Companies that go public are listed on one of the major U.S. stock exchanges. For investors, that presents an opportunity to invest in these budding businesses and see their money grow, and many companies themselves rely on investors to provide an influx of cash.
With that being said, though, how does the stock market (and stock exchanges) work? The following guide will introduce you to the basics of stock investing, so you can be better equipped to make solid financial decisions.
How the Stock Market Works
Understanding the mechanics of the stock market demands a basic knowledge of stocks, shares, and the exchanges through which they are bought and sold.
What Are Stocks?
A “stock” is an investment vehicle that represents ownership in a publicly-traded company. Stocks are purchased in units known as “shares,” and when a company’s value rises and falls, so does the price of its shares. Each share will have the same value: For example, if a company is worth $1 million and issues 10,000 stock shares, each will be valued at $100.
What Is the Stock Market?
The stock market is the venue through which investors and companies can buy, sell, and trade shares of stock. Though the term “stock market” refers to the broad landscape of investing, stock trades are more specifically conducted via stock exchanges.
The most well-known of these exchanges are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ), though many other exchanges exist, including over-the-counter (OTC) stock exchanges, though these tend to be riskier options.
What Is a Stock Market Index?
Financial analysts are also interested in understanding how the stock market works, and one of the primary means of measuring the performance of the market is by looking at various indices. A stock market index represents a cross-section of the entire stock market, containing a representative sample of companies within.
The most common stock market indices include:
- The Dow Jones Industrial Average (DJIA, or just “the Dow”) – contains 30 large-cap stocks
- Stanley & Poor 500 (S&P 500) – contains 500 large companies
- NASDAQ Index – contains 2,500 companies
If you’re one to keep up with reading or watching the news, you’ll likely hear about the movement of the Dow or NASDAQ. These indices do not wholly represent the entire stock market, though they are meant to accurately reflect how the market is performing.
How Does Stocks Work: What Determines Share Price?
Every publicly-traded company will sell its shares at a unique price, but how does the stock market work to determine a company’s share price?
Understanding IPO
When a company enters the stock market, they engage in what’s called an “initial public offering,” or IPO. Underwriters determine the company’s share price by giving the business a thorough valuation, considering data like discounted cash flow and enterprise value and comparing the company to others in the industry.
Supply and Demand Within the Stock Market
Stock prices will increase as the company performs well and when there are enough buyers for the company’s shares. Remember: There are only a limited number of company shares to go around, so if buyers are competing for them, it can drive their prices skyward.
Some companies deliberately inflate these prices through the use of specialists or market makers, which can give the company momentum if there are no other buyers at a given moment.
What Causes Dropping Share Price?
Share prices will decline if the company performs poorly, though a decline can also reflect broader industry trends. If shareholders start liquidating their shares, it can cause the price of each to drop since supply now far exceeds demand.
How Does Stock Market Work for Investors?
Naturally, investors have several questions regarding how the stock market works to build their investments. To that end, here’s what investors need to know about buying and selling stocks through the stock market:
Types of Stock
Investors can purchase two types of stock: common shares and preferred shares. The former provides you with voting rights, which give you a voice in the company’s decisions. Some companies go even further with a dual-class structure, giving Class A shares 10 votes per share, while Class B shares receive only one vote per share. In contrast, preferred shares lack voting rights, but their holders are given priority over common shareholders if the company is ever forced to liquidate its assets.
Fractional Shares
Say that you want to invest in a large-cap corporation like Chipotle. The company has been performing favorably despite inflation concerns, but that also means that each share costs over $1,600 (as of April 2023), which can be prohibitive for casual investors.
Many investing platforms allow you to purchase fractional shares, which — as their name may suggest — let you purchase fractions of a total share, which then allows you to invest in top-performing companies without having to empty your wallet.
Understanding Order Types
Investors can buy and sell stocks by placing “orders,” of which there are multiple types, all of which can influence an investor’s strategy. The most common types of stock orders are as follows:
- Market order: Agreement to buy/sell stock at its current market price
- Limit order: Agreement to buy a stock only at a predetermined price
- Stop order: Agreement to sell the stock if it drops below a predetermined threshold
Limit and stop orders require some strategic prowess. For instance, if you want to buy five shares of Company X, you might place a limit order to buy them only if the share price drops to $2,000 per share. Doing so will ensure that you never spend more than $10,000 on your total order, and if the price never drops, your order is never executed.
Stop orders work in much the same way, liquidating your stock if its price drops below a level you’re comfortable with, thus protecting you from severe losses. Investors can combine these features and those of limit orders in a stop-limit order, which provides a greater degree of control over when a stock is sold and for what price.
Dividends
If a company performs favorably, it can convert its excess profits into payments, known as dividends, which are then distributed to shareholders. For example, Pioneer Natural Resources recently offered common shareholders a cash dividend of $5.71 per share.
The advantage for the company is that these payments help attract and retain shareholders, and for investors, dividends offer a modest form of passive income, which can be converted into cash or even reinvested back into the company. Some dividend stocks even offer dividend reinvestment programs (DRIPs) which let you easily convert dividends into additional stock.
Funds
While it’s always possible to invest in individual stocks, doing so can be risky. Most investment brokers can assist in purchasing an investment fund, through which the money from multiple investors is pooled together, allowing you to purchase a fund that contains a small variety of stocks that often represent a range of industries.
Common funds include:
- Mutual funds
- Exchange-traded funds (ETFs)
- Index funds
The advantage of a fund is that it gives you direct access to built-in diversification, which can protect you from economic downturns as well as fill your portfolio with stocks from multiple industries.
The Best Decisions Come from the Best Data
How does the stock market work? The best way to answer this question is with time, experience, and the right research tools. Gorilla Trades can help. Each of our members gets access to more educational resources and tools to make and track your investments. Start your free trial and receive 30 days of stock tips delivered straight to your inbox.