How Do Stocks Work? [Ultimate Guide]
How Do Stocks Work? [Ultimate Guide]

By RyanLuke | arrestyourdebt | 5 Apr 2020


According to a Gallup poll, more than 50 percent of Americans own stock. If you’d like to join their ranks, you’re going to need to study up about stock market basics.

The sooner you start, the better off you’re apt to be. The stock market has been a bull market – one that experiences rising prices – since March 2009, which makes it the longest bull market in U.S. history. It will inevitably and eventually turn into a bear market – one in which stock prices fall over a period of time by at least 20 percent – at some point.

Table of Contents

My Disclaimer About Stocks

This post will give you a detailed view of the stock market and how to invest in individual stocks, bonds, and other investments. However, I will go back to my mantra that slow and steady wins the race.

Your retirement funds should be in low fee index funds and you should be riding the market through the ups and downs. Trying to time the market will end in a disaster if you are playing with your retirement.

However, if you’re properly funding your retirement with 18% – 20% of your income and you have extra money to spare, investing in the stock market for fun or as an investment is something you can definitely experiment with. This guide will give you the basics you need to know before you start investing outside of your retirement account.

The Basics of Stocks

The first thing to understand is what a stock market actually is. Also known as a share market or equity market, a stock market is actually a collection of markets, or stock exchanges, where participants engage in the buying, selling and issuance of shares of publicly traded companies.

These exchanges operate under specific regulations, and they are actually subsets of the stock market itself.

If you trade in the stock market, you actually buy or sell shares or equities on one or more of several stock exchanges that operate within the market. The top stock exchanges in the U.S. are the New York Stock Exchange, or NYSE; the Nasdaq; the Better Alternative Trading System, or BATS; and the Chicago Board Options Exchange, or CBOE.

About The Stock Market

The stock market is a dedicated market where buyers and sellers meet, interact and engage in various transactions with one another. Because it involves a massive number of participants, the market assures fair prices as well as pricing transparency – key components of effective trading.

One of the most crucial aspects of the free market economy, the stock market earns this significance through a number of means. Some of the things that make it such a key component of the economy include:

Stocks Allow Companies To Raise Money

By going public and entering the stock market, a company can raise the money that it needs to keep growing and remain profitable. The stock market facilitates this primarily by allowing companies to sell stocks, or shares, to investors.

Companies can also issue corporate bonds, which are investments in debt that are sold to investors. Through these bonds, companies get the cash that they need when they need it and pay a pre-determined number of interest payments to investors. When such a bond reaches maturity, the interest payments cease, and investments are returned to investors.

Investors Make Money When A Company Makes Money

Stocks let common investors participate in the financial achievements of companies. The stock market provides a level playing field that allows common investors to enjoy the fruits of public companies’ labor.

This may occur through capital gains, which represent an increase in the value of a capital asset that propels its worth over the purchase price; such gains are not realized until the stock, or asset, is sold. Shareholders may also be rewarded through dividend payments, which are explained later in this article.

Investing In Stocks Helps Our Economy

Stocks help with capital formation and economic growth for the country. By acting as a platform through which individuals’ investments and savings are channeled into productive investment proposals, the stock market helps to generate more capital for the nation while helping the economy to continue to grow.

For individuals, the stock market provides a controlled, managed and secure environment in which hundreds of thousands of participants can safely buy and sell stocks. In the past, these stocks were issued on actual paper; today, the stock market operates almost exclusively on an electronic basis.

The Primary Market

primary stock market

Many people don’t realize it, but the stock market actually consists of two types of markets: the primary market and the secondary market. The primary market is the one that lets companies issue and sell shares to the common public for the first time via initial public offerings, or IPOs.

IPOs allow companies to raise the capital (money) they need to grow and become profitable through the sale of shares to investors. Essentially, the company is divided into a number of shares, and it sells part of them to the public at a specific price.

For example, a company might be divided into 50 million shares, offering 10 million shares to the public. If it sells all of those shares at $10 each, it can raise $100 million in funding. Investors can then hold onto shares that are anticipated to grow in value, and they may also receive dividend payments.

Companies may also issue new, additional shares at later stages. Rights issues, or rights offerings, may be offered to current shareholders. These shares are known as subscription warrants, and they are offered in proportion to the company’s existing holdings, thereby diluting the overall value. Shareholders aren’t obligated to buy these warrants, which are usually discounted; if they do, they can trade them as they see fit.

Public companies may also offer follow-on offers, or FPOs, which occurs when more shares are issued following an IPO. The shares that come in already exist, so their overall value isn’t diluted. This means that the earnings per share, or EPS, remains the same.

Additionally, public companies are allowed to perform buybacks, which reduces the total number of shares that are available on the market. They may also delist shares voluntarily or involuntarily, which usually happens with a company goes out of business, files for bankruptcy, becomes private, doesn’t meet listing requirements or becomes engaged in a merger.

Dividends versus Retained Earnings

Companies may reward shareholders through the issuance of dividend payments, which come from a portion of its earnings. The majority of those earnings are kept as retained earnings by the company. The rest may be issued as cash payments to certain classes of shareholders, which is the most common way.

They may also be issued as shares of stock or other property. Even if a company isn’t experiencing a profit, it may issue dividends to certain shareholders to maintain a good track record. These may be issued on a monthly, quarterly or annual basis; they may also be issued non-recurring dividends, or special dividends.

The Secondary Market

secondary market

The secondary market encompasses the regular trading of stocks and other securities, including exchange-traded funds, or ETFs; commodities; corporate bonds; derivatives based on stocks; currencies; and more.

When most people talk about trading on the stock market, they are referring to trading on this secondary market.

Top Roles Of Stock Exchanges

A stock exchange takes on many roles. Most importantly, it:

  • Maintains trading systems that effectively manage buy and sell orders from a variety of participants, performing a crucial price-matching function that ensures fair buying and selling prices
  • Creates and maintains a number of market-level and sector-specific indicators that provide a benchmark by which participants can track the movement of the overall market – the S&P 500 and the Nasdaq 100 are well-known examples
  • Maintains all corporate announcements, news, and financial reporting through official websites
  • Supports other transaction-related, corporate-level activities such as allowing profitable companies to reward investors through dividend payments.

Primary Participants In The Stock Market

To learn share market basics, it helps to understand the types of participants that are involved in it on a regular basis. Perhaps the most common participants are long-term investors who tend to be more conservative with their activities.

Short-term investors, better known as day traders, actively trade on the market throughout any given day. Such investors will be active during stock market business hours; for the NYSE and the Nasdaq, those occur weekdays from 9:30 a.m. until 4 p.m.

Of course, investors and day traders aren’t the only ones who are involved with the stock market. Other participants include:

Stockbrokers

Also known as regulatory representatives, stockbrokers are licensed professionals who buy and sell securities on behalf of investors. In other words, they act as intermediaries between investors and stock exchanges like the NYSE.

If you are a common investor, you will need a cash account with a stockbroker – who most typically works for a brokerage firm – to access the exchanges.

Portfolio Managers

As the name implies, portfolio managers are professionals who focus on developing effective investment portfolios – collections of securities – for their clients. They most commonly work for hedge funds, mutual funds, and pension plans, where they make buying and selling decisions for the portfolios that are under their management.

They make these decisions by staying abreast of the latest share market trends, establishing investment strategies that are based on things like recommendations from analysts and short- and long-term financial charts.

Investment Bankers

Investment bankers typically act as representatives for companies in a variety of capacities. For example, when a company wants to go public and engage in an IPO, it will work with an investor banker who will handle every aspect of the process on their behalf. These professionals may also be hired to assist with pending mergers and acquisitions and related activities, handling the process in a way that ensures compliance with regulatory standards.

Custodians

Along with depot service providers, custodians are institutions that hold clients’ securities for safekeeping so they can trade effectively on the stock exchanges.

Custodians work in sync with stock exchanges to efficiently transfer shares to and from respective accounts. These entities help to keep the markets moving effectively, so they play a crucial role in the operation of the economy on a daily basis.

Market Makers

Finally, market makers are broker-dealers who maintain their own inventory of shares. These professionals post up-to-the-second bid and ask prices, and they then profit from the difference between the prices that they quote. For example, a brokerage house is a type of market maker because it offers buying and selling solutions for investors, helping to maintain the liquidity of financial markets.

Primary Functions of the Stock Market

Whether you want to learn to be an active, long-term investor on the stock market or are interested in becoming a short-term day trader, it helps to also understand the primary functions that are handled by the stock market. With a firm grasp of these concepts, you will be better prepared to make effective trading decisions.

The seven most important functions of the stock market are:

  1. Fair dealing in securities transactions – One of the top functions of the share market is to ensure fair dealing in securities transactions. In this vein, it ensures that all market participants have instant, real-time access to data for buy and sell orders, which allows for transparent and fair pricing. It also efficiently matches these buy and sell orders, facilitating the seamless operation of these transactions.
  2. Efficient pricing discovery – The stock market is responsible for ensuring efficient pricing discovery, which involves deciding the appropriate prices for securities. This is typically accomplished by assessing the supply and demand of the market, but many other factors come into play as well. The market utilizes efficient mechanisms that ensure accurate pricing for all participants.
  3. Liquidity maintenance – To keep the exchanges functioning properly, the stock market must also ensure that anyone who is qualified and willing to trade securities receives instant access to real-time information. These participants must also be able to place orders that are executed at fair prices – and they should be assured of that.
  4. Validity and security of transactions – For the market to operate properly and effectively for everyone, it must work to ensure that all participants are verified. These participants must also remain compliant, so the market relies on regulatory agencies like the Securities and Exchange Commission, or SEC, to ensure this. There is no wiggle room for default by any involved parties, so this is a particularly important function of the stock market.
  5. Support of all eligible types of participants – The stock market must also ensure that all eligible participants are able to operate seamlessly within the exchanges. These participants include market makers; investors; day traders; speculators; and hedgers.
  6. Protection of investors – Because there is a vast number of small, common investors who typically have limited financial and investing knowledge and are largely ignorant of the common pitfalls of operating on the market, the share market must also implement measures to protect and shield them from losses. One example of such a measure is categorizing stocks into segments that are based on risk profiles; the market may impose limits or allow no trading by common investors on particularly risky categories. Restrictions may also be imposed on individuals who have limited income or knowledge; for example, only certain investors may trade certain high-risk derivatives.
  7. Balanced regulation – The market must also ensure the balanced and fair regulation of publicly listed companies. In the U.S., for example, such companies’ dealings are monitored by the SEC. The market also mandates certain requirements for such companies, including the timely filing of financial reports and the real-time reporting of relevant developments to shareholders.

How Stock Exchanges Make Money

make money on the stock market

It’s obvious that participants in stock exchanges like the NYSE are in it to make money. What many don’t realize, however, is that the exchange itself generates money. In fact, it has to do so to continue functioning.

As you will discover when trading on the market, various fees are imposed and passed along to the exchanges to keep these for-profit institutions up and running.

The primary ways in which stock exchanges make money include:

Transaction Fees

Every time a trade is performed on an exchange, a fee is imposed. This means that whenever you make a buy or sell order, you are paying a transaction fee for the pleasure. Depending on how you trade on the market – in other words, whether you work through a robo-advisor, through a mutual fund or with help from a stockbroker – the fees you pay may vary.

Listing Fees

A stock exchange also earns money through the charging of listing fees. Whenever a company engages in an IPO, for example, it must pay a variety of listing fees to do so. Similarly, listing fees are imposed for activities like follow-on offerings. These fees, therefore, don’t pertain to common investors, but they are a major source of income for exchanges.

Market Data Sales

Stock exchanges generate vast amounts of market data on their platforms on a continual basis. They then turn around and sell this data to various clients, including brokerages, so that they can engage in effective equity research and the like. The types of data that may be sold by an exchange include real-time data; reference data; historical data; and summary data.

Tech Product Sales

Many stock exchanges are also in the business of selling tech products to various participants. Interested parties may purchase things like trading terminals and dedicated network connections directly from exchanges – and the exchanges price these products to ensure that profits are made every time.

Private Services

Stock exchanges may also offer certain private services, charging clients for the privilege. For example, an exchange may provide special access to high-frequency trading systems to larger clients like mutual funds and asset management companies, or AMCs. Participants may pay various regulatory and registration fees to gain access to such services.

How to Learn Stock Market Basics

 

Now that you know the basics of the share market and stock exchanges, you’re better prepared to learn the basics of trading on them.

First, it helps to understand what it actually means to own stock.

Contrary to popular belief, owning stock in a company doesn’t give you any real, direct influence over how it conducts business.

The vast majority of people who own stock own only a microscopically small percentage of shares in any given company.

Rather than having direct influence by owning shares in a company, doing so is a way of putting your faith in the company’s management. If you lose faith for any reason, you can always just sell your shares and move on. An important thing to keep in mind is that most public companies provide stock options to senior executives.

Also known as insiders, these execs often have as many shares as most common investors; in many cases, they have far more than average. Companies do this to give these executives incentives for maintaining and increasing the price of the company’s stock.

Depending on the company and how much stock you own in it, you may be entitled to voting rights. This does not mean that you are allowed to vote on important decisions for a company. Rather, it means that you are able to vote for its directors. These directors are responsible for hiring upper management, so you may enjoy a small amount of influence under such circumstances.

Stock Order Types

Before you can effectively trade on the market, you must familiarize yourself with the most basic order types that are involved in doing so. Here’s a simple breakdown of the basic types:

  • Market Orders – A market order is one in which stock is bought or sold immediately and at prevailing market prices. It remains open until the order is completely filled, which can take time in some cases. Fees tend to be lowest for these types of orders, which are the bread and butter of long-term investors.
  • Limit Orders – Also known as pending orders, limit orders are most commonly used by day traders. This type of order specifies a certain price at which the order must be filled. If the price of the necessary stocks is too high or too low, there is no guarantee that the order will trade at all. A common type of limit order is a stop order, in which a particular stock must move above or below a certain level to trade.
  • Other Order Types – Depending on the brokerage you use, you may also be able to place a variety of other order types. One very popular and useful one is the stop-loss order, which remains dormant until the relevant stock passes a certain price threshold. It then becomes an active market order. Other popular order types include all-or-nothing, or AON, orders; immediate-or-cancel, or IOC, orders; and stop-limit orders.

Getting Started with Trading on the Stock Market

If you are a beginner at trading on the share market, it’s natural to be apprehensive. However, getting started with buying and selling stock is actually quite easy. That’s especially true thanks to online trading, which has leveled the playing field and democratized the process even more.

The simplest way to begin is by setting up an account with an investment firm or brokerage firm. Stockbrokers employed by such firms accept market orders and facilitate payments between you and other trading participants. Once you have submitted an order with your broker, he will fill it from his inventory or route it through the trading network to find a matching seller. The trade is then executed.

How to Make Money on the Stock Market

Like any trader, you would probably like to start making money on the stock market as quickly as possible. Put simply, the key to doing so is buying at the right time and selling at the right time. A good rule of thumb is to only sell stock that you own under the following circumstances:

  • Buying it was a mistake
  • The price has risen dramatically
  • The stock has attained an unsustainable or ridiculous price

Remember too that the stock market is not like a slot machine. Therefore, it’s crucial to keep greed and emotion out of the trading process – something that’s often easier said than done, especially for beginning traders.

Stock Trading Platform Options

Determine what your goals are for trading on the stock market, and then choose from the following options to get started:

  • Online Brokers – Most common investors used discounted online brokers rather than full-service ones. These brokers provide you with tools that allow you to make informed trading decisions.
  • Robo-Advisors – Robo-advisors use computer algorithms to automatically make investment decisions for clients. They are among the most affordable ways to go, and they’re ideal for people who are interested in long-term wealth building.
  • Traditional Brokerage Firm – Most common investors don’t need to bother with this option anymore.
  • Through Your Employer – If your budget is extremely tight, investing just 1 percent of your salary into your employer’s retirement plan can be a good way to get started with investing.

Advice for Beginning Stock Market Traders

Regardless of which of the above options that you use, you can hit the ground running as a trader by keeping a few things in mind. Develop a diversified portfolio of stocks and stock index funds, and hold onto it through thick and thin.

Diversification allows you to not put all of your eggs into one basket, so to speak; when certain stocks underperform, others may excel, which balances things out. Ideally, 10 percent or less of your portfolio should be made up of individual stocks; the rest should consist of index funds.

The S&P 500, a popular index stock index, delivers historical average returns of 7 percent annually. If you invested $1,000 into it 30 years ago, you would have $7,600 today – all without having lifted a finger, so to speak.

The Bottom Line

This guide has merely scratched the surface of the complex world of the stock market and stock market trading. However, you should now have a general idea about how to proceed with learning how it works and how to start trading. With time and patience, you can become an effective trader who earns nice profits from your investment activities!

 

This post originally appeared on Arrest Your Debt.


RyanLuke
RyanLuke

I am a personal finance blogger at https://arrestyourdebt.com


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