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How Does the Stock Market Work? Detailed Guide for Beginners

Knowledge Crunch | Wednesday, July 28, 2021 11:55 AM GMT

Want to know how stocks work?

Oftentimes, there can be a lot of jargon associated with stock trading that can make it an intimidating process to start.

You'll need to put in the time to research stock and the markets you invest in, and being here is the first step. 

We're going to cover all the information you need to know about how the stock market works, including:

 

 Let's get right to it.

 

Table of Contents

 

What is a Stock? A Simple Definition of ‘Stock’

How Does the Stock Market Work?

Types of Stocks

How Are Stock Prices Set?

What is a Stock Exchange?

How Do You Invest in the Stock Market?







What is a Stock? A Simple Definition of ‘Stock’

A stock is a security that represents your ownership stake in a company, giving you the right to have a claim on the assets and earnings of the business. 

When you own stock in public companies you may be able to:

  • Get paid a dividend, or share of the profit, from the company depending on when you bought your stock
  • Have a right to vote on the direction of the company at the annual general meeting (AGM), depending on the type of stock you own
  • Receive a share of liquidated assets if the company closes 

 

Photo by Scott Graham on Unsplash

To own stocks, you need a brokerage firm who will be the "middleman" and purchase the stock on your behalf - we'll get into more details about how a brokerage helps you soon.

You've likely heard the phrase "stocks and shares" and may even hear some people use the words interchangeably, but are they the same thing?

 

What is the difference between a stock and a share?

The main difference between stocks and shares is that stock is a collective term for each piece of a company you own, whereas a share is each piece of each company you own. 

Think of it like talking about the suit you just bought.

You would tell your friends you just bought a new suit for work, which is a collection of items like the blazer, pants, waistcoat, tie, etc. 

The suit is stock - a collection of items that comes together to be known as one word. 

Each item we listed is a share; the basic items that make up the collective. 

If you were to say to your friend, "I own stock in Apple," this means that you own more than one unit, or certificate, in Apple. 

However, if you instead say, "I own a share of Apple," you'd be telling them you have exactly one piece of Apple; "I own shares in Apple," will also mean you own more than one share.  

Photo by Julian O'hayon on Unsplash

 

Generally, you won't trip yourself up in a conversation about the stock market by using the words interchangeably, but it is worth being aware of the subtle difference. 

Now you know what stock is, it's time to find out where you go to buy some.

 

How Does the Stock Market Work?

A stock market is a place where licensed people, or brokers, go to buy and sell stock in a company. 

How does that stock get there and why do people want to own it? 

First, a company needs to be listed on a market like the New York Stock Exchange (NYSE), based on Wall Street, for people to be able to trade its shares. 

A company will choose to list its shares to the public usually in order to raise cash to invest in the business activities and it's called an IPO, or initial public offering. 

When this happens, the company sells off slices of the business so anyone is able to buy a piece and the company receives the money. 

Facebook Inc., traded with the symbol FB on the Nasdaq exchange, had one of the largest IPOs in the last decade with an initial share price of $38, and $16 billion was raised when it first sold stock on May 18, 2012. 

Photo by Solen Feyissa on Unsplash

 

After the process of first selling off shares is complete - known as the primary market -  traders and investors can buy and sell the stock between each other at whatever price they agree on - which is called the secondary market. 

Important players in keeping a stock market functioning are market makers. 

A market maker is usually a company, likely a brokerage firm, that will publicly list their buy and sell prices, connecting buyers and sellers by facilitating both sides of the transaction. 

It's unlikely individual investors will come into contact with a market maker directly, but it's useful to be aware they exist.  

 

Now we're going to look at the different types of stock you buy on the stock markets.

 

Types of Stocks

There are two main types of stock that investors buy: common and preferred stock. 

Both types of stock can be bought through a broker, although not all brokers will trade in preferred stock, so it's worth checking before you open an account if this is the type of stock you want. 

Key differences between the two types of stock are:

  • Voting rights
  • Dividend payments
  • Value and price
  • How they are handled during a liquidation

 

We're going to look at each of these factors for both common and preferred shares before looking at a different type of stock called over-the-counter stock.

 

Type #1: Common stock

Common shares are the type of stock that you'll probably think of when talking about Wall Street stock trading. 

This stock gives the owner the right to vote on decisions in the business, for example at the AGM, when looking at who to appoint to the board of directors for example. 

Not all common stock will receive dividend payments - Tesla doesn't pay a dividend on its common stock whilst Apple (AAPL) has paid a dividend each quarter for many years. 

Image Source: Nasdaq

 

The price of common stock is more closely linked to the success of a company than preferred stock and may be more likely to perform better in the long run in terms of price increases. 

In a liquidation of a company - when it's closed down and all assets are sold off - owners of common stock are last in the queue to receive a payout.

 

Type #2: Preferred stock

Few major stock companies offer preferred stock, but if you're interested in investing in this type of stock, there are exchange-traded funds (ETFs) such as the iShares Preferred and Income Securities ETF (PFF). 

Image Source: Yahoo Finance

 

Preferred stocks don't give the owners the right to vote on the company direction or any other business decision. 

In terms of dividends, the returns on preferred stock tend to be higher and a company must pay dividends to preferred stock before they pay out anything to common stockholders. 

The market price of a preferred share is linked to the price of the share rather than how the company is performing - in this way it's more like a bond that you invest in for the potential yield. 

If the company you own preferred shares in goes through liquidation, you'll get preference for a payout over common stock.

 

Type #3: Over-the-counter stock

When a stock isn't eligible to be traded on the main stock markets, it's traded over-the-counter and is known as an OTC security. 

Lots of OTC securities are penny stocks - stocks that trade for less than $5 each, according to a definition by the US Securities and Exchange Commission (SEC). 

These stocks aren't as easy to trade since they're in smaller companies and the chances of finding a person to buy them from you are smaller - there aren't market makers for OTC securities like on the stock exchanges. 

Moving on to see how the price of a share is determined.

 

How Are Stock Prices Set?

The basic premise for how a stock's price is set is the supply and demand in a market. 

In simple terms, when there's high demand for a share of stock, the price will increase until the number of shares available matches the number of people happy to pay the price. 

Conversely, when no one is interested to buy a share at its current price, that price will need to drop until people are willing to pay that sum of money. 

The supply side of the market works in a similar way - when there's a high number of shares available to buy, the price will be low because there is no scarcity, whereas when there aren't many shares available, prices are high because the shares are hard to come by. 

The price that someone is prepared to sell a share at is called the ask price, whilst the price someone will buy at is the bid price

Each party - the buyer and seller - must be content with the price for the deal to go through. 

This is the general theory of why shares of stock are at a certain price, but there are a whole range of other factors that go into setting the price, so let's explore them.

 

Element #1: Company performance

How well a company is performing, in terms of revenue, profit, and dividends they pay, is one of the key factors in the price its shares will trade at. 

How much a trader is prepared to pay for a share of a company is based on how much they think that company is worth. 

A company that announces healthy profits will likely see a short-term increase in its stock price. 

For example, when Google (GOOGL) announced better than expected profits for the first quarter of 2021, their stock price jumped more than 4% from 2,290 to 2,392 in the two days after the announcement. 

Image Source: Yahoo Finance

 

In more detail, analysts will look at the price market investors are prepared to pay for a stock compared to the money the company earns, known as the price/earnings ratio. 

This ratio is calculated by looking at the market capitalization - the total value of all shares - and dividing it by the company's net revenue for the year. 

 

Other company news can also cause price movements and cause investors to buy or sell shares, such as:

  • A change in leadership
  • A new product launch
  • Missed financial targets
  • Changes in operations

 

Moving on to the next thing that can determine the price of a stock.

 

Element #2: Market environment

Much more outside the influence of a company are factors within the stock market that can affect the price of individual stocks

In a bull market, prices of stocks rise further than you'd expect based on company information, meaning prices of a share may be higher in a bull market than in normal times. 

A recent example would be the increase in the Nasdaq between March 2020 and February 2021, where there was a more than 100% increase in the overall value of the market. 

Image Source: Yahoo Finance

In contrast, a bear market is when the overall price of a stock in a financial market reduces for a long time, affecting the prices of most if not all of the stocks being traded. 

It's not always easy to know when the market is bullish or bearish so this factor may not be able to inform your investment decisions, but it's useful to understand how to read historic data.

 

Element #3: Politics and macroeconomics

Markets don't function in a vacuum - the political climate and what's going on in the wider economy will affect the price of an individual stock or the wider market. 

The sudden drop in the market we can see in the previous screenshot was mirrored the world over as the recent coronavirus pandemic spread globally. 

As you can see in the Dow Jones Industrial Average (DJIA) stock index...

Image Source: Yahoo Finance

… and the London Stock Exchange's FTSE100 composite index:

Image Source: Yahoo Finance

There are many other wider political and economic factors that can influence the price of a stock market in general or cause a market crash, such as:

  • A change to the central bank interest rates
  • An election
  • Natural disasters
  • Geopolitical conflicts

 

Whilst other changes may only affect one or some stock prices, like:

  • A change in government policy pivoting towards nuclear rather than oil power stations can affect oil company prices
  • Closing a tax loophole aimed at taxing profits of global technology companies which may impact their share price

 

Time for the final factor that can influence how much a share is worth.

 

Element #4: Professional opinion

At the start of a company's journey to becoming a publicly traded company, an investment bank is brought in to assess the business. 

As we discussed a little further up, when a company starts to sell shares to the public for the first time, we call this an IPO. 

Since the level of demand for a share isn't easy to know, other details are assessed such as the company's financial history and the trading performance of similar stocks. 

For a new social network launching on a stock market, the investment bank would look more closely at Facebook and Twitter rather than American Airlines or Johnson & Johnson, for example. 

Now we've got a handle on how the prices are set, it's time to look at where you can trade stocks.

 

What is a Stock Exchange?

A stock exchange is a place where buyers and sellers come together to trade the stock that they own.

Stock exchanges started in a way we'd recognize today in the 17th century in port cities like London, Antwerp, and Amsterdam, with the latter being the first in the world

Back then, trading was done manually with face-to-face deals and stock exchanges worked along the same lines for hundreds of years, until computers and the internet happened. 

Whilst you may have the image of workers in brightly colored jackets making complex hand signals when you think of Wall Street or other stock exchanges, nearly all trading is now done through computers. 

Photo by Adam Nowakowski on Unsplash

 

There's a range of people who trade on a stock exchange, such as institutional investors, private equity firms, and hedge fund managers. 

Individuals can also trade on stock exchanges to boost their retirement account for example, but you'll need to use a stockbroker to get access to the markets.  

 

There is more than just shares of a company traded on a stock exchange, you can trade:

  • Commodities like oil, gold, and wheat
  • Index funds such as the S&P 500 index
  • Mutual funds
  • Government bonds
  • Real estate mortgages and other loans
  • Commercial paper
  • Exchange-traded funds

 

From what an exchange is, we're going to look at the biggest ones in the world. 

 

Largest stock exchanges in the world

You've probably heard of some or all of the largest stock exchanges in the world.  

Measured by the amount of capital invested in USD in the stock on the exchange, the top ten largest stock exchanges in the world, as of February 2021, are:

  • New York Stock Exchange, USA, $25.62 trillion
  • Nasdaq, USA, $19.51 trillion
  • Hong Kong Exchanges, Hong Kong, $6.76 trillion
  • Shanghai Stock Exchange, China, $6.56 trillion
  • Japan Exchange Group, Japan, $6.54 trillion
  • Euronext, Europe, $5.08 trillion
  • Shenzhen Stock Exchange, China, $4.83 trillion
  • LSE Group, UK and Italy, $3.83 trillion
  • TMX Group, Canada, $2.62 trillion
  • National Stock Exchange of India, India, $2.58 trillion

 

Coming up is how it works when you start to invest in the stock market. 



How Do You Invest in the Stock Market?

Now you know the answer to "what is the stock market?", we're going to go through how you can start to invest in the stock market

Although you don't need to have a degree-level education to start stock investing, you do need to have:

  • Funds to invest
  • Time to dedicate to learning about trading
  • The ability to work with numbers when you test your investment strategies
  • Ability to control emotions

Once you've got the basics, here's a quick guide to how to invest in the stock market.

 

Step #1: Choose your investment instrument

The first of many investment choices you have to make is where exactly you'll invest your money in the stock market. 

You can put your money into a range of investments depending on your risk tolerance, and whether you're looking for long- or short-term investment, such as:

  • ETFs
  • Mutual funds
  • Index funds
  • Individual stocks
  • CFDs

All of which will mean you have your money invested in the price of stocks, either directly or indirectly. 

Some have more risk than others and you should do your research and due diligence before you choose to invest your money.

 

Step #2: Set a budget for your investment

It's important that you know how much money you have in your budget to invest.

 

Photo by Firmbee.com on Unsplash

There is always a chance that you'll lose money when you buy and sell securities, as we saw when we looked at the stock market crashes associated with the recent pandemic. 

You should assess your affordability and how much risk you're prepared to take. 

If you're unsure about how much money to invest, you can seek investment advice from a financial advisor.

 

Step #3: Open an investment account

To start trading stocks and other instruments, you need to open a brokerage account with a stockbroker. 

This will be the company that holds your money and buys and sells stock on your behalf. 

There are lots of online brokers you can sign up with and connect to an online trading platform such as ZuluTrade

You'll need to provide some documentation before your accounts are open, too.

 

Step #4: Decide how you'll invest

You have two ways that you can invest in the equity markets:

  • Manual trading
  • Copy Trading

Manual trading requires a lot of work and research to be able to understand all the information that will affect the price of a stock that we looked at earlier. 

Copy Trading, on the other hand, is easier in that you choose which professional investor you wish to follow, decide how much of your money will copy their moves, and ZuluTrade will send the exact same signals to your brokerage account as the trader makes.

 

Step #5: Buy your stocks and manage your portfolio

The next step is to open your first position and execute your first trade. 

Using ZuluTrade, it's a simple process where you choose the asset you want to invest in, set options such as your stop-loss value, and then complete the purchase. 

Photo by MayoFi on Unsplash

 

You can use the data provided by ZuluTrade to monitor your positions, such as the bid-ask spread and price volatility

Choosing to Copy Trade and have your money follow the movement of professional Traders will need less hands-on management, although it's worth checking on the market performance and your investments to ensure everything is how you expect. 

That's how you invest in stocks and securities, it's time to ring the bell and bring this to a close.

 

Now Over to You

We're finished. 

That's everything you need to know about how the stock market works. 

We've looked at what stocks are, how they get their price, and where you can buy and sell stock. 

Now you're armed with information about terminology like:

  • Stocks and shares
  • Common and preferred stock
  • Bull markets and bear markets

 

You should be closer to starting your stock trading journey. 

Keen to know how to get started? 

Create an account with ZuluTrade and prepare to start trading. 



Disclaimer: The views expressed do not constitute investment or any other advice/recommendation/suggestion and are subject to change. Reliance upon information in this material is at the sole discretion of the reader. Opinions expressed in this article do not represent the opinion of ZuluTrade Social Trading Platform and do not constitute an offer or invitation to anyone to invest or trade. Every metric and the statistical number is a result of a past performance which does not constitute a promise or a certainty for a future one.

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