How the Stock Market Works: A Beginner’s Guide

how the stock market worksThe stock market, which is also known as the stock exchange or equity market, is the platform where publicly traded companies sell their stock to attract investors. The main aim of the stock market is to facilitate the buying and selling of shares between buyers/traders and investors. This can be done virtually or from a trading floor. Without the stock market, it would be difficult to trade stocks. Whenever stocks are sold on the stock market buyers and traders are attracted for different reasons; while traders will try to bid higher or lower prices for a share depending on how they feel about the future potential of a company, buyers seek lower prices to guarantee higher return on their investments when they decide to sell.

The course Stock Market For Beginners-Learn to Trade provides over 42 lectures that help beginners to understand the market, use software, check indicators among other areas to trade successfully.

Stock Market Terms

Before we more forward, lets establish the definitions of some commonly used terms on the stock market:

  • Stock

Stocks are sold by public traded companies to raise capital they need to ensure the daily operations of the company are carried seamlessly without any type of financial glitches. Apart from raising capital, the owners of the company may also want to avoid selling their business in order to pay investors who initially invested in their ideas. Investors can offer their percentage of shares for sale and their return may be higher or lower based on the market sensitivity at the time of selling. The sale of stock is a form of equity financing that does not involve the high interest rates associated with debt financing (borrowing money through a loan). The sale of stock may also be a form of encouraging top performing employees to invest in the company by their share ownership.

  • Share

A share of stock gives buyers some type of “ownership” in a company depending on the number of shares they buy. With the share of stock the buyer may be entitled to some of the assets of the company. Those that acquire the shares are referred to as stockholders/shareholders.

  • Initial Public Offering

An Initial Public Offering essentially happens when a company moves from private to being public so that it can offer shares to the general public. The Initial public offering is part of the primary market. A Secondary IPO occurs after the initial IPO and the time-frame is established according to the companies needs and governing regulations. The Secondary IPO is part of the secondary market.

  • Dow Jones Industrial Average

Often referred to as the DJI of simply “the Dow” are indicators within the United States that measure different sectors such as industry, transportation and utilities. They are used to track the stock exchange by using the best companies to represent the main industries considered in the indice calculations.

  • Bull Market

Whenever the economy is growing, investors refer to this as a bull market. This is commonly caused by progress through business development in different sectors that impact the economy. In the bull market, investors take advantage of the rising stock prices with the sole intention of capitalizing on the good financial climate. A rise in stock occurs when the demand for good and services is more than the available good and services as explained below.

  • Bear Market

The bear market is the contrary of the bull market where the economy presents a stagnated or slow development profile. During this period investors usually consider investing in bonds instead of stocks because of the uncertainty of the market. In the bear market, stock price fall considerably.

The Supply Demand Relationship In the Stock Market

To understand how the stock market works it is important to first understand the relationship between supply and demand. The basic formula that establishes the relationship is: Price (P) = Demand (D) / Supply (S)

What this formula shows is that price is inversely proportional to supply. This simply means that the more goods are being supplied in the market, the lower the prices. On the contrary, price is proportional to demand which reinforces the theory that once demand increases, the price will also increase. By reducing supply, the price also increases.

The relationship with the above explanation and formula with the stock market is that without the rise of money (or demand) there will not be a rise in stock prices.

Trading On The Stock Market

In the United States, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ) have been around since the nineteenth and twentieth centuries respectively as the major stock exchanges in the country. While the NASDAQ offers an over-the-counter (OTC) market arrangement, the NYSE involves face-to-face trading with a trading floor where brokers meet.

A recently approved merger in January 2014 of Bats Global Markets Inc. and Direct Edge Holdings LLC, by the Securities and Exchange Commission (SEC), established the Bats Global Markets – which is now larger than NASDAQ. It is important to note that every country has its own stock exchange and by following the behavior of exchanges and indices, investors are able to assess the state of the economy and decide where to put their money.

The main advantages of investing in the stock exchange is that over time the shares probably increase in value and investors can enjoy better return on investment through dividends. The payment of dividends is done on a per share basis and depends on the size and policies of the company the investor is investing with. Large companies generally offer dividends to investors and make an effort to adjust the amount paid on a yearly basis to investors, whereas, small companies rarely offer dividends as part of their share packages.

If the shares do not increase in value, the inverse is true that they will decrease and investors will lose the monetary value they initially paid to have them. The demand for a company’s share is governed by how people perceive the company will perform. If a company maintains a clean record, shows promising profitability and is growing considerably, people are more likely to invest. However a company that is riddled with scandals and other disturbing news will push investors away, consequently leading a slump in share prices. This is why many people consider trading on the stock exchange as risky because it can be rather cruel to companies and investors alike due to its fluctuating nature. Buying trends of the stock market are better explained in the course Essential Options: Strategies for Mastering the Stock Market.

When a private company decides to go public to raise capital on the stock market it will issue what us known as an IPO as defined in the definitions above. This step will involve the company directly, as it is the one that creates the securities it intends to sell. When the previously created securities are re-traded they are traded on the Secondary IPO. The Secondary IPO is in fact the stock market or stock exchange which is part of the secondary market as explained above.

Finding the best stocks to buy is usually a challenge for first-time investors. Different people apply various strategies to get the best stocks that will give them higher returns when the prices go up. This can range from suggestions from brokers, positive news about a company, indicators, technical analysis of the markets to a mere hunch. When investing, it is oftentimes tempting to want to invest a large amount on shares that appear will do well. However, it is important to remember that there is no guarantee given the volatility of the stock market to certain factors. Most investors will pay attention to the market to determine whether it has the characteristics of a bear or bull market. If they are confident there is a bull market, they will go ahead and invest in stock. However, if they see that it is a bear market, they will refrain from investing in stock and consider safer investment options. The blog post Finding Share Trading Tips for Beginners highlights some other useful ways to stay grounded when considering investing through the stock exchange.

The Types of Orders

With the rise of the internet just about anyone can trade on the stock exchange by simply buying stocks online or going through a stock or discount broker. The difference between the two is based on the type of services they offer. Where a stock broker will offer guidance a discount broker simply performs what the client directs. When buying online, this is done by depositing money into the brokers account and subsequently placing an order for the stocks that are promising. There are essentially three types of orders that a broker can place and each has its specific distinction: limit order, market order, and stop order.

  • Limit Order

A limit order is placed when the prices of the stock are satisfactory and never before. It is based on the parameters that investor and broker establish as suitable. The limit order arrangement is clearly the best because it offers the investor the opportunity to capitalize on the favorable situation of the market.

  • Market Order

This is the easiest form of stock trading and basically involves little research. The broker that is handling the transaction simply buys and sells stocks at the best prices.

  • Stop Order

A sharp decline in the value of a stock can result in great financial losses. To avoid this, investors usually give brokers the authority to sell shares before the price slips too much If shareholders and brokers scramble to sell the shares to avoid falling prices, this can lead the stock market to crash if many buyers are suddenly trying to trade their stocks. This situation can lead to a recession which can cause serious economic problems that may take years to resolve.

The stock exchange is restricted and not just about any investor can trade directly. Brokers will charge a fee for their services so this must also be considered carefully when considering the amount of money to spend. It is important that the actual value of their services is clearly outlined to determine whether it is variable or fixed.

Understanding the stock exchange as a beginner can feel intimidating at first, but with the right information first-time investors can master the symbols and technicalities of trading through a broker. Those that prefer to hold the bull by the horns can learn from the How to Invest in The Stock Market course and also the 133 lectures of the Option Profit Mini Course – Learn How to Trade Stock Options.