Stock Market: An Overview of How It Works

The stock market acts as a platform that allows investors to buy and sell shares in companies that are publicly traded.
While physical exchanges like the New York Stock Exchange (NYSE) and the NASDAQ exist, most transactions occur electronically,
connecting traders from different locations. This exchange system is essential for businesses to raise capital from investors.
Stock prices also serve as valuable indicators, providing insights into the economy’s health.

Key Takeaways

• The stock market is essentially a trading network for buying and selling company shares and their derivatives.
• It’s a fundamental part of modern economies, allowing companies to raise significant funds to help startups grow, expand existing businesses, consolidate operations, and reduce debt.
• Companies listed on stock exchanges are publicly traded, meaning anyone can purchase their shares. These companies must comply with strict regulations that ensure transparency.
• Stocks are bought and sold by institutional investors, wealthy individuals, and everyday investors looking for profit from dividends, potential appreciation, or influence in company decisions.
• The Securities and Exchange Commission (SEC) and state-level regulators regulate the U.S. stock market.
• Stock prices fluctuate based on supply and demand, influenced by factors such as company performance, economic conditions, and the price of the stock. Different investors make decisions based on different factors, creating a constantly shifting market.

People invest in stocks for various reasons. Some aim to generate income through dividends, others speculate on future stock price increases to sell for a profit, and some want a voice in company governance by voting at shareholder meetings.

The terms “stock market” and “stock exchange” are often used interchangeably, but they aren’t the same. A stock exchange is a component of the broader stock market where trades are executed. Key U.S. stock exchanges include the NYSE and the Nasdaq.

How Does the Stock Market Work?

Understanding the Stock Market

The stock market is a complex network that facilitates the buying and selling of company shares. It operates within a regulatory framework designed to protect against fraud and ensure fairness.
By moving money between investors and companies, the stock market is pivotal to the functioning of modern economies.

To grasp how the stock market works, it helps to break it down into its core elements—public companies, stock exchanges, shares, and market indices.

What Are Public Companies?

Only some businesses can offer stock to the public. Only companies that have gone public through an initial public offering (IPO) are eligible for trading on exchanges like the NYSE or Nasdaq.
Public companies must meet strict reporting and disclosure requirements from the IPO process onward.

A company that sells securities directly to investors does so in the primary market. This includes IPOs, follow-on public offerings, private placements, and debt offerings.
Once the shares have been sold, they are traded in the secondary market, primarily through stock exchanges or over-the-counter (OTC) markets.
Today, more than 58,000 companies worldwide are publicly traded.

What Are Stocks: Buying and Selling Shares

When you purchase a stock, you acquire a piece of ownership in that company. The proportion of ownership depends on how many shares you hold relative to the total shares issued by the company.
A single share could represent a significant portion of ownership in small, private companies. For large, publicly traded companies like Apple Inc., one share is a tiny fraction of the company.

Shareholders are entitled to a portion of the company’s profits, which may be distributed as dividends. Depending on the type of stock they hold, they also have the right to vote on important company matters.

What Is a Stock Exchange?

Once a company has gone public, its shares can be traded freely among investors in the secondary market, which operates primarily through stock exchanges.
These exchanges date back to 1602 in Amsterdam and have evolved into highly sophisticated institutions.

Stock exchanges provide an organized platform for buying and selling securities. They play a critical role in helping companies raise capital by offering their shares to the public.
Examples of major exchanges include the NYSE, Nasdaq, and international counterparts like the London Stock Exchange and Tokyo Stock Exchange.

Stock exchanges must comply with local and national laws to ensure fair trading and transparency, which in turn builds investor confidence.
Most importantly, exchanges offer liquidity, enabling investors to quickly buy and sell securities during trading hours.

Some stock exchanges also offer cross-listing, allowing companies listed on one exchange to be traded on others, expanding their access to capital and giving investors more options.

Though it’s a stock market, other securities, such as exchange-traded funds (ETFs), are also traded on these exchanges.

Over-the-Counter Market

Besides stock exchanges, stocks and other securities can also be traded “over the counter” (OTC). These transactions occur directly between investors without the formal oversight of an exchange, using a network of brokers and dealers.
The OTC market is often used by smaller, less liquid companies that don’t meet the stringent listing requirements of exchanges.

While OTC trading offers access to a broader range of securities, it also poses higher risks due to lower regulatory oversight and limited public information about the companies involved.

Other Assets Traded in the Stock Market

Apart from stocks, a variety of assets are traded on stock exchanges and in OTC markets. These include:

• American Depositary Receipts (ADRs): Represent shares in foreign companies traded on U.S. exchanges, allowing American investors to invest in international businesses without dealing with foreign exchanges or currencies.
• Derivatives: Financial instruments whose value derives from underlying assets like stocks, bonds, or commodities. Derivatives include options and futures contracts, allowing investors to speculate on or hedge against future price changes in these assets.
• Funds: These include mutual funds, which pool money from many investors to buy a diverse portfolio of securities, and ETFs, which trade on exchanges like stocks and aim to track specific sectors or market indices.
• Preferred Stocks: These stocks offer fixed dividends and take priority over common stocks in the distribution of profits or assets if the company goes bankrupt.
• Real Estate Investment Trusts (REITs): Companies that own or finance real estate and must distribute 90% of their profits as dividends. REITs allow investors to gain exposure to real estate without directly owning property.

Investors and Traders: Who Participates in the Stock Market?

Institutional Investors

These include pension funds, insurance companies, mutual funds, and hedge funds that manage large sums of money and trade in large volumes, significantly influencing the market.

Retail Investors

These individual investors trade for personal accounts and can range from beginners to experienced traders. Most retail investors today use online trading platforms.

Accredited Investors

High-net-worth individuals with enough capital and expertise to invest in more complex and risky opportunities, such as private equity or venture capital.

Investors vs. Traders

Investors generally take a long-term approach, buying stocks, ETFs, or mutual funds in hopes that their value will grow over time. They focus on fundamental analysis of companies, looking at financial performance, market position, and growth potential.

On the other hand, traders adopt a short-term approach, often buying and selling securities within short periods to capitalize on market fluctuations.
Traders typically use technical analysis, studying charts and trends to predict future price movements.

While trading can offer quick profits, it also involves higher risks. It requires a deep understanding of the market and an active, hands-on strategy.

Role of Brokers

Brokers are essential intermediaries in the stock market, bridging the gap between investors and the securities markets. This role is similar to their functions in other sectors, such as insurance. These licensed entities are responsible for buying and selling stocks and other securities on behalf of individual and institutional clients. Brokerage firms vary from small, specialized boutiques to large, multinational corporations, providing a range of services including investment advice, research, wealth management, and executing trades.

Full-service brokers offer extensive financial guidance, portfolio management, and personalized services, making them suitable for investors seeking a comprehensive approach to managing their investments. In contrast, discount brokers offer a more self-directed experience, catering to investors who prefer to make their own trading decisions at a lower cost.

Online brokerage firms have gained popularity due to their user-friendly platforms that facilitate electronic trading at reduced costs and greater convenience. These platforms often feature educational resources, analytical tools, and real-time market data. Additionally, robo-advisors have emerged as low-cost, automated financial planning services, enhancing accessibility and convenience in online trading.

All types of brokers are regulated by the SEC and the Financial Industry Regulatory Authority (FINRA) in the United States.

Regulators

Regulation is a vital aspect of the stock market, governing the trading processes and practices. In the United States, the Securities and Exchange Commission (SEC) plays a key role. Established in 1934 in response to the 1929 stock market crash and the Great Depression, the SEC’s mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

The SEC enforces laws against market manipulation, insider trading, and other fraudulent activities. It ensures that public companies disclose significant financial information to help investors make informed decisions. Additionally, the SEC supervises stock exchanges, broker-dealers, investment advisors, mutual funds, and public utility holding companies to maintain fair and orderly markets.

Besides the SEC, stock exchanges have their own regulations, including timely financial reporting and immediate disclosure of significant corporate developments, ensuring all market participants have equal access to information.

FINRA focuses on overseeing brokerage firms and their registered representatives, with a particular emphasis on protecting retail investors. Similar regulatory bodies exist globally, reflecting the interconnected nature of the global stock market. While regulations vary by country, they aim to ensure fair practices, protect investors, and build confidence in the financial markets.

How Stock Prices Are Determined

Stock prices might appear straightforward on brokerage accounts or online charts, but they result from a complex interplay of supply and demand. The price of a stock is determined through negotiations between buyers and sellers, influenced by various factors.

Stock prices are shaped by both fundamental and technical factors. Fundamental factors include a company’s earnings, profitability, and the value of its products or services. Technical factors relate to market sentiment and statistical analyses of historical price movements.

High stock prices can reflect a company’s success or investor confidence in its performance, but they may also result from stock splits, dividends, or share buybacks. Conversely, a decline in stock price indicates a decrease in the stock’s market value rather than a loss of overall market money. For example, if a company reports better-than-expected profits, its stock price may rise as investors buy more shares in anticipation of future growth. Economic events like interest rate changes or geopolitical issues can also impact stock prices and investor confidence.

Market Indexes

Stock market indexes are often the first indicators of market trends for many people. Indexes like the Dow Jones Industrial Average (DJIA) and the S&P 500 provide snapshots of broader market performance. For instance, the DJIA tracks 30 major publicly traded companies, while the S&P 500 represents 500 of the largest U.S. public companies, spanning various sectors such as technology, healthcare, and consumer discretionary.

Indexes serve as benchmarks for evaluating stock and portfolio performance. For example, if you invest in technology stocks, you may compare their performance to a technology-specific index to assess your investments’ performance.

What Does the Stock Market Do?

The stock market fulfills several crucial functions:

• Corporate Governance: Publicly traded companies are required to follow strict reporting standards, ensuring transparency and accountability. This transparency helps investors make informed decisions and maintains market confidence, providing the public with insights into major corporations that would otherwise be less transparent.
• Economic Indicator: The performance of the stock market is often viewed as a gauge of overall economic health. Rising stock prices generally signify corporate profitability and economic growth, whereas falling prices might indicate potential financial problems.
• Investment Opportunities: The stock market provides opportunities for investors to grow their portfolios over time. Historically, it has offered returns that outpace inflation, making it a vital tool for retirement planning, wealth building, and financial security.
• Liquidity: The stock market offers the ability to quickly buy and sell shares and other securities, providing liquidity to investors.
• Raising Capital: One of the primary functions of the stock market is to help companies raise funds by issuing stocks. This capital is essential for business expansion, research and development, and other corporate activities. By selling shares to the public, companies can access funds without incurring debt.
• Resource Allocation: The stock market helps allocate resources efficiently by reflecting the collective judgment of investors through stock prices. This process directs capital to companies deemed more likely to succeed and away from those that are not.

Why Is the Stock Market So Important?

The significance of the stock market has evolved significantly over time. In its early days, the global economy was centered around physical goods and industries like agriculture and textiles. Early stock markets played a crucial role in financing trade and exploration ventures but were less central to everyday economic life.

Today, the stock market is a cornerstone of the global economy, driven by financialization and the dominance of financial markets. Its role extends beyond being a barometer of economic health to being integral to wealth distribution and creation.

For many Americans, the stock market is not just a financial tool but a significant part of their investment strategies and retirement planning. Economic events affecting the stock market can have direct impacts on personal finances, including 401(k) plans and other investments.

The stock market also influences technological advancements and public services. For instance, funding for research and development in areas like artificial intelligence and medical devices relies on capital raised through the stock market. Additionally, pension funds invested in the stock market impact the financial health of retirement systems and, consequently, millions of retirees.

What’s the Difference Between the Bond Market and the Stock Market?

Globally, the bond market surpasses the stock market in size, with approximately $130 trillion in bonds compared to $101 trillion in stock market capitalization. Bonds and stocks serve distinct purposes and offer different risk-reward profiles.

In the bond market, investors purchase debt securities issued by governments or corporations. Investing in bonds means lending money in exchange for regular interest payments and the return of the bond’s face value at maturity.

The stock market involves buying and selling shares and derivatives of publicly traded companies. Stocks represent ownership in a company and offer the potential for higher returns through dividends and price appreciation. However, stocks also carry higher risks due to their volatility.

What Is an Alternate Trading System?

Alternative trading systems (ATS) are platforms designed for matching large buy and sell orders outside traditional exchanges. Examples include dark pools, various cryptocurrency exchanges, and private trading forums operating within limited groups.

Who Helps an Investor Trade on the Stock Market?

Several professionals assist investors in stock trading:

• Stockbrokers: Act as intermediaries between stock exchanges and investors, executing trades on their behalf.
• Portfolio Managers: Manage investment portfolios for clients, making investment decisions and strategies.
• Investment Bankers: Help companies with initial public offerings (IPOs), mergers, acquisitions, and other financial services.

The Bottom Line

The stock market is a dynamic network where shares of companies and other financial instruments are traded. It plays a crucial role in determining stock prices, which reflect companies’ perceived values and market conditions. The stock market facilitates capital raising for companies and provides opportunities for investors to grow their wealth. It is integral to the global economy, influencing products, job availability, and retirement planning. Even if you don’t trade directly, the stock market’s impact is far-reaching and significant.