How Does the Stock Market Work?

Investing in the stock market scares you? Well, you are not alone. 

If you have limited knowledge of the stock markets, you can be easily terrified by dreadful stories of people investing and losing 50% of their portfolio value ( maybe you heard about the terrible bear markets in the late ‘90, in 2008, and the Covid-19 pandemic) or you can be misled by your best friend’s “hot tips” which promise you big rewards (but rarely pay off).

Be aware that your investment attitude is deeply influenced by investment sentiment, which always oscillates between fear and greed.

The harsh reality is that investing in the stock market has many risks, but when you approach it in a conscious and disciplined way, it is the most efficient and powerful way to build your wealth.

Average Joe will “invest” all of his meager hard-earned monthly salary in his home, he buys every year a new smartphone and loses thousands of dollars buying a new car. 

Millionaires know that money can make more money and invest most of their wealth in stocks. Which one do you want to become? 

Learning how the stock market works and how to invest your money is the only way to escape the “Rat race” and say goodbye to your meaningless 9 to 5 job in a cubicle.

How Does the Stock Market Work: What is a Stock?

A stock or “share” (also known as a “company’s equity”) is a financial instrument that represents your ownership of a company or corporation.

It also represents a title to proportionately claim on its assets (what the company owns) and earnings (what the company generates in profits). 

“Stock ownership” is a simple concept.

It means that you as a shareholder own a slice of a company, and your slice is equal to the number of shares held as a proportion of the company’s total outstanding shares.

For example, if you own 10 shares of a company with 100 outstanding shares, you have a 10% ownership stake in it. 

Most companies have millions (or billions) of outstanding shares.

To understand how does the Stock Market Work you need to know how many tipes of stock you can find in the market.

There are two main types of stock—common and preferred. 

“Equities” is synonymous with “common shares”, as their combined market value and trading volumes are many magnitudes larger than that of preferred shares.

Preferred Stock vs Common Stock

The main difference between preferred and common stock is simple. A “preferred stock” gives you no voting rights to shareholders while “common stock” does.  

Preferred shares have preference over the common shares in a company when it’s time to receive dividends as well as assets in case of a liquidation. 

Common stock can be further classified in terms of their voting rights.

Some companies have multiple classes of stock with different voting rights.

For example, imagine a dual-class structure: class A and Class B stocks.

The Class A shares may have 1000 votes per share, while the Class B “subordinate voting” shares may only have one vote per share.

 Multiple-class shares were created to allow the founders of a company to control its patrimony. 

Today’s Corporate and Tech Giants need the Stock Market. 

Corporations issue (…sell) stock to raise funds to operate their businesses.

To transform a good idea growing in an entrepreneur’s head into a real company, is necessary a factory, an office, employees, raw materials, equipment, and a solid distribution network. 

 Combining all these elements requires a huge amount of capital.

A company can raise the capitals it needs by selling shares (equity financing) or borrowing money (debt financing).

Debt financing is very difficult for a young startup: the banks require valuable assets to pledge for a loan, and startups rarely have any valuable assets, so Equity Financing is most common for most startups in search of capital. 

In the beginning, usually, the entrepreneur will take the necessary funds from his personal savings. 

If the business grows the entrepreneur will seek angel investors and venture capital firms.

When a company is founded, it can need access to a larger amount of capital than what it can get from a traditional bank loan, so it can sell shares to the public with an initial public offering (IPO). 

 The IPO changes the status of the company, transforming it from a private firm to a “publicly traded company”, and its shares will be held by the public. 

When the company’s shares are finally listed on a stock exchange the share price will fluctuate every day, depending on supply and demand.

Stock exchanges (e.g. NYSE, NASDAQ) are Secondary Markets. 

This is where investors can buy and sell securities they already own. 

Stocks can be also sold on the Primary Market when they are first issued.  

The corporations listed on stock markets don’t regularly buy and sell their own shares, so when you buy a share of stock on the stock market, you are not buying it from the company but from some other shareholder. 

Similarly, when you sell your shares, you don’t sell them back to the company, but you sell them to another investor.

 In the developed countries, stock exchanges are S.R.O.s (self-regulatory organizations), non-governmental organizations with the power to create and enforce regulations and standards to protect investors.

The prices of shares on a stock market are usually set through an auction process where buyers and sellers place bids and offer to buy or sell. 

Bid Price vs Ask Price

The Bid Price is the price at which somebody wishes to buy.

The Ask Price is the price at which somebody wishes to sell.

When the bid and ask meet, a trade is made.

The market is made up of millions of people (traders and investors), with different ideas about the value of the stocks.

When investors and traders convert their intentions to actions by buying or selling a stock, they affect the price of the stock.

It will increase or decrease, minute by minute, during every single trading day. 

A stock exchange is, simply, a place where buyers and sellers meet and make transactions.

If you want to access stock exchanges, you need a Stockbroker, that is a middleman between the buyer and the seller. 

 Today you can easily find a Stockbroker asking to your bank or searching for (a well-established) online brokers. 

How Does the Stock Market Work: The Law of Supply and Demand.

Stock markets give you a beautiful example of the laws of supply and demand at work in real-time. For every transaction, there must be a buyer and a seller. 

If buyers of a specific stock are more than the sellers of it, the stock price will go up. 

Vice-versa, if sellers are more than the buyers, the price will go down.

The bid-ask spread represents the difference between the highest price that a buyer is willing to pay for a stock and the lowest price that a seller is willing to accept. 

A trade transaction is done when the buyer accepts the asking price or a seller takes the bid price.