How Does the Stock Market Work?

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Contributor, Benzinga
July 16, 2023

The U.S. stock market is now collectively worth $47 trillion. It holds the accumulated retirement wealth of multiple generations, the hopeful investments of individual investors and the portfolios of massive institutional powerhouses.

As of 2019, about 53% of the stock market was owned by household investors who buy shares of individual companies. To own stock in a company is to own a piece of it — a share. Many investors are not active traders — they participate in the stock market in a more passive or even peripheral way by owning mutual funds or exchange-traded funds (ETFs) for investment vehicles like 401(k)s and IRAs. They may also invest in mutual funds, where the fund buys stocks individual stocks and the investor buys shares in the fund.

The question for all these investors is, “how does the stock market work?” As you read, you can teach yourself what the stock market is all about, make informed decisions and do more with your money.

What is the Stock Market?

A market is a place to buy and sell and the stock market is no different, except that the quantities changing hands are sometimes massive and that shares in companies and funds are primarily what’s being exchanged.

Going back to their origins, stock markets were physical buildings where stock trading took place, complete with frenzied running to place orders amid scattered confetti of “ticker tape” and deafening crowds of screaming traders. Most trades are done electronically now, allowing for a more efficient market, despite its growth over the years.

We commonly refer to the stock market as though there’s only one, but there are many stock markets that make up the overall U.S. stock market, sometimes called exchanges. Many of these exchanges have become household names themselves, such as the Nasdaq Exchange (NASDAQ) or the New York Stock Exchange (NYSE), with its 2,400 traded companies representing about two-thirds of the total U.S. stock market by value.

What is a Stock?

Companies can be either public or private and both types can have shares — but a public company has its shares publicly traded on a stock exchange. Public companies that aren’t listed with an exchange are still traded, but they are traded either as OTCBB (over the counter) if they don’t meet the listing requirements of NASDAQ or the NYSE.

(For example, most penny stocks trade over the counter. The major sources of over-the-counter penny stocks are the OTCQX, OTCQB, and Pink Markets (owned by OTC Markets Group) and the over-the-counter bulletin board (OTCBB), which is owned by FINRA. Companies that list on the OTCBB must register with the SEC. Securities that trade on the OTCQX, OTCQB and Pink Markets do not require SEC registration.)

A publicly traded company issues its first shares during an Initial Public Offering (IPO). The revenue from these shares is usually used for growth plans and other expenses.

Growth in the number of shares after the IPO is often due to stock splits, which are a tool companies use to lower the per-share price without reducing the value of investors’ holdings. If you had invested $5,000 in Apple at its IPO, you’d have over $2 million today and you’d have over 50 shares for every one share you bought at the IPO, the latter due to stock splits.

A share in a company is ownership in the company. However, owning a handful of shares doesn’t earn a seat at the boardroom table. Apple, for example, has nearly a billion shares after beginning an aggressive buy-back program that reduced the number of outstanding shares. Ownership may come with other benefits, however.

Many companies pay a dividend on their shares. When the company does well and decides to fund its dividend, investors are paid a dividend for each share, allowing investors to benefit from any growth in the value of the stock as well as earn a bit extra for their ownership. These dividends can be taken as cash or they can be reinvested. Most references to historical stock market performance include income from dividends as well as stock value appreciation.

How Does the Stock Market Work?

While extremely complex, it's easy to distill how the stock market works into a few steps:

  • First, buyers place bids and sellers offer asking prices for shares of stock.
  • When the bid equals the ask, a trade occurs. 
  • The difference between what buyers will pay and sellers will accept is called the bid-ask spread. A smaller bid-ask spread indicates a more liquid security.
  • A stock's price represents what the cumulative market of buyers and sellers decide the price is — it's all based on supply and demand.

What is an Index?

Stock market indices are groupings of stocks that share common traits or that meet the criteria to be included in the index. Indices can be based in part on market capitalization, which is the total value of all outstanding shares. Indices can vary in company type ranging from a broad spectrum, like the S&P 500, to indices heavily weighted in a certain segment, such as the NASDAQ Composite Index, which has a strong representation of tech stocks.

The larger indices serve as a bellwether for the overall stock market, often driving investor sentiment up or down with each change in the index’s value. Most often, it’s the Dow Industrial Index, made up of the 30 largest and most influential companies, and the S&P 500 that make headlines, demonstrating how an index can come to represent the broad market.

What is a Stock Broker?

If you want to buy a share of stock or sell a share of a publicly traded company, you need a broker to help you complete the transaction. Stockbrokers are individuals or firms that execute buy or sell orders at your request.

In exchange for executing your trades, the broker collects a commission or a fee. Brokers can be either discount brokers or full-service brokers, with each type catering to a different type of trading. A discount broker executes trades inexpensively, typically charging between $5 to $15 per trade, but usually doesn’t provide personalized guidance for its least-expensive trading services.

Full-service brokers offer a more comprehensive variety of services, often including investment advice. The higher level of service provided by a full-service broker usually means higher fees. Before the advent of discount brokers, stock trading was largely a pursuit for more affluent investors who could afford a full-service broker. The internet can be credited with changing that paradigm, making stock trading easily accessible to anyone with an internet connection and a desire to invest.

For more information about the best online brokers, check out Best Online Brokerages on Benzinga or see below.

Stock Market Prices: Bids and Asks

As you begin to learn about stock market investing, you’ll encounter the terms bid and ask. The bid is the price a buyer is willing to pay for a stock, while the ask is the price at which a seller is willing to sell.

If you wanted to buy a stock for $10, you can place the order with your broker to buy a fixed number of shares at that price. However, if nobody is willing to sell for that price, the trade won’t be executed. There is also the option to buy or sell at “market” price, which usually results in a faster transaction.

In smaller markets, like OTC trading, a market maker helps to facilitate trades by buying shares offered for sale and then posting those shares for sale again. This is particularly useful when the spread between the bid and ask is wide and a stock is thinly traded, meaning there aren’t many buyers or sellers.

Following Stock Market News

The stock market is affected by a multitude of factors, including economic indicators, geopolitical events, and corporate earnings reports. By keeping up with these news and events, investors can better understand the market sentiment and identify potential investment opportunities or risks.

Market news provides valuable insights into the performance of individual companies and industry sectors. Traders can stay abreast of important announcements such as mergers and acquisitions, shareholder meetings, new product launches, or regulatory changes that can significantly impact a company's stock price. This knowledge allows investors to adjust their portfolios accordingly, buying or selling stocks based on the potential growth or decline of specific companies or sectors.

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Use the Stock Market to Your Advantage

Investing is an excellent way to grow wealth — in periods of market volatility and while the stock market is sailing. How does the stock market work? It depends on where you invest, how much and what your established goals are.

The best way for beginners to get started investing in the stock market is to put money in an online investment account to buy shares of stock or stock mutual funds. Many online brokers let you start investing for the price of a single share.

Frequently Asked Questions

Q

What is the value of the US stock market?

A

The total value of the US stock market is $49 trillion.

Q

What is the wash sale rule?

A

It is a regulation that prohibits the sale of a stock at a loss and repurchasing it in the next 30 days to take the write-down.

Related link: COMPARING STOCK INDICES