How Does the Stock Market Work?
Owning a stock is owning a very small slice of a company. Learning how stocks work can help investors better understand the benefits of investing.
April 7, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
Most financial experts stress the importance of investing. And in most cases, “investing” refers to investing in stocks.
But there’s a lot of confusion about the stock market, stock investing and what stocks really are.
How do stocks work, exactly?
The stock market can be a confusing place, especially for new investors.
This article will provide all the information you need to know to start understanding stocks and the stock market.
What is the stock market?
The term “stock market” refers to public markets that allow investors to buy and sell stocks.
Stocks, also known as equities, are fractional ownership shares of a company. When an investor buys a share of Microsoft stock, they own a very small percentage of Microsoft.
Stock markets exist to connect buyers and sellers and to give companies a place to issue shares and raise money.
You can access the stock market through a brokerage account. A stockbroker (such as Fidelity, Vanguard or E-Trade) provides a simple way to access the stock market and buy and sell shares.
The stock market is highly regulated by the Securities and Exchange Commission (SEC). The SEC’s function is to maintain fair, orderly and efficient markets, to facilitate capital formation and to protect investors.
What are stock exchanges?
A stock exchange is an actual market where securities (stocks) are traded.
The New York Stock Exchange (NYSE) is America’s primary stock exchange. The NASDAQ, also based in the U.S., is a separate exchange.
Each major country has its own stock exchange. These exchanges provide the actual infrastructure for completing trades.
What are stock market indexes?
“Stock market” can also refer to common stock market indexes, such as the S&P 500, the NASDAQ or the Dow Jones Industrial Average (DJIA).
Indexes track the prices and performance of many large, important companies. The S&P 500, for instance, tracks 500+ of the largest publicly traded companies in America.
Indexes provide a birds-eye view of what the overall market’s doing. When people say that “the stock market is up 1% today,” they are likely referring to one of these indexes (rather than the entire stock market).
Buying an S&P 500 index fund is similar to buying a small portion of all the 500+ companies in the index — but it’s much simpler to do.
For an investor who doesn’t want to research specific companies or spend much time on investment strategy, buying index funds is an excellent option.
How do stocks work?
Stocks represent fractional ownership of companies. Individuals can buy “shares” in the company’s stock. When you see Netflix stock trading at $400, that means that one share of Netflix stock is worth $400.
Publicly traded companies list their shares on the stock market to be bought and sold by everyday people.
When an investor buys a share of a company, they now own a very small percentage of that company. If the company is worth more in the future, that share will be worth more.
When companies make a profit, they may choose to distribute some of that profit to their shareholders in the form of dividends. Dividends are excellent for passive income.
Types of stock
The more in-depth answer to “how do stocks work” also depends on the specific type of stock.
Common stock — Common stock is the standard type of stock purchased on exchanges. It represents fractional ownership of the given company and it allows voting rights for major company decisions. Common stock may or may not receive dividends, depending on the company.
Preferred stock — Preferred stock doesn’t come with voting rights, but it has priority in dividend distributions. Some types of preferred stock function similarly to a bond, in that the owner of the preferred stock is guaranteed a stream of income (dividends).
Over-the-counter (OTC) stocks — OTC stocks are stocks in companies that don’t meet the requirements to be traded on a major stock exchange. Instead, they are traded on OTC markets, which use “market makers” to facilitate trades. OTC stocks are less regulated and may be riskier to invest in.
There are other categories of stock that investors may refer to, such as value stocks, growth stocks or blue-chip stocks. These terms are defined in greater detail in this guide to the different types of stocks.
How do stock market transactions work?
The stock market connects buyers and sellers. There’s a common misconception that when you buy a stock, you’re buying it from the company itself.
This is only the case during the initial public offering (IPO). To illustrate how this works, let’s look at an example.
Company XYZ is growing and wants to raise money
They decide to conduct an IPO and sell company shares to the public
They list 1,000,000 shares at an IPO price of $50 per share
Investors, hedge funds, and financial institutions buy all the shares for $50 each shortly before the IPO date
The company raises $50 million (minus fees) from the shares that they can use to operate the business
On the IPO date, the shares begin trading on the stock market and anyone can buy them
From here on out, shares are traded directly between investors. For someone to buy a share, someone else has to sell one. The company itself no longer raises any funds or sells shares directly
After the IPO date, the market sets the price for the stock. If investors believe the stock is worth more than $50 per share, they may push the price up to $60, $70, or even $100+ per share. If they don’t think the company is worth that much, the price may fall below the IPO price of $50.
Every transaction on the stock market involves a buyer and a seller. Transactions take place during market hours (9:30 a.m. to 4 p.m. ET, Monday through Friday), although some investors participate in premarket and aftermarket trading.
Orders are placed on either end — a seller could place an order to sell 50 shares at “market” price (meaning the current market price of that stock), or a buyer could place an order to buy 10,000 shares at $25 per share.
The seller’s order would complete instantly, as long as it was during market hour; the buyer’s order would only complete if sellers were willing to sell for $25 per share. If the price was $26 per share, for example, the buyer’s order wouldn’t fill until the market price drops.
Learn more about investing
Ready to learn more about investing? Here are some helpful resources to explore:
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