How The Stock Market Works

By Cory Mitchell | August 26, 2014 AAA

If the thought of investing in the stock market scares you, you aren't alone. False promises and highly public stories of investors striking it rich or losing everything skew perceptions of the reality of the average investor. By understanding a little more about the stock market, and how the stock market works, you'll likely find it isn't as scary as you may think and that it's a viable investment.

What is a Stock or Share?

When you buy a stock you're buying a piece of the company. When a company needs to raise money, they issue shares. This is done through an initial public offering (IPO), where the price of shares are set based how much the company is estimated to be worth, and how many shares are being issued. The company gets to keep the money raised to grow its business, while the shares (also called stocks) continue to trade on an exchange, such as the New York Stock Exchange (NYSE).

Traders and investors continue to buy and sell the stock of the company on the exchange, although the company itself no longer receives any money from this type of trading. The company only receives money from the IPO.

Why Buy Shares?

Traders and investors continue to trade a company's stock after the IPO because the perceived value of company changes over time. Investors can make or lose money depending on whether their perceptions are in agreement with "the market." The market is the vast array of investors and traders who buy and sell the stock, pushing the price up or down.

Trying to predict which stock will rise or fall, and when, is very difficult. Over time stocks as a whole tend to rise, which is why many investors choose to buy a basket of stocks and hold them for the long-term, attempting to take advantage of the long-term bias and not concern themselves with the moment to moment fluctuations in stock prices. This is called diversification. The ultimate goal of buying shares is to make money by buying stocks in which you believe the outlook for the company is good and its perceived value (in the form of the share price) will rise.

Mature and established companies may also pay a dividend to shareholders. A dividend is a cut of the company's profit, which they send to you as long as you remain a shareholder and the company continues to pay the dividend. Aside from the dividend, the share price will continue to fluctuate, so the losses the gains associate with the share price are independent of the dividend. Dividends can be large or small (or nonexistent with many stocks); investors seeking regular income from their stock market investments tend to favoring buying high dividend paying stocks. 

When you buy shares of a company you own a piece of that company, and therefore have a vote in how it is run. While there are different classes of shares (a company can issue shares more than once), typically owning shares gives you voting rights equal to the amount of shares you own. Shareholders, as a whole based on their individual votes, select a board of directions and can vote on major decisions the company is making. 

Why Sell Shares?

For every stock transaction there must be a buyer and a seller. When you buy 100 shares of stock (called a "lot") someone else must sell it to you. Either buyers or sellers can be more aggressive than the other, pushing the price up or down.

When the price of a stock goes down, sellers are more aggressive because they are willing to sell at a lower and lower price. The buyers are also timid and only willing to buy at lower at lower prices. The price will continue to fall until the price reaches a point where buyers step in and become more aggressive, and are willing to buy at higher prices, pushing the price back up.

Investors don't all have the same agenda, which leads traders to sell stocks at different times. Someone may have reaped a nice a profit, and so they sell to lock in that profit and extract the cash. Another trader may have bought at a higher price, is now in a losing position, and chooses to sell because they don't want the loss to get bigger. Investors and traders may also sell because they believe the stock is going to go down, based on their research.

Volume

How many shares change hands in a day is called volume. Many stocks on major exchanges such as NYSE or NASDAQ have millions of shares issued. That means potentially thousands of investors in a stock may decide to buy or sell on any particular day. A stock that has lots of daily volume is attractive to investors because the volume means they can easily buy or sell their shares whenever they please.

When volume is inadequate, or no one is actively trading a stock, it's still usually possible to dispose of a small of amount of shares because the exchanges mandate certain traders (firms) to provide volume. These traders are commonly referred to as Market Makers, and act as buyers and sellers of last resort when there are no buyers or sellers. They don't have to stop a stock from rising or falling though, which is why most traders and investors still choose to trade stocks with lots of volume, and thus not rely on these "market makers" which are now mostly electronic and automated. There are still people on the floor of the NYSE. Those men and women in the blue jackets trade stocks for their firms, and also help facilitate orders from the public (see above).

The Bottom Line

Stock are issued by companies to raise cash, and the stock then continues to trade on a exchange. Overall stocks have risen over the long-term which makes owning shares attractive. There are also additional perks such as dividends (income), profit potential and voting rights. Share prices also fall though, which is why investors typically choose to invest in a wide array of stocks, only risking a small percentage of their capital on each one. Shares can be bought or sold at any time, assuming there is enough volume available to complete the transaction, which means investors can cut losses or take profits whenever they wish.

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