What is a stock market

Stock Market

What is the ‘Stock Market’?

Also known as the equities market, a stock market is a place where shares of publicly owned companies can be bought and sold. Publicly traded shares can be traded either through centralised exchanges or OTC (over-the-counter). The stock market is essentially a free economy market where companies can access capital by offering part ownership to interested investors who are basically outsiders. This is beneficial for both investors and the underlying companies.

For investors, the stock market offers a unique opportunity to be part of an established or already running business and to reap any of their resulting rewards without the high risk of investing in a new, unproven business, that has to contend with the associated start-up costs, overheads and other running costs and management. For the underlying companies, the stock market allows them to access a convenient source of capital to fund their growth or expansion activities. This creates a win-win situation for both parties.

But like any investment activity, there are also risks involved. The amount of risk a trader incurs depends entirely on the price of the stock held. If the price of a stock increases, a trader will earn profits if they sell their shares. On the other hand, losses will be realised if the stock is sold at a lower price than it was bought at. The extent of profits or losses realised will depend on the amount of stock that was initially bought, and of course, how much the price of the stock rises or falls.

How is the Stock Market Broken Down?

There are various segments of the stock market to consider when entering into a purchase or interest in the shares of a particular public company. The stock market is divided into the primary market and the secondary market.

Primary Market

The primary market is when new securities are created or issued, and they then become available for trading by individuals and institutions. Here, securities are directly issued by the company that seeks to raise capital to fund its long-term goals and ambitions. The most common way companies interact in the primary market is through an IPO (Initial Public Offering) where stocks are listed for the first time to trade in the market. Companies can also engage in the primary market through a Rights Issue (raising money through existing shareholders) or a Preferential Allotment (issuing shares to a few shareholders at a predetermined price).

Secondary Market

After the initial offering in the primary market, all subsequent trading of securities takes place in the secondary market between investors, with the underlying company not involved. Trades are facilitated by stock exchanges or by brokers who act as intermediaries.

OTC Market

Also known as trading off-exchange, trading OTC (over-the-counter) is an option for investors to buy and sell stocks in a decentralised market. Trades are conducted between two parties via a dealer network, with a centralised exchange not involved. Typically, the OTC market is for stocks or stock prices not listed on a stock exchange. Decentralised is where a transaction of buying or selling will take place between two parties, such as the trader and the broker. There are generally no rigid conditions in an OTC market, with trading being very flexible with as few limitations as possible.

There are many reasons a company would want to list on an exchange. Raising capital is the primary motivation, but companies that get listed attain many more benefits. Going public gives a company massive publicity that can open up even more business opportunities. A company can gain the attention of diversified pools of investors ranging from institutional investors to foreign investors. This naturally leads to increased brand equity as well. There is also the prestige of being a company listed on a top stock exchange, as well as the ability to attract top talent by offering sought-after perks, such as stock options.

Process of Stock Market Listing

The process of listing a company differs from exchange to exchange. But it will typically start with filing a registration with a relevant regulatory agency, such as the Securities Exchange Commission (SEC) in the US. A company will do this if it meets the conditions of the underlying stock exchange they wish to get listed on, such as the NYSE or NASDAQ. The next step will be to employ an underwriter, which is an investment bank or a major financial services company, to manage the sale of shares.

An underwriter serves as a bridge that connects the underlying company to investors as well as a risk assessor. It is the underwriter that will be responsible for drafting a prospectus, a document that will attempt to entice investors to invest in the underlying company. Listing on a stock market also comes with some downsides. To start with, the process of stock market listing is costly, time-consuming and labour intensive.

As well, going public literally means that a company becomes public property. There is increased scrutiny and demands for accountability both by the public and the relevant capital markets regulatory agency. For founders and other early investors, there is the risk of undervaluation as well as share dilution. It is the underwriter(s) that determines the IPO price by taking into account factors such as demand for the stock, growth prospects, the company business model and past industry equivalents.

After a company goes public, the share price is determined by market forces of demand and supply. There are different and varied factors that influence stock prices including fundamental factors, such as revenue and earnings per share; technical factors, such as inflation, industry performance, liquidity and trends; and sentimental factors such as investor speculation activity as well as reaction to political and economic news releases and events.

The Stock Exchange

Also known as the bourse, the stock exchange is a place where securities, such as stocks are bought and sold. It is also a place that provides facilities for issuing and redeeming financial instruments, including income and dividend payments. In addition to stocks, stock exchanges list other assets, such as bonds, unit trusts, derivatives, as well as pooled investment products such as exchange-traded funds and stock market indices.

The main Stock Exchanges

In most cases, companies will use their local stock exchanges as a platform to go public. Here are some of the major stock exchanges around the world, whose assets are also available for trading at AvaTrade.

Investing in Stocks

There are two fundamental strategies when investing in stocks: value investing and growth investing. The two strategies complement each other and applying them to individual stocks can help investors maintain a well-balanced portfolio.

Value Investing

This is a strategy that aims to identify stocks that are undervalued in the market. Value investors actively seek companies that they believe are underpriced in the market, with the hope that sooner or later they will be priced accordingly. These can be stocks of companies priced below similar companies in the same industry or companies whose business models carry less risk in their operating markets. Value stocks are considered a bargain as well as relatively safe for investors over the long run.

Growth Investing

Growth investing involves identifying stocks of companies that have performed admirably in the recent past and they are expected to grow faster than other companies. Growth can be in terms of revenue, cash flow, or profit. It is important to note that this growth is expected, but not guaranteed. Growth stocks have a higher ceiling in terms of price appreciation, but they are naturally riskier and more volatile.

Price-Earnings Ratio

Better known as the P/E Ratio, this ratio is used to value a company by measuring its current share price relative to its earnings per share.

Here is how the price-earnings ratio is calculated:

By taking the stock price of the company and dividing it by is earnings per share (EPS) = market value per share. The P/E ratio is a dollar amount that a trader can expect to invest in a company in order to receive one dollar of that company’s earnings.

Dividend-Paying Stock

Dividend stocks are companies that pay out regular dividends to shareholders. Dividends are a share of profits distributed directly to shareholders. Companies that pay out dividends regularly to investors are typically more established with proven and sustainable business models. Dividends are usually paid out quarterly, which means that they can be a regular source of income for investors.

Shares Trading

Swing Trading

Swing trading is a popular style for trading stocks. A swing trader attempts to earn a profit from a price movement that is expected to happen in the short to medium term. Due to its short-term nature, swing traders typically utilise technical analysis methods to pick out ideal entry and exit price points in the market.

Day Trading

Day trading is a trading style where financial assets, such as stocks, commodities, indices or currencies, are bought and sold within the same day. The difference between swing trading and day trading is simply the holding period. When day trading, all trade positions are liquidated strictly on the same day. No trade positions are left overnight. Naturally, day trading carries a higher level of risk and can result in higher trading costs due to the amount of trading activity done within a short period.

Trading Stocks CFDs with AvaTrade

AvaTrade has simplified stock trading for investors. There are numerous stocks drawn from several global exchanges available for trading. When trading stock CFDs with AvaTrade, you are trading contracts for differences, which means that you get the chance to trade the price movement of underlying stocks without necessarily owning them.

AvaTrade offers leveraged trading of up to on stocks and traders can enhance their trading activity by utilising handy trading tools and resources such as the Economic Calendar, Trading Central, AvaProtect™, and AvaSocial. AvaTrade is also a globally regulated broker that provides top trading services through multiple advanced trading platforms.

Additionally, AvaTrade offers multilingual support to ensure that traders have the necessary support and assistance for their trading activities.

Stock Market Main FAQs

All investing forms come with risks. Volatility is one of the risks of trading stocks. Volatility is characterised by choppy price swings and can particularly be witnessed in individual stocks during news or events such as an earnings release. Volatility can increase the risk of losses but it typically evens out over time. This means that a cure for volatility is to hold stocks over a longer period and to ride both the ups and downs in the market.

Different markets are located in different places, and in some instances, there is no physical location for the market or index. For example, the NYSE is physically located in New York City at 11 Wall Street, and you can actually go there and see the floor traders. By contrast, the Nasdaq is fully electronic, and while it has its headquarters in New York City, there is no trading floor where you can go to see the open outcry form of trading. Nearly every country in the world has one or more stock markets, and most have physical locations but have been increasingly migrating towards electronic trade.

Most stock markets work through an auction process, with buyers placing bids for the price they are willing to pay for a stock, and sellers setting an ask price for how much they are willing to sell for. When the two prices meet, a trade is conducted, and shares can exchange hands. In the past all of these trades were made on stock market floors or pits, using an open outcry system where the market makers would yell, or cry out the prices at which shares could be bought or sold. That has evolved into an electronic auction system, which is good since stock markets today consist of millions of individuals, all of whom have their own ideas of what a stock is worth.

Join thousands of clients that enjoy the benefits of being part of the AvaTrade family and start trading with confidence.

What Is the Stock Market?

James Chen, CMT is an expert trader, investment adviser, and global market strategist. He has authored books on technical analysis and foreign exchange trading published by John Wiley and Sons and served as a guest expert on CNBC, BloombergTV, Forbes, and Reuters among other financial media.

Kirsten Rohrs Schmitt is an accomplished professional editor, writer, proofreader, and fact-checker. She has expertise in finance, investing, real estate, and world history. Throughout her career, she has written and edited content for numerous consumer magazines and websites, crafted resumes and social media content for business owners, and created collateral for academia and nonprofits. Kirsten is also the founder and director of Your Best Edit; find her on LinkedIn and Facebook.

What Is the Stock Market?

The term stock market refers to several exchanges in which shares of publicly held companies are bought and sold. Such financial activities are conducted through formal exchanges and via over-the-counter (OTC) marketplaces that operate under a defined set of regulations.

Both “stock market” and “stock exchange” are often used interchangeably. Traders in the stock market buy or sell shares on one or more of the stock exchanges that are part of the overall stock market.

The leading U.S. stock exchanges include the New York Stock Exchange (NYSE) and the Nasdaq.

Key Takeaways

Stock Market

Understanding the Stock Market

The stock market allows buyers and sellers of securities to meet, interact, and transact. The markets allow for price discovery for shares of corporations and serve as a barometer for the overall economy. Buyers and sellers are assured of a fair price, high degree of liquidity, and transparency as market participants compete in the open market.

The first stock market was the London Stock Exchange which began in a coffeehouse, where traders met to exchange shares, in 1773. The first stock exchange in the United States began in Philadelphia in 1790. The Buttonwood Agreement, so named because it was signed under a buttonwood tree, marked the beginning of New York’s Wall Street in 1792. The agreement was signed by 24 traders and was the first American organization of its kind to trade in securities. The traders renamed their venture the New York Stock and Exchange Board in 1817.

A stock market is a regulated and controlled environment. In the United States, the main regulators include the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).

The earliest stock markets issued and dealt in paper-based physical share certificates. Today, stock markets operate electronically.

Though it is called a stock market, other securities, such as exchange-traded funds (ETFs) are also traded in the stock market.

How the Stock Market Works

Stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence, with zero to low operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and secondary markets.

As a primary market, the stock market allows companies to issue and sell their shares to the public for the first time through the process of an initial public offering (IPO). This activity helps companies raise necessary capital from investors.

A company divides itself into several shares and sells some of those shares to the public at a price per share. To facilitate this process, a company needs a marketplace where these shares can be sold and this is achieved by the stock market. A listed company may also offer new, additional shares through other offerings at a later stage, such as through rights issues or follow-on offerings. They may even buy back or delist their shares.

Investors will own company shares in the expectation that share value will rise or that they will receive dividend payments or both. The stock exchange acts as a facilitator for this capital-raising process and receives a fee for its services from the company and its financial partners. Using the stock exchanges, investors can also buy and sell securities they already own in what is called the secondary market.

The stock market or exchange maintains various market-level and sector-specific indicators, like the S&P (Standard & Poor’s) 500 index and the Nasdaq 100 index, which provide a measure to track the movement of the overall market.

Following an IPO, the stock exchange serves as a trading platform for buying and selling the outstanding shares. This constitutes the secondary market. The stock exchange earns a fee for every trade that occurs on its platform during secondary market activity.

What Are the Functions of a Stock Market?

The stock market ensures price transparency, liquidity, price discovery, and fair dealings in trading activities.

The stock market guarantees all interested market participants have access to data for all buy and sell orders, thereby helping in the fair and transparent pricing of securities. The market also ensures efficient matching of appropriate buy and sell orders.

Stock markets need to support price discovery where the price of any stock is determined collectively by all of its buyers and sellers. Those qualified and willing to trade should get instant access to place orders and the market ensures that the orders are executed at a fair price.

Traders on the stock market include market makers, investors, traders, speculators, and hedgers. An investor may buy stocks and hold them for the long term, while a trader may enter and exit a position within seconds. A market maker provides necessary liquidity in the market, while a hedger may trade in derivatives.

How Stock Markets Are Regulated

Most nations have a stock market, and each is regulated by a local financial regulator or monetary authority, or institute. The SEC is the regulatory body charged with overseeing the U.S. stock market.

The SEC is a federal agency that works independently of the government and without political pressure. The mission of the SEC is stated as “protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.”

Companies listed on the stock market exchanges are regulated, and their dealings are monitored by the SEC. In addition, the exchanges set certain requirements such as mandating timely filing of quarterly financial reports and instant reporting of relevant corporate developments, to ensure that all market participants are equally informed.

Failure to adhere to the regulations can lead to suspension of trading and other disciplinary measures.

What Is the Significance of the Stock Market?

The stock market is a component of a free-market economy. It allows companies to raise money by offering stock shares and corporate bonds and allows investors to participate in the financial achievements of the companies, make profits through capital gains, and earn income through dividends. The stock market works as a platform through which savings and investments of individuals are efficiently channeled into productive investment opportunities and add to the capital formation and economic growth of the country.

What Is an Alternate Trading System?

Alternative trading systems are venues for matching large buy and sell transactions and are not regulated like exchanges. Dark pools and many cryptocurrency exchanges are private exchanges or forums for securities and currency trading and operate within private groups.

Who Helps an Investor Trade on the Stock Market?

Stockbrokers act as intermediaries between the stock exchanges and the investors by buying and selling stocks and portfolio managers are professionals who invest portfolios, or collections of securities, for clients. Investment bankers represent companies in various capacities, such as private companies that want to go public via an IPO or companies that are involved in pending mergers and acquisitions.

Stock Market

Public markets for issuing, buying, and selling stocks

What is the Stock Market?

The stock market refers to public markets that exist for issuing, buying, and selling stocks that trade on a stock exchange or over-the-counter. Stocks, also known as equities, represent fractional ownership in a company, and the stock market is a place where investors can buy and sell ownership of such investible assets. An efficiently functioning stock market is considered critical to economic development, as it gives companies the ability to quickly access capital from the public.

Purposes of the Stock Market – Capital and Investment Income

History of Stock Trading

Although stock trading dates back as far as the mid-1500s in Antwerp, modern stock trading is generally recognized as starting with the trading of shares in the East India Company in London.

The Early Days of Investment Trading

Throughout the 1600s, British, French, and Dutch governments provided charters to a number of companies that included East India in the name. All goods brought back from the East were transported by sea, involving risky trips often threatened by severe storms and pirates. To mitigate these risks, ship owners regularly sought out investors to proffer financing collateral for a voyage. In return, investors received a portion of the monetary returns realized if the ship made it back successfully, loaded with goods for sale. These are the earliest examples of limited liability companies (LLCs), and many held together only long enough for one voyage.

The East India Company

The formation of the East India Company in London eventually led to a new investment model, with importing companies offering stocks that essentially represented a fractional ownership interest in the company, and that therefore offered investors investment returns on proceeds from all the voyages a company funded, instead of just on a single trip. The new business model made it possible for companies to ask for larger investments per share, enabling them to easily increase the size of their shipping fleets. Investing in such companies, which were often protected from competition by royally-issued charters, became very popular due to the fact that investors could potentially realize massive profits on their investments.

The First Shares and the First Exchange

Company shares were issued on paper, enabling investors to trade shares back and forth with other investors, but regulated exchanges did not exist until the formation of the London Stock Exchange (LSE) in 1773. Although a significant amount of financial turmoil followed the immediate establishment of the LSE, exchange trading overall managed to survive and grow throughout the 1800s.

The Beginnings of the New York Stock Exchange

Enter the New York Stock Exchange (NYSE), established in 1792. Though not the first on U.S. soil – that honor goes to the Philadelphia Stock Exchange (PSE) – the NYSE rapidly grew to become the dominant stock exchange in the United States, and eventually in the world. The NYSE occupied a physically strategic position, located among some of the country’s largest banks and companies, not to mention being situated in a major shipping port. The exchange established listing requirements for shares, and rather hefty fees initially, enabling it to quickly become a wealthy institution itself.

Modern Stock Trading – The Changing Face of Global Exchanges

Domestically, the NYSE saw meager competition for more than two centuries, and its growth was primarily fueled by an ever-growing American economy. The LSE continued to dominate the European market for stock trading, but the NYSE became home to a continually expanding number of large companies. Other major countries, such as France and Germany, eventually developed their own stock exchanges, though these were often viewed primarily as stepping stones for companies on their way to listing with the LSE or NYSE.

The late 20 th century saw the expansion of stock trading into many other exchanges, including the NASDAQ, which became a favorite home of burgeoning technology companies and gained increased importance during the technology sector boom of the 1980s and 1990s. The NASDAQ emerged as the first exchange operating between a web of computers that electronically executed trades. Electronic trading made the entire process of trading more time-efficient and cost-efficient. In addition to the rise of the NASDAQ, the NYSE faced increasing competition from stock exchanges in Australia and Hong Kong, the financial center of Asia.

The NYSE eventually merged with Euronext, which was formed in 2000 through the merger of the Brussels, Amsterdam, and Paris exchanges. The NYSE/Euronext merger in 2007 established the first trans-Atlantic exchange.

How Stocks are Traded – Exchanges and OTC

Most stocks are traded on exchanges such as the New York Stock Exchange (NYSE) or the NASDAQ. Stock exchanges essentially provide the marketplace to facilitate the buying and selling of stocks among investors. Stock exchanges are regulated by government agencies, such as the Securities and Exchange Commission (SEC) in the United States, that oversee the market in order to protect investors from financial fraud and to keep the exchange market functioning smoothly.

Although the vast majority of stocks are traded on exchanges, some stocks are traded over-the-counter (OTC), where buyers and sellers of stocks commonly trade through a dealer, or “market maker”, who specifically deals with the stock. OTC stocks are stocks that do not meet the minimum price or other requirements for being listed on exchanges.

OTC stocks are not subject to the same public reporting regulations as stocks listed on exchanges, so it is not as easy for investors to obtain reliable information on the companies issuing such stocks. Stocks in the OTC market are typically much more thinly traded than exchange-traded stocks, which means that investors often must deal with large spreads between bid and ask prices for an OTC stock. In contrast, exchange-traded stocks are much more liquid, with relatively small bid-ask spreads.

Stock Market Players – Investment Banks, Stockbrokers, and Investors

There are a number of regular participants in stock market trading.

Investment banks handle the initial public offering (IPO) of stock that occurs when a company first decides to become a publicly-traded company by offering stock shares.

Here’s an example of how an IPO works. A company that wishes to go public and offer shares approaches an investment bank to act as the “underwriter” of the company’s initial stock offering. The investment bank, after researching the company’s total value and taking into consideration what percentage of ownership the company wishes to relinquish in the form of stock shares, handles the initial issuing of shares in the market in return for a fee, while guaranteeing the company a determined minimum price per share. It is therefore in the best interests of the investment bank to see that all the shares offered are sold and at the highest possible price.

Shares offered in IPOs are most commonly purchased by large institutional investors such as pension funds or mutual fund companies.

The IPO market is known as the primary, or initial, market. Once a stock has been issued in the primary market, all trading in the stock thereafter occurs through the stock exchanges in what is known as the secondary market. The term “secondary market” is a bit misleading, since this is the market where the overwhelming majority of stock trading occurs day to day.

Stockbrokers, who may or may not also be acting as financial advisors, buy and sell stocks for their clients, who may be either institutional investors or individual retail investors.

Equity research analysts may be employed by stock brokerage firms, mutual fund companies, hedge funds, or investment banks. These are individuals who research publicly-traded companies and attempt to forecast whether a company’s stock is likely to rise or fall in price.

Fund managers or portfolio managers, which includes hedge fund managers, mutual fund managers, and exchange-traded fund (ETF) managers, are important stock market participants because they buy and sell large quantities of stocks. If a popular mutual fund decides to invest heavily in a particular stock, that demand for the stock alone is often significant enough to drive the stock’s price noticeably higher.

Stock Market Indexes

The overall performance of the stock market is usually tracked and reflected in the performance of various stock market indexes. Stock indexes are composed of a selection of stocks that is designed to reflect how stocks are performing overall. Stock market indexes themselves are traded in the form of options and futures contracts, which are also traded on regulated exchanges.

Among the key stock market indexes are the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 Index (S&P 500), the Financial Times Stock Exchange 100 Index (FTSE 100), the Nikkei 225 Index, the NASDAQ Composite Index, and the Hang Seng Index.

Bull and Bear Markets, and Short Selling

Two of the basic concepts of stock market trading are “bull” and “bear” markets. The term bull market is used to refer to a stock market in which the price of stocks is generally rising. This is the type of market most investors prosper in, as the majority of stock investors are buyers, rather than short-sellers, of stocks. A bear market exists when stock prices are overall declining in price.

Investors can still profit even in bear markets through short selling. Short selling is the practice of borrowing stock that the investor does not hold from a brokerage firm that does own shares of the stock. The investor then sells the borrowed stock shares in the secondary market and receives the money from the sale of that stock. If the stock price declines as the investor hopes, then the investor can realize a profit by purchasing a sufficient number of shares to return to the broker the number of shares they borrowed at a total price less than what they received for selling shares of the stock earlier at a higher price.

Analyzing Stocks – Market Cap, EPS, and Financial Ratios

Stock market analysts and investors may look at a variety of factors to indicate a stock’s probable future direction, up or down in price. Here’s a rundown on some of the most commonly viewed variables for stock analysis.

A stock’s market capitalization, or market cap, is the total value of all the outstanding shares of the stock. A higher market capitalization usually indicates a company that is more well-established and financially sound.

Publicly traded companies are required by exchange regulatory bodies to regularly provide earnings reports. These reports, issued quarterly and annually, are carefully watched by market analysts as a good indicator of how well a company’s business is doing. Among the key factors analyzed from earnings reports are the company’s earnings per share (EPS), which reflects the company’s profits as divided among all of its outstanding shares of stock.

Analysts and investors also frequently examine a number of financial ratios that are intended to indicate the financial stability, profitability, and growth potential of a publicly-traded company. The following are a few of the key financial ratios that investors and analysts consider:

Price to Earnings (P/E) Ratio: The ratio of a company’s stock price in relation to its EPS. A higher P/E ratio indicates that investors are willing to pay higher prices per share for the company’s stock because they expect the company to grow and the stock price to rise.

Debt to Equity Ratio: This is a fundamental metric of a company’s financial stability, as it shows what percentage of a company’s operations are being funded by debt compared to what percentage are being funded by equity investors. A lower debt to equity ratio, indicating primary funding from investors, is preferable.

Return on Equity (ROE) Ratio: The return on equity (ROE) ratio is considered a good indicator of a company’s growth potential, as it shows the company’s net income relative to the total equity investment in the company.

Other commonly used financial ratios include return on assets (ROA), dividend yield, price to book (P/B) ratio, current ratio, and the inventory turnover ratio.

Two Basic Approaches to Stock Market Investing – Value Investing and Growth Investing

There are countless methods of stock picking that analysts and investors employ, but virtually all of them are one form or another of the two basic stock buying strategies of value investing or growth investing.

Value investors typically invest in well-established companies that have shown steady profitability over a long period of time and may offer regular dividend income. Value investing is more focused on avoiding risk than growth investing is, although value investors do seek to buy stocks when they consider the stock price to be an undervalued bargain.

Growth investors seek out companies with exceptionally high growth potential, hoping to realize maximum appreciation in share price. They are usually less concerned with dividend income and are more willing to risk investing in relatively young companies. Technology stocks, because of their high growth potential, are often favored by growth investors.

Additional Resources

Thank you for reading CFI’s guide on Stock Market. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

How Does the Stock Market Work?

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Kirsten Rohrs Schmitt is an accomplished professional editor, writer, proofreader, and fact-checker. She has expertise in finance, investing, real estate, and world history. Throughout her career, she has written and edited content for numerous consumer magazines and websites, crafted resumes and social media content for business owners, and created collateral for academia and nonprofits. Kirsten is also the founder and director of Your Best Edit; find her on LinkedIn and Facebook.

If the thought of investing in the stock market scares you, you are not alone. Individuals with very limited financial experience are either terrified by horror stories of average investors losing 50% of their portfolio value or are beguiled by «hot tips» that bear the promise of huge rewards but seldom pay off. It is not surprising, then, that the pendulum of investment sentiment is said to swing between fear and greed.

The reality is that investing in the stock market carries risk, but when approached in a disciplined manner, it is one of the most efficient ways to build up one’s net worth. While the average individual keeps most of their net worth in their home, the affluent and very rich generally have the majority of their wealth invested in stocks. In order to understand the mechanics of the stock market, let’s begin by delving into the definition of a stock and its different types.

Key Takeaways

How The Stock Market Works

What Is a Stock?

A stock is a financial instrument that represents ownership in a company or corporation and represents a proportionate claim on its assets (what it owns) and earnings (what it generates in profits). Stocks are also called shares or equity.

Owning stock means that a shareholder owns a slice of the company equal to the number of shares held as a proportion of the company’s total outstanding shares. For instance, an individual or entity that owns 100,000 shares of a company with one million outstanding shares would have a 10% ownership stake in it. Most companies have outstanding shares that run into the millions or billions.

Stocks are also called shares or a company’s equity.

Types of Stock

There are two main types of stock: common shares and preferred shares. The term equities is synonymous with common shares, because their market value and trading volumes are many times larger than those of preferred shares.

The main distinction between the two is that common shares usually carry voting rights that enable the common shareholder to have a say in corporate meetings and elections, while preferred shares generally do not have voting rights. Preferred shares are so named because preferred shareholders have priority over common shareholders to receive dividends as well as assets in the event of a liquidation.

Common stock can be further classified in terms of their voting rights. While the basic premise of common shares is that they should have equal voting rights—one vote per share held—some companies have dual or multiple classes of stock with different voting rights attached to each class. In such a dual-class structure, Class A shares may have 10 votes per share, while Class B shares may only have one vote per share. Dual- or multiple-class share structures are designed to enable the founders of a company to control its fortunes, strategic direction, and ability to innovate.

Why Companies Issue Shares

Many of today’s corporate giants started as small private entities launched by a visionary founder a few decades ago. Think of Jack Ma incubating Alibaba (BABA) from his apartment in Hangzhou, China, in 1999, or Mark Zuckerberg founding the earliest version of Facebook (now Meta), from his Harvard University dorm room in 2004. Technology giants like these have become among the biggest companies in the world within a couple of decades.

However, growing at such a frenetic pace requires access to a massive amount of capital. In order to make the transition from an idea germinating in an entrepreneur’s brain to an operating company, they need to lease an office or factory, hire employees, buy equipment and raw materials, and put in place a sales and distribution network, among other things. These resources require significant amounts of capital, depending on the scale and scope of the business.

Raising Capital

A startup can raise such capital either by selling shares (equity financing) or borrowing money (debt financing). Debt financing can be a problem for a startup because it may have few assets to pledge for a loan—especially in sectors such as technology or biotechnology, where a firm has few tangible assets—plus the interest on the loan would impose a financial burden in the early days, when the company may have no revenues or earnings.

Equity financing, therefore, is the preferred route for most startups that need capital. The entrepreneur may initially source funds from personal savings, as well as friends and family, to get the business off the ground. As the business expands and its capital requirements become more substantial, the entrepreneur may turn to angel investors and venture capital firms.

Listing Shares

When a company establishes itself, it may need access to much larger amounts of capital than it can get from ongoing operations or a traditional bank loan. It can do so by selling shares to the public through an initial public offering (IPO).

This changes the status of the company from a private firm whose shares are held by a few shareholders to a publicly-traded company whose shares will be held by numerous members of the general public. The IPO also offers early investors in the company an opportunity to cash out part of their stake, often reaping very handsome rewards in the process.

Once the company’s shares are listed on a stock exchange and trading in it commences, the price of these shares fluctuates as investors and traders assess and reassess their intrinsic value. There are many different ratios and metrics that can be used to value stocks, of which the single-most popular measure is probably the price-to-earnings (PE) ratio. The stock analysis also tends to fall into one of two camps—fundamental analysis, or technical analysis.

What Is a Stock Exchange?

Stock exchanges are secondary markets where existing shareholders can transact with potential buyers. It is important to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis. Companies may engage in stock buybacks or issue new shares but these are not day-to-day operations and often occur outside of the framework of an exchange.

So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company—rather you sell them to some other investor.

History of Stock Exchanges

The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities or trading hubs such as Antwerp, Amsterdam, and London. These early stock exchanges, however, were more akin to bond exchanges as the small number of companies did not issue equity. In fact, most early corporations were considered semi-public organizations since they had to be chartered by their government in order to conduct business.

In the late 18th century, stock markets began appearing in America, notably the New York Stock Exchange (NYSE), which allowed for equity shares to trade. The honor of the first stock exchange in America goes to the Philadelphia Stock Exchange (PHLX), which still exists today. The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Prior to this official incorporation, traders and brokers would meet unofficially under a buttonwood tree on Wall Street to buy and sell shares.

The advent of modern stock markets ushered in an age of regulation and professionalization that now ensures buyers and sellers of shares can trust that their transactions will go through at fair prices and within a reasonable period of time. Today, there are many stock exchanges in the U.S. and throughout the world, many of which are linked together electronically. This in turn means markets are more efficient and more liquid.

Over-the-Counter Exchanges

There also exists a number of loosely regulated over-the-counter (OTC) exchanges, which may also be referred to as bulletin boards (OTCBB). These shares tend to be riskier since they list companies that fail to meet the more strict listing criteria of bigger exchanges. Larger exchanges may require that a company has been in operation for a certain amount of time before being listed and that it meets certain conditions regarding company value and profitability.

In most developed countries, stock exchanges are self-regulatory organizations (SROs), non-governmental organizations that have the power to create and enforce industry regulations and standards.

The priority for stock exchanges is to protect investors through the establishment of rules that promote ethics and equality. Examples of such SRO’s in the U.S. include individual stock exchanges, as well as the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).

How Share Prices Are Set

The prices of shares on a stock market can be set in a number of ways. The most common way is through an auction process where buyers and sellers place bids and offers to buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.

The overall market is made up of millions of investors and traders, who may have differing ideas about the value of a specific stock and thus the price at which they are willing to buy or sell it. The thousands of transactions that occur as these investors and traders convert their intentions to actions by buying and/or selling a stock cause minute-by-minute gyrations in it over the course of a trading day.

A stock exchange provides a platform where such trading can be easily conducted by matching buyers and sellers of stocks. For the average person to get access to these exchanges, they would need a stockbroker. This stockbroker acts as the middleman between the buyer and the seller. Getting a stockbroker is most commonly accomplished by creating an account with a well-established retail broker.

Stock Market Supply and Demand

The stock market also offers a fascinating example of the laws of supply and demand at work in real-time. For every stock transaction, there must be a buyer and a seller. Because of the immutable laws of supply and demand, if there are more buyers for a specific stock than there are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.

The bid-ask or bid-offer spread (the difference between the bid price for a stock and its ask or offer price) represents the difference between the highest price that a buyer is willing to pay or bid for a stock and the lowest price at which a seller is offering the stock.

A trade transaction occurs either when a buyer accepts the ask price or a seller takes the bid price. If buyers outnumber sellers, they may be willing to raise their bids in order to acquire the stock. Sellers will, therefore, ask higher prices for it, ratcheting the price up. If sellers outnumber buyers, they may be willing to accept lower offers for the stock, while buyers will also lower their bids, effectively forcing the price down.

Matching Buyers to Sellers

Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers.

A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer. The more narrow the price spread and the larger size of the bids and offers (the amount of shares on each side), the greater the liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth.

Matching buyers and sellers of stocks on an exchange was initially done manually, but it is now increasingly carried out through computerized trading systems. The manual method of trading was based on a system known as the open outcry system, where traders used verbal and hand signal communications to buy and sell large blocks of stocks in the trading pit or the exchange floor.

However, the open outcry system has been superseded by electronic trading systems at most exchanges. These systems can match buyers and sellers far more efficiently and rapidly than humans can, resulting in significant benefits such as lower trading costs and faster trade execution.

High-quality stock markets tend to have small bid-ask spreads, high liquidity, and good depth, which means that individual stocks of high quality, large companies tend to have the same characteristics.

Benefits of Stock Exchange Listing

Until recently, the ultimate goal for an entrepreneur was to get his or her company listed on a reputed stock exchange such as the NYSE or Nasdaq, because of the obvious benefits, which include:

These benefits mean that most large companies are public rather than private. Very large private companies such as food and agriculture giant Cargill, industrial conglomerate Koch Industries, and DIY furniture retailer Ikea are among the world’s most valuable private companies, and they are the exception rather than the norm.

Problems of Stock Exchange Listing

But there are some drawbacks to being listed on a stock exchange, such as:

While this delayed listing may partly be attributable to the drawbacks listed above, the main reason could be that well-managed startups with a compelling business proposition have access to unprecedented amounts of capital from sovereign wealth funds, private equity, and venture capitalists. Such access to seemingly unlimited amounts of capital would make an IPO and exchange listing much less of a pressing issue for a startup.

The number of publicly-traded companies in the U.S. is also shrinking—from more than 8,000 in 1996 to around 4,300 in 2017.

Investing in Stocks

Numerous studies have shown that, over long periods of time, stocks generate investment returns that are superior to those from every other asset class. Stock returns arise from capital gains and dividends.

A capital gain occurs when you sell a stock at a higher price than the price at which you purchased it. A dividend is the share of profit that a company distributes to its shareholders. Dividends are an important component of stock returns. They have contributed nearly one-third of total equity return since 1956, while capital gains have contributed two-thirds.

While the allure of buying a stock similar to one of the fabled FAANG quintet—Meta, Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Google parent Alphabet (GOOGL)—at a very early stage is one of the more tantalizing prospects of stock investing, in reality, such home runs are few and far between.

Investors who want to swing for the fences with the stocks in their portfolios should have a higher tolerance for risk. These investors will be keen to generate most of their returns from capital gains rather than dividends. On the other hand, investors who are conservative and need the income from their portfolios may opt for stocks that have a long history of paying substantial dividends.

Market Cap and Sector

While stocks can be classified in a number of ways, two of the most common are by market capitalization and by sector.

The industry standard for stock classification by sector is the Global Industry Classification Standard (GICS), which was developed by MSCI and S&P Dow Jones Indices in 1999 as an efficient tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered industry classification system that consists of 11 sectors and 24 industry groups. The 11 sectors are:

This sector classification makes it easy for investors to tailor their portfolios according to their risk tolerance and investment preference. For example, conservative investors with income needs may weigh their portfolios toward sectors whose constituent stocks have better price stability and offer attractive dividends through so-called defensive sectors such as consumer staples, health care, and utilities. Aggressive investors may prefer more volatile sectors such as information technology, financials, and energy.

The year the first modern stock exchange opened in Amsterdam. There was only one stock to trade: the Dutch East India Company.

Stock Market Indices

In addition to individual stocks, many investors are concerned with stock indices, which are also called indexes. Indices represent aggregated prices of a number of different stocks, and the movement of an index is the net effect of the movements of each individual component. When people talk about the stock market, they often allude to one of the major indices such as the Dow Jones Industrial Average (DJIA) or the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and the fact that it only consists of 30 stocks (when there are many thousands to choose from), it is not really a good indicator of how the stock market is doing. The S&P 500 is a market-cap-weighted index of the 500 largest companies in the U.S. and is a much more valid indicator.

Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market sector. Investors can trade indices indirectly via futures markets, or via exchange-traded funds (ETFs), which act just like stocks on stock exchanges.

A market index is a popular measure of stock market performance. Most market indices are market-cap weighted, which means that the weight of each index constituent is proportional to its market capitalization. Keep in mind, though, that a few of them are price-weighted, such as the DJIA. In addition to the DJIA, other widely watched indices in the U.S. and internationally include the:

Largest Stock Exchanges

Stock exchanges have been around for more than two centuries. The venerable NYSE traces its roots back to 1792 when two dozen brokers met in Lower Manhattan and signed an agreement to trade securities on commission. In 1817, New York stockbrokers operating under the agreement made some key changes and reorganized as the New York Stock and Exchange Board.

The NYSE and Nasdaq are the two largest exchanges in the world, based on the total market capitalization of all the companies listed on the exchange. The number of U.S. stock exchanges registered with the Securities and Exchange Commission has reached nearly two dozen, though most of these are owned by either Cboe Global Markets, Nasdaq, or NYSE-owner Intercontinental Exchange. The table below displays the 20 biggest exchanges globally, ranked by the total market capitalization of their listed companies.

Source: Trading Hours.

How Does Inflation Affect the Stock Market?

Inflation refers to an increase in consumer prices, either due to an oversupply of money or a shortage of consumer goods. The effects of inflation on the stock market are unpredictable: in some cases, it can lead to higher share prices, due to more money entering the market and increased job growth. However, higher input prices can also restrict corporate earnings, causing profits to fall. Overall, value stocks tend to perform better than growth stocks in times of high inflation.

How Much Does the Stock Market Grow Every Year?

The S&P 500 has grown about 10.5% per year since it was established in the 1920s. Using this as a barometer for market growth, one can estimate that the stock market grows in value by about the same amount each year. However, there is an element of probability: in some years the stock market sees greater growth, and in some years it grows less. In addition, some stocks grow faster than others.

How Do People Lose Money in the Stock Market?

Most people who lose money in the stock market do so through reckless investments in high-risk securities. Although these can score high returns if they are successful, they are just as likely to lose money. There is also an element of psychology: an investor who sells during a crash will lock in their losses, while those who hold their stock have a chance of seeing their patience rewarded. Finally, margin trading can make the stock market even riskier, by magnifying one’s potential gains or losses.

The Bottom Line

Stock markets represent the heartbeat of the market, and experts often use stock prices as a barometer of economic health. But the importance of stock markets goes beyond mere speculation. By allowing companies to sell their shares to thousands or millions of retail investors, stock markets also represent an important source of capital for public companies.

Stock Market 101

Does a lack of confidence about how the stock market works put you off investing too? It doesn’t have to. We can help you understand what a stock market is, and how it works so the thought of investing seems less overwhelming.
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When you hear about the stock market does it feel like you’re listening to a different language? One you really want to learn but just can’t seem to grasp? You’re not alone, that’s for sure.

Does a lack of confidence about how the stock market works put you off investing too? It doesn’t have to. We can help you understand what a stock market is, and how it works so the thought of investing seems less overwhelming.

What are stocks?

There are two main types of stocks, one is called a common stock and the other is a preferred stock. The main difference between the two is that common stocks give shareholders the right to vote on company matters and participate in the growing earnings of the company while preferred stocks don’t. Preferred shares may come with a higher fixed dividend payout.
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Let’s break it down, starting with the basics. Stocks, also known as equities, are a security representing partial ownership of a publicly traded company. So, when you buy stocks in a company, it means you own a part of that company. A share is the unit of stock; the more shares you buy, the more stock you have in a company. Stocks are issued by companies to raise money to grow their business.

There are two main types of stocks, one is called a common stock and the other is a preferred stock. The main difference between the two is that common stocks give shareholders the right to vote on company matters and participate in the growing earnings of the company while preferred stocks don’t. Preferred shares may come with a higher fixed dividend payout.

What is a stock market?

Private companies list shares of their stock on an exchange through a process called an initial public offering (IPO). Investors purchase those shares, which allows the company to raise money from the public to grow its business. Once the company is listed on a stock exchange it is now a public company and investors can buy and sell the company’s shares on an exchange which tracks the stock price.

The supply and demand helps determine the price for each security at which investors and traders are willing to buy or sell.

An easy way to think about think about the stock market is to consider it as a network of stock exchanges where traders and investors buy and sell shares of publicly traded companies.

Private companies list shares of their stock on an exchange through a process called an initial public offering (IPO). Investors purchase those shares, which allows the company to raise money from the public to grow its business. Once the company is listed on a stock exchange it is now a public company and investors can buy and sell the company’s shares on an exchange which tracks the stock price.

The supply and demand helps determine the price for each security at which investors and traders are willing to buy or sell.

How does the stock market work?

The primary market is where securities are created, and a company lists their shares through an IPO. Remember, an IPO is when a company first lists their shares publicly.

The secondary market, which is essentially the stock exchange, is where the supply and demand of these shares (along with the thousands of other stocks on the market) are bought, sold, and traded every day. The TSX is open weekdays from 9:30am – 4:00pm (ET), the NYSE is open for business Monday to Friday, during the hours of 9:30am – 4pm (ET), the NASDAQ follows the same opening and closing schedule as the NYSE.

When it comes to trading shares on a stock exchange, there are two main types of investing strategies. Day trading, as the name implies, buying and selling the same shares within one day, sometimes making trades that last for just minutes or even seconds. The intent is to take advantage of small fluctuations in price. Then, there are more long-term trades or investments where the buyer holds shares for longer periods of time and hopes to take advantage of the company’s long-term growth in earnings.

The stock market serves two important purposes. First, it helps companies raise money often referred to as capital from the public by offering shares for sale, which can be used to fund and expand their business. Secondly, it gives an investor, who purchases those shares, an opportunity to have a share in the company’s profits. Investors can profit from owning stocks in one of two ways. Some stocks pay regular dividends (a given amount of money per share) at regular intervals which provides a return on the amount of money invested in the shares. Alternatively, a return can also be earned through capital appreciation which is when the stock price increases.
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To better understand how the stock market works, it helps to know that there are two types of markets: the primary market and the secondary market.

The primary market is where securities are created, and a company lists their shares through an IPO. Remember, an IPO is when a company first lists their shares publicly.

The secondary market, which is essentially the stock exchange, is where the supply and demand of these shares (along with the thousands of other stocks on the market) are bought, sold, and traded every day. The TSX is open weekdays from 9:30am – 4:00pm (ET), the NYSE is open for business Monday to Friday, during the hours of 9:30am – 4pm (ET), the NASDAQ follows the same opening and closing schedule as the NYSE.

When it comes to trading shares on a stock exchange, there are two main types of investing strategies. Day trading, as the name implies, buying and selling the same shares within one day, sometimes making trades that last for just minutes or even seconds. The intent is to take advantage of small fluctuations in price. Then, there are more long-term trades or investments where the buyer holds shares for longer periods of time and hopes to take advantage of the company’s long-term growth in earnings.

The stock market serves two important purposes. First, it helps companies raise money often referred to as capital from the public by offering shares for sale, which can be used to fund and expand their business. Secondly, it gives an investor, who purchases those shares, an opportunity to have a share in the company’s profits. Investors can profit from owning stocks in one of two ways. Some stocks pay regular dividends (a given amount of money per share) at regular intervals which provides a return on the amount of money invested in the shares. Alternatively, a return can also be earned through capital appreciation which is when the stock price increases.

Bull and bear markets

What do a bull and a bear have to do with the stock market? They refer to market conditions, whether it’s increasing or decreasing in value. One day the market goes up, and then the next day it goes down. These are called market fluctuations and they’re part of how the whole system works. The bull and the bear are two symbols that have long been associated with the stock market. A bear market is one where stocks are declining in value over a period of time and a bull market, is where stock prices are rising over a period of time. Typically, one market type follows the next and in general, the average bull market tends to outlast a bear market.

There are major market indices (the plural of index) that track the performance of a group of stocks. These indices are used to represent the movement of specific stock exchanges such as the TSX or NYSE and they’re the ones that are being referenced when the market goes up or down. Indices work by measuring a weighted average value of a collection of securities.

Some of the major indices are the TSX Composite, the Dow Jones Industrial Average (DJIA), the S&P 500 and the Nasdaq composite index. When an index drops, it means the average value of all the stocks in the index are down from the previous business day.

Commonly known stock exchanges in North America

The size of a stock exchange is directly related to the number and size of companies that are listed on the exchange. Below are three of the most commonly known American and Canadian stock exchanges.

NYSE (New York Stock Exchange) is an American stock exchange in the Financial District of Lower Manhattan in New York City and is the world’s largest stock exchange 1 by market capitalization of its listed companies with billions of trades happening daily.

What are brokerages?

Think of a brokerage firm as a type of financial institution that acts as a go-between (or broker). They help investors buy and sell stocks by working with both sides: the buyer and the seller. There are multiple ways to place a trade. You can place your buy and sell orders by phone, online or an app. Most brokerage firms charge per trade.

There are two main types of brokerage firms, Full-Service and Discount Brokerages.

Full-Service
Full-service brokerage firms are known for having a collection of diversified financial services and usually assign an advisor to each client. Sometimes they’re also able to offer additional financial services, including planning, consulting, wealth management and trust services. It’s worth noting that a higher level of service usually means a higher price tag.

Discount Brokerage
Rather than provide financial consulting or planning services, discount brokerages are a form of direct investing (or online investing), which provide self-directed investors access to online market research, online education, and a range of direct-access trading platforms. For example, with TD Direct Investing, you’re able to make trades over the phone, online, or through an app. Keep in mind that even though commissions may be lower, there can be a monthly fee associated with the more complex platforms. However, with TD Direct Investing, you may qualify for a waived maintenance fee, free streaming market data, and lower trading commissions.

Why invest in the stock market?

Although it takes time to understand the stock market and how it works, once you do, technology has made it easy to be involved with your own financial portfolio. By investing, you can also increase your financial literacy.

Of course, there are risks associated with investing in the stock market. You do need to educate yourself and invest wisely.
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The most obvious reason to consider investing in the stock market is to help grow your money over time. You’re also supporting other companies to grow and supporting the economy as a whole.

Although it takes time to understand the stock market and how it works, once you do, technology has made it easy to be involved with your own financial portfolio. By investing, you can also increase your financial literacy.

Of course, there are risks associated with investing in the stock market. You do need to educate yourself and invest wisely.

How to invest in the Canadian stock market

Whether you take the DIY approach or you have a financial advisor help with your investing goals, the more you know the better off you are towards making informed decisions.
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You’ve done your research on the stock market, and now you’re ready to invest. Your first decision is to decide if you’d like to do it yourself as a self-directed investor or work with an advisor. Learn more about your investing options in the article on How to Invest Your Money.

Whether you take the DIY approach or you have a financial advisor help with your investing goals, the more you know the better off you are towards making informed decisions.