred stock shares are very similar to corporate bonds and holders of these stocks do not have voting rights. Stockholders of preferred stocks enjoy a fixed dividend as compared to common stockholders whose dividend varies from year to year. They also have another protection against their investment as they get paid before common stockholders in case of liquidation. 

What are stock market indexes?

Stock market indexes consist of stock selection designed to reflect the overall performance of stocks. The performance of various stock market indexes tracks and reflects the overall performance of a stock market. Stock market indexes are also available for trading on stock markets in the form of options and futures contracts. Dow Jones Industrial Average (DJIA), the NASDAQ Composite Index, the Financial Times Stock Exchange 100 Index (FTSE 100), the Standard and Poor’s 500 (S&P 500), the Hang Seng Index, and the Nikkei 225 Index are among the world’s key stock market indexes. 

Stock market trading

Stock market trading is all about buying stocks in a company with hopes and expectations that its share price will rise. It works exactly on the axiom, “buy low, sell high.” However, it isn’t the only way to earn through trading and investing in stock markets. Companies also pay dividends to their shareholders. Moreover, shareholders have also the voting rights to determine the company’s corporate policy. 

How do prices rise and fall on stock markets?

As we have discussed earlier that forces of supply and demand are the most substantial and forceful factors. The other factors that can also contribute to the rise and fall of stock prices include news events about the company’s profits and overall economy and investor’s confidence. 

What do Bull and Bear markets mean?

Bull and bear markets are among the major concepts in stock market trading. The bull market means a stock market where stock prices are generally rising. A bull market is extremely fruitful for investors and they usually prosper in such markets. The reason is that the majority of participants in such markets are buyers rather than short-sellers. 

On the other hand, a bear market means a stock market where stock prices are generally declining. Investors also can gain in bear markets through a short-selling trading strategy. The short-selling strategy involves burrowing shares from brokerage companies and selling those borrowed shares in secondary markets. Traders know that prices will fall further and when prices do fall, they buy back sufficient stocks to return to brokerage companies. Thus, they make significant profits from falling prices of stocks in bear markets. 

How to analyze stocks on stock markets? 

Stock market analysts and investors look at various factors to analyze stocks and predict the future direction of stocks. However, the following are the most common factors to analyze stocks.

Capitalization: A stock’s market capitalization, also known as “mark cap” is the total value of a stock’s all outstanding shares. Companies that are well-established and develop have a very high market capitalization. 

Earning per share: All the regulatory authorities require publicly listed companies to provide earning reports. Investors keenly observe those earning reports to analyze the company’s performance. Earning per share is the most common factor in earning reports that investors look at more closely. Earning per share ratio reflects how much dividend a company paid to its shareholders. 

Financial ratios: Financial ratios are other key figures that help to analyze a company’s performance. Those ratios help investors to observe the profitability, financial situation, and growth capacity of a company. Important financial ratios are: 

  • Return on Equity (ROE) ratio: ROE indicates how much a company earned against the overall equity investment. It is a crucial ratio that paints a clear picture of the growth potential of a company. 
  • Debt to Equity ratio: The Debt to Equity ratio indicates how much a company owes to creditors as compared to its own capital. It is a key ratio to analyze a company’s stability. 
  • Price to Earnings (P/E) ratio: The P/E ratio is a measure that compares stock price to earnings per share. A Higher P/E ratio reflects more confidence of investors as they believe has the growth potential and its stock prices will rise.

What is a stock market crash and correction?

Stock markets are highly rewarding and on the same note, they are highly risky too. They are prone to sudden and extreme downfalls known as a stock market correction and a stock market crash. A stock market correction means the decline of stock prices below 10%. A stock market crash means the decline of stock prices below 10% in just one day. The great recessions always follow a crash in stock markets. History has witnessed that stock markets occurred regularly. 

A bear market is totally different from a stock market correction and crashes. A bear market means the decline of stock prices below 20% or more. Bear markets last for an average of 22 months, although some bear markets only managed to last for just three months.

What are the main approaches to invest in stock markets?

Although there are myriads of approaches that investors employ to invest in stock markets. However, all of those investment approaches are offshoots of the two major stock market investment approaches, value investing and growth investing. 

Value investing approach

The value investing approach is a risk-averse investment strategy. Value investors look to invest in well-established enterprises with steady profitability. They offer regular dividends and the level of risk is also significantly low. Value investors tend to buy stocks when they think the stock is available at an undervalued bargain price.

Growth investing approach

The growth investing approach is a risky investment approach as compared to value investing. Growth investors tend to invest in companies with high growth potential. They are less concerned with steady dividend income and take risks to invest in new companies. 

Portfolio diversification

The bear trend in stock markets is a bitter reality and investors can’t avoid it. They can only diversify their portfolios to avoid excessive risks. Diversified portfolios protect you from inevitable market downfalls. You cannot throw all your money into a single company no matter how much growth potential it has. That company’s growth can halt because of several reasons. That is why you need to diversify your portfolio by pooling several types of stocks together. However, portfolio diversification isn’t easy. It takes time, energy, patience, and research. But the good thing is, once you are done with your portfolio, you will be able to eliminate risks associated with investing in one or two companies 

How can you invest in the stock market? 

There are the following multiple ways that you can adopt to invest in the stock market. 

  • The most straightforward, easiest, quickest, and cheap way is to buy stocks online. There are many online brokers like TD Ameritrade, E-Trade, etc. who charge nothing for stock trading. You can also employ mobile applications like Acorns or Robinhood for stock trading. However, it is stock trading that you do yourself. These platforms offer no guidance services on how to invest in stocks.
  • Another relatively cheap option for stock trading is investment clubs. You can join any one of them and get guidance at a very reasonable price.
  • Hiring a stockbroker is the most popular way of stock trading. Brokers are highly competent and experienced players who professionally guide you according to your own goals, risk profile, and available capital. 
  • Hiring a money manager is the easiest way but it is the most expensive. However, he/she will do all your work. 
  • Financial advisers also offer their services and charge annual fees. They provide you professional recommendations and guidelines on stock investments. 
  • Some large investment banks also provide financial planning services to do stock trading. 

Why stock markets are good to invest in? 

Stock market investment proves really fruitful for investors. The maxim “high risks, high rewards” perfectly matches the trading situation at stock markets. That is the reason that stock markets are good to invest in. 

Especially when the economy is growing, it is more fruitful to invest in stock markets because strong economies enable companies to grow. A strong economy brings bull markets when broad market indexes continue to grow above 20% for at least two consecutive months. Moreover, stock market investments have the potential to give returns that can beat inflation. Stock market investment returns also outpace returns from other investments like bonds. 

Final thoughts

Stock markets are financial enterprises where traders and investors buy and sell financial like shares. Stock markets made a public listing of the companies. Otherwise, there would have no publicly listed companies. Hence, stock markets have made it possible for laymen to be a part owners in companies. 

People trade or invest in stock markets. Traders frequently buy and sell shares to take advantage of small price fluctuations. On the other hand, long-term investors buy and hold stock shares. They let share prices to appreciate. Both ways, stock markets are the best source to make money although the associated risks are also high. 

Finally, stock markets are advantageous for both, companies and common investors. They also significantly contribute to a country’s economy. When the economy is strong and growing, everyone can make significant livings. That is why people should invest in stock markets. However, stock market investment needs proper education, knowledge, experience, commitment, and persistence. Otherwise, you won’t be able to make the most of the stock markets. 

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