How does the stock market work

How Does The Stock Market Work

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How does the stock market work? In the simplest terms, the stock market is similar to a giant auction house. It’s where people can buy and sell investments referred to as stocks via a stock exchange. Stocks are shares of ownership in a public company and they are sold between traders and investors for negotiated prices.  

Companies offer shares in their business as a way to raise cash and traders then try to make money from these shares by purchasing or selling them at the right time based on what the overall stock market is doing. The level of supply and demand for each stock determines the price and the entire process is managed online via stock brokers.  

Find Out More About The Stock Market 

The Stock Market can seem like a daunting place for the uninitiated, so if you’re a first time investor, are considering getting into online trading of stocks and shares, or are just curious to know what the stock market is and how it works, then you’re in the right place as we’re going to take you through everything you need to know. 

Investing in the stock market can be a great way to make money if you know what you’re doing. As online trading educators, the team here at Trade Room plus supports thousands of investors taking their first steps into the world of online trading every year making us well placed to help you understand how the stock market works. 

Now that we’ve given you a simple snapshot of how the stock market works, in the rest of this article we will take you through what the stock market is and how it works in more detail as we aim to provide a  great introduction for those looking to enjoy a successful and profitable start to trading stocks online.

We will cover: 

  1. What is the stock market
  2. What does the stock market do
  3. What are stocks 
  4. Why are stocks issued
  5. How is the price of stocks determined 
  6. Why do stock prices fluctuate
  7. Analysing the stock market
  8. What type of stock should you invest in
    1. What are common stocks
    2. What are preferred stocks
    3. Categories of stock 
  9. Why should I invest in the stock market
  10. How to invest in the stock market 
    1. Finding a good broker
    2. Investment options
    3. Stock mutual funds
    4. Individual stocks 
    5. How to minimise risk
  11. Why is time invested so important 
  12. Stock market trading 101 
  13. Find out more about trading online 

What Is The Stock Market? 

The stock market is where investors connect to buy and sell stocks, which are shares of ownership in a public company.

Investors hope to make a profit from their investment via movement in stock prices and the term stock market itself generally refers to one of the major stock market indexes such as the FTSE 100 or Dow Jones Industrial Average or the S&P 500. 

Market Indexes are a group of investment holdings which represents a segment of the financial market. Because it’s hard to track every single stock available, these indexes include a section of the stock market and their performance is viewed as representative of the entire market. 

What does the stock market do? 

Companies list shares of their stock in order to raise cash to grow their business further. They list their stock on a network of exchanges (the stock exchange) through a process called an ‘initial public offering’ (IPO) and this makes them available for purchase by traders and investors. 

The stock exchange monitors the supply and demand of each stock listed and traded between investors. Those in high demand will command a higher purchase price than those less in demand and the whole process operates much like an auction house, enabling buyers and sellers to negotiate prices and make trades.

What Are Stocks?

The stock market at work

A stock is an investment into a public company. Companies can sell shares of stock to the public as either common stock or preferred stock and those that purchase stocks from companies own a small piece of that company called a share and are therefore shareholders. 

Why Are Stocks Issued?

Stocks are issued by companies in order to raise cash, usually in order to grow their business or take on new projects. The process of selling shares dilutes the company’s ownership and ownership is determined by the number of shares a person owns relative to the number of shares available. 

For traders and investors, stocks provide a platform to grow their wealth and they hope that any money invested will grow with the company and profit from it’s success, as with certain kinds of share ownership comes a claim to a proportion of the company’s assets and earnings. Investors will usually purchase stocks in companies that they think will go up in value so they can sell their share for a profit.  

How Is The Price Of Stock Determined? 

The initial public offering, (IPO) will in theory be equal to the value of its expected future dividend payments but this price will fluctuate based on supply and demand. 

Potential buyers of any given stock will offer a ‘bid’ via their trading account. This bid indicates the highest amount they are willing to pay, which is usually lower than the amount the seller is asking for. For the trade to go ahead, the buyer will need to increase their price or the seller will need to decrease theirs. The goal of any investor is to buy low and sell high. 

Although the price of each stock is managed individually by its supply and demand, the overall stock prices will move up or down in relation to what is going on in the world’s political and economic markets and generally follow cycles known as a bull market, (Economically sound and on the rise) or bear market. (receding & declining in value).  

Traditionally this bidding process took place in person but nowadays the process is managed by online stockbrokers who can match buyers and sellers across the stock exchange in split seconds. 

Why Do Stock Prices Fluctuate? 

Money on the stock market

The price of stocks will go up and down because new investors are entering the market all the time. As they enter they bring with them new target buying and selling prices and if someone needs or wants to get out of the market quickly, they will often buy or sell for whatever price they are offered.

Aside from supply and demand surrounding the stocks available and the prices traders are willing to buy and sell at, market sentiment and company performance will also impact the price of stocks. 

Market Sentiments – Sentiments of the market drive attitude of an investor towards the direction of the market. Sentiments are bullish when the prices are rising and are bearish when prices are falling.

Company’s performance – Current performance of a company has a huge role in determining its stock price. Any recent change or introduction of a new product will have an impact on the stock price of a company.

How To Analyse The Stock Market? 

The stock market increasing

Knowledge is power when it comes to investing and you won’t know what you should invest in without conducting your own research or paying attention to those that regularly analyse stock markets professionally. 

Those that invest in the stock market generally tend to focus on a particular industry or sector (find out more about these later in this article) and then take a deep dive approach to finding out as much as they can about those areas, what causes them to do well or struggle. 

This kind of research will help an investor to spot when the market might be on it’s way up, down, or is under pressure so they can make a logical decision on when would be a good time to take action in the form of buying or selling the stocks they’re invested in. . 

When deciding how to invest you should review company finance statements, business models, growth analysis and look at their competitors and suppliers in order to get a big picture of its stability and ability to withstand market pressures. Finally, review the company’s stock value – You will have to decide if it’s worth the asking price and if there’s potential for growth.

What Type Of Stock Should I Invest In? 

The type of stock that you invest in should be entirely dependent on your trading style, how much you have to invest, your attitude to risk and how much time you can dedicate to trading. To take advice from one of the most successful traders in the world; “Buy a stock the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market.”

What Are Common Stocks

As the name suggests common stocks are the most common type of stock issued by companies. Common stocks give owners voting rights proportional to the number of shares owned and have the potential for higher long term returns as they entitle shareholders to a share in the company’s profits, meaning stock owners share the company’s success or lack of it.

As there are no price ceilings, it’s possible for shares to multiply in value several times over – but know they can always lose value too. The downside to common stocks is that dividends are not always available and if they are, they are not guaranteed and are generally lower than preferred stocks but common stocks are a good option for investors looking for long term investment growth.

What Are Preferred Stocks

Preferred stocks are generally considered less volatile than common stock but this means there is also less potential for profit. Preferred stocks don’t come with voting rights and generally have lower long-term growth potential than common stocks. Dividends are typically higher, fixed, guaranteed and paid out before the dividends on common stock – important in the case of bankruptcy or liquidation.

For those investing for income via dividends, preferred stock can be an attractive option but note that if company profits rise, preferred dividends are fixed. Preferred stock is good for investors looking for income over long term growth but you should note that companies can purchase preferred shares back from shareholders at any time for any reason.

Categories Of Stock 

Stocks are generally grouped into categories based on company size, industry or sector, how they react to the strength of the economy as a whole and their potential for growth and stock will generally fall into multiple categories. 

  • Company Size – Also referred to as large-cap, mid-cap and small-cap, short for marketing capitalisation and is a measure of the dollar value of a company. This value figure is worked out by multiplying the amount of outstanding shares by the current market price and generally fall into the following brackets: $10 billion or more, $2 – $10 billion and $300 million – $2 billion respectively. 

  • Industry & Sector Stocks – examples include utilities, financial companies, technology sector. It’s important to have an understanding of what industry your stocks are in as those in the same industry can often react in the same way to market or economic events so it’s important to invest in stocks from a variety of sectors to spread your risk. 

  • Growth & Value stocks: These are stocks that are either growing quickly (growth stocks) or are deemed to be under-priced by investors with the assumption they will increase in price eventually. (value stocks). 

  • Defense & cyclical Stocks – How stocks react to the strengths and weaknesses in the general economy. Defence stocks generally industries that people always need such as groceries, medicines and utilities whereas cyclical stocks are more sensitive to economic fluctuations like luxury goods and travel. 

When Should I Invest In The Stock Market?

You should only invest in the stock market when you are confident you know what you are doing, have the money to do so, are willing to lose some or all of your investment, and can commit to staying in the market long enough to see a return on your initial investment. 

If you can satisfy these criteria then the stock market is a good investment for long-term investors, including beginners. Stocks make excellent long term investments (over five years) because it’s rare for any market downturn to last longer than that and it gives your money time to grow and beat inflation over time.

If you’re looking to build a retirement fund, stocks are a great way to do this if you have plenty of years before you retire but as you draw closer to when you want to be able to use your investment cash, you should move to safer investment choices such as bonds. 

How To invest In Stocks

If you’ve decided that investing in stocks is for you and you want to manage your investments yourself, you will need to open an account with an online broker. A broker is an individual or company that is licensed to trade stocks through the exchange and they will provide traders with trading software that can be used to access the markets they want to trade in. 

When you have selected an online broker, you will have the option to manage your stock investments yourself or can choose to use their auto-advisor services that will take care of the legwork for you. If taking the DIY approach, you can open an individual retirement account (IRA) or you can simply choose a taxable brokerage account if your retirement fund is in place elsewhere. 

How To Choose A Good Broker

Do your research. Look at customer reviews, ensure they are fully regulated and conduct transactions using secure and encrypted technology. Also consider the expenses you will be liable for such as trading commission and account fees, as well as checking that they can actually offer access to the kind of stocks that you want to invest in. 

What Are My Investment Options? 

Once you are all set up with your broker, the next step is to decide what you’re actually going to invest in and how. For most people this is a choice between stock mutual funds or individual stocks.  

Stock Mutual Funds 

Stock mutual funds let you purchase small pieces of lots of different stocks in one transaction meaning you will own small parts of each of the companies within the fund. Investing in several funds together is a good way to build a divest investment portfolio. Examples of mutual funds include index funds and exchange traded funds (ETFs) and they allow you to invest in a healthy chunk of the stock market in one go. 

Individual Stocks 

If you know that you want to invest in a specific company, you can purchase a single share in that company or multiple shares. Taking this approach will take a longer time to build a diverse investment portfolio and it usually requires higher levels of investment capital. You will also need to know how to manage a portfolio, which only comes with time and experience. You should only invest in individual stocks if you truly believe in the company’s long term growth. 

What Are The Pros And Cons Of These Investments? 

Whatever you invest in, there will always be a risk but as stocks are likely to experience sudden dips, if you are likely to need your money back in the short term, then you may want to consider other types of securities to invest in. 

The stock market will go up and down and your appetite for risk should determine how much you invest and what in. Mutual Funds tend to be diverse so you are spreading your risk but individual stocks can often be seen to rocket (or decline) in value very quickly making them more volatile in times of market uncertainty. . 

How To Minimise Risk Investing In The Stock Market 

The risks of the stock market and how it works

To minimise your risk when investing in the stock market you should:

  1. Have an clear investment goal and trading strategy to follow
  2. Have a diverse investment portfolio that spans multiple products and economic sectors
  3. Learn as much as you can about the companies and markets that you want to invest in
  4. Make logical decisions regarding the risks you are prepared to take
  5. Never invest more than you can afford to lose 
  6. Never invest more than 1-3% of your trading account in any one trade. 

Knowledge Is Power 

We’ve all heard the phrase knowledge is power, and taking the time to learn about the various industries you trade in, the variables that are likely to impact the trades you take part in such as market fluctuations and business sales, how they generally perform, along with any known cycles, will help your ability to look for key signs and act at the right time to improve your success rate and minimise risks when trading. 

Learn From Your Mistakes

It goes without saying that you will lose money when trading but by keeping a trading diary you can look back at your successes and your mistakes in order to keep honing your strategy. We recommend and use Edgewonk here at Trade Room Plus. 

The Risk / Reward Ratio 

The risk reward ratio is a measure of how much a trader can expect to earn for every dollar that is invested and should be used for every trade you want to make.

The actual ratio used will vary between traders, their strategies and the markets they operate in but generally speaking 1:1.5 is seen as an ideal place to start. It is calculated by dividing the amount they stand to lose if the price of an asset moves in an unexpected direction (the risk) by the amount of profit that is expected when the position is closed (the reward.) 

Why Invest In The Stock Market? 

Why invest in the stock market

With the right education, time and dedication, online traders can make returns that beat any savings account going with an average return of nearly 10%. 

To ensure you enjoy this healthy level of return, you must stay in the market long enough as the time in market is your best predictor of performance. Sadly many investors move in and out too quickly and therefore miss out. 

Why Is Time Invested So Important?

We’ve all heard the phrase, “Time Is Money” and when it comes to the stock market, time really can MAKE you money, but why is this? 

In the simplest terms, the longer you invest for, the more opportunity there is for your investment to go up as if you invest wisely, companies profits will tend to go up over time, meaning a better return for the investors who bought shares. 

Secondly, if the company you invest in pays dividends, then you can collect additional returns here too – but only if you’re in the market on the critical payout dates which is less likely to happen if you’re trading stock left right and centre. 

A motivation trading quote to remind you to be patience when investing in the stock market is: 

“Time is your friend; impulse is your enemy.” – John Bogle

So always be patient and don’t give into your impulses when investing in the stock market. 

Stock Market Trading 101

We’ve covered a lot of ground on the stock market now so we’ll finish up with some general advice for trading online as a whole. 

Trading isn’t easy and it relies on your ability to learn a set of rules to play by and the parameters in which to play them. This is called your trading strategy and the goal of your trading strategy is to give you the tools you need to know when and how to make a final trading action of buying or selling a financial security. Find out how to create your trading strategy here. 

Aside from learning as much as you can, knowing your attitude to risk and having a plan, we recommend you pay attention to the following tips for a successful online trading experience whilst you’re learning the stock market basics. 

  • Reduce expenses – keep broker commission costs and account fees to a minimum  
  • Analyse your performance – keep a trading diary to see what works and what didn’t 
  • Analyse the markets you’re trading in – stay on top of factors likely to affect growth trends and Follow respected financial journalists that cover the products, type of investments, companies and markets that you’re interested in trading in. 
  • Know your attitude to risk – and invest accordingly 
  • Be prepared to lose money – all investors will lose money at some point 
  • Find a good teacher & practice – learn from those who can demonstrate they know what they’re doing and practice with dummy investment accounts before spending a penny of your real money. 

Where Can I Find Out More About Trading Online? 

We hope this article has provided a broad overview of what the stock market is and how it works by answering some of the most frequently asked questions of new investors. 

If you have decided that you would like to join the exciting world of online trading, the best way to learn the ropes is to see it demonstrated by somebody who knows what they’re doing, then try it yourself under the guidance of an expert before taking the plunge to start trading solo which you can do with the expert team at Trade Room Plus. 

Try Trade Room Plus FREE for 14 days 

If you’re ready to join thousands of online investors taking control of their financial profitability online, our online trading education hub, free 14 day trial and excellent customer satisfaction scores make Trade Room Plus a brilliant place to start your online trading journey.  

Have a look at our live trade room and our membership options if you want to take courses, see live trading in action and receive our profitable trade signals. Our membership and the training education available is suitable for those looking to trade part-time either in the evening or during the day and those wishing to trade full time

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