If you’re not familiar with the fundamentals of the stock market, the flashes of green and red crossing the bottom of your screen and the stock trading info spewing from the news can come out as a lot of gibberish. Indeed, everyone has come across the term ‘stock market’ but few actually know what it is and how it works.
The stock market; we’re talking about the assemblage of markets and exchanges where constant activities of issuance, buying, and selling of shares of publicly-traded companies take place. Although known as a stock/ equity market, other financial securities including, corporate bonds, exchange traded funds (ETF)s, bonds, commodities, and currencies, are also bought and sold in the stock markets.
Institutionalized formal exchanges/ Over-the-counter (OTC) marketplaces provide a base for conducting such financial activities. These institutions operate under a determined set of regulations. The leading stock exchanges operating in the United States include Nasdaq, the “New York Stock Exchange” (NYSE), the “Chicago Board Options Exchange” (CBOE), and the “Better Alternative Trading System” (BATS).
Understanding the stock market
Thanks to the internet, sellers can deal just about anything at a price that suits their liking. Quite a gold mine, huh? Well, not entirely. See, there’s a designated market place for every commodity. It’s no surprise that someone would drive for miles simply because they can’t get their regular supply of groceries from another store other than Walmart or another preferred choice.
Such dedicated markets create a platform for numerous buyers and sellers to meet, interact, and transact. The huge number of market participants dealing with the same commodity acts as an assurance of fair price. Suppose there’s only one supplier of groceries in the entire city. Won’t he have the liberty to price his/her commodity anyhow he/she wants as the buyers will have nowhere else to go? However, if there is a large number of grocery sellers in a common market place, they’ll have to compete against themselves to bag buyers. This makes it a fair market with transparent prices. The same applies to shopping online.
A stock market works in an exact similar way; a designated market where various kinds of securities are traded in a secure, controlled, and managed environment. Hundreds of thousands of participants wishing to trade shares all converge here. This ensures transparency in transactions and fair pricing practices.
Stock market participants
Stock brokers - licensed professionals who trade securities on behalf of the investors
Investment bankers – Company representatives in various capacities, say when a private company wants to go public through an IPO, or one that’s involved in pending acquisitions and mergers.
Custodian - Institutions that hold the customer’s securities for safekeeping as a risk management strategy for theft/ loss. Custodians/ depot service providers also work with the exchange to facilitate the transfer of shares to/from the accounts of the transacting parties.
Portfolio managers- Professionals who invest portfolios/ securities for clients. Fetching recommendations from analysts, they make trade decisions for the portfolio.
How does the stock market work?
Stock markets can operate as primary and secondary markets.
The stock market, as a primary market, makes it possible for companies to avail and sell part of their shares to the public for the very first time through an IPO- Initial Public Offerings. Through this activity, companies are able to raise needed capital from investors. This means that a company has to divide itself into a specified number of shares, say 30 million shares, and decide to sell a part of them, say 10 million shares, to the common public at, say $10 per share.
The company needs a marketplace to facilitate the selling of these shares. That is where the stock market comes in. Should everything go smoothly, the company will sell the 10 million shares at $10 per share and amass $100 million worth of funds. Investors can hold the company shares that they receive for their preferred duration. This is a lot of facilitation work for which the stock exchange receives a service fee from the company and its relevant financial partners.
The stock market as a secondary market comes after the IPO listing process. The stock exchange serves as a trading platform for the facilitation of regular trading of listed shares. Every trade occurring on its platform throughout the secondary market activity is money in the pocket for the stock exchange.
Functions of the stock market
1. Economic barometer
Every significant change in the economy of a country reflects in the share prices. The rise in the share prices indicates the boom cycle of the economy while the fall in the prices of shares is an indication of the recession cycle. Talk about the stock exchange being an economic mirror.
2. Pricing of securities
The stock market aids in putting a value to the securities based on demand and supply factors. Securities of profitable and sprouting companies have a higher value due to their increased demand. Creditors, investors, and the government, all benefit from the valuation of securities.
3. Safety of transactions
Stock exchange authorities will never include the name of a company in the trade list without verifying its soundness. Listed companies also have to comply with the set rules and regulations to ensure safety of dealing via the stock exchange.
4. Contribution to economic growth
The buying and selling of securities of various companies in a process of disinvestment and reinvestment aids to invest in productive investment proposal, leading to economic growth and capital formation.
5. Provides scope for speculation
The stock exchange allows healthy speculation of securities for demand of securities supply as well as liquidity purposes.
Trading in the stock exchange market as an investor gives you the ability to convert your investment into cash whenever you want.
Furthermore, you can easily convert a long-term investment project into medium-term and short-term.
How stock markets make money
Stock markets function as “for-profit” institutes, charging a fee for every service they give. The transaction fees that the stock exchange collects for every trade executed on its platform, forms its main source of income. Listing fees for IPOs and other follow-up offerings add to this revenue.
Selling market data spawned on its platform is another way the exchange makes money. We’re talking real-time data, summary data, reference data, and historical data- all which play a vital role in equity research, among other uses.
Sometimes, the stock market offers privileged services such as high-frequency trading to bigger clients like Asset Management Companies (AMC) and mutual funds, and earn money accordingly.
Many exchanges have the tools to provide courses and certificates on a diverse range of financial topics, the kind that you wouldn’t find for free.
To sum up, the stock market plays an important part in the economy of every country. It lets common investors take part in the financial accomplishments of companies, profit from capital gains, and earn through dividends, not forgetting that losses are part of the wins.
It’s worth noting that there is a lot more to the stock exchange than what is written above. This piece, however, provides you with everything you need to know about the stock market if you are just starting. We leave you with a few tips to shine light on your path to being a solid investor:
• Buy low, sell high
• Get familiar with filings
• Think long-term
• Dividends are your friend
• There isn’t a perfect metric
• A $5 stock is not cheap and a $100 stock is not expensive