How Does the Stock Market Work? (2024)

Source: Trading Hours.

Over-the-Counter Exchanges

There also exist several loosely regulated over-the-counter (OTC) exchanges, which may also be referred to as bulletin boards (OTCBB). These shares tend to be riskier since they list companies that fail to meet the more strict listing criteria of bigger exchanges. Larger exchanges may require that a company has been in operation for a certain amount of time before being listed and that it meets certain conditions regarding company value and profitability.

In most developed countries, stock exchanges are self-regulatory organizations (SROs), non-governmental organizations that have the power to create and enforce industry regulations and standards.

The priority for stock exchanges is to protect investors through the establishment of rules that promote ethics and equality. Examples of such SROs in the U.S. include individual stock exchanges, as well as the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).

Stock Market Indexes

Indices represent aggregated prices of several different stocks, and the movement of an index is the net effect of the movements of each component. Major stock market indexes include theDow Jones Industrial Average (DJIA) and the .

The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and the fact that it only consists of 30 stocks (when there are many thousands to choose from), it is not a good indicator of how the stock market is doing. The S&P 500 is a market-cap-weighted index of the 500 largest companies in the U.S. and is a much more valid indicator.

Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market sector. Investors can trade indices indirectly via futures markets, or via exchange-traded funds (ETFs), which act just like stocks on stock exchanges.

A market index is a popular measure of stock market performance. Most market indices are market-cap weighted, which means that the weight of each index constituent is proportional to its market capitalization. Keep in mind, though, that a few of them are price-weighted, such as the DJIA. In addition to the DJIA, other widely watched indices in the U.S. and internationally include the:

S&P 500

Nasdaq Composite

Russell Indices (Russell 1000, Russell 2000)

TSX Composite (Canada)

FTSE Index (UK)

Nikkei 225 (Japan)

Dax Index (Germany)

CAC 40 Index (France)

CSI 300 Index (China)

Sensex(India)

Why Companies Issue Shares

To make the transition from an idea germinating in an entrepreneur's brain to an operating company, they need to lease an office or factory, hire employees, buy equipment and raw materials, and put in place a sales and distribution network, among other things. These resources require significant amounts of capital, depending on the scale and scope of the business.

Raising Capital

Many corporate giants started as small private entities launched by visionary founders like Jack Ma of Alibaba (BABA)or Mark Zuckerberg of Meta.

A startup can raise capital either by selling shares through equity financing or borrowing money through debt financing. Debt financing can be a problem for a startup because it may have few assets to pledge for a loan.

Equity financing is the preferred route for most startups that need capital. The entrepreneur may initially source funds from personal savings, as well as friends and family, to get the business off the ground. As the business expands and its capital requirements become more substantial, the entrepreneur may turn to angel investors and venture capital firms.

Listing Shares

Companies can access larger amounts of capital than they can get from ongoing operations or a traditional bank loan by selling shares to the public through an initial public offering (IPO).

This changes the status of the company from a private firm whose shares are held by a few shareholders to a publicly-traded company whose shares will be held by numerous members of the general public. The IPO also offers early investors in the company an opportunity to cash out part of their stake, often reaping very handsome rewards in the process.

Once the company's shares are listed on a stock exchange and trading on the market, the price of these shares fluctuatesas investors and traders assess and reassess their intrinsic value. There are many different ratios and metrics that can be used to value stocks, of which the single-most popular measure is probably the price-to-earnings (PE) ratio. Stock analysis tends to fall into one of two camps—fundamental analysis, or technical analysis.

How Share Prices Are Set

The prices of shares on a stock market can be set in several ways. The most common way is through an auction process where buyers and sellers place bids and offer to buy or sell. A bid is a price at which somebody wishes to buy, and an offer, or ask, is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.

Stock Market Supply and Demand

The stock market also offers a fascinating example of thelaws of supply and demand at work in real time. For every stock transaction, there must be a buyer and a seller. Because of the immutable laws of supply and demand, if there are more buyers for a specific stock than there are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.

The bid-ask or bid-offer spread, the difference between the bid price for a stock and its askor offer price, represents the difference between the highest price that a buyer is willing to pay or bid for a stock and the lowest price at which a seller is offering the stock.

A trade transaction occurs either when a buyer accepts the asking price or a seller takes the bid price. If buyers outnumber sellers, they may be willing to raise their bids to acquire the stock. Sellers will, therefore, ask higher prices for it, ratcheting the price up. If sellers outnumber buyers, they may be willing to accept lower offers for the stock, while buyers will also lower their bids, effectively forcing the price down.

Matching Buyers to Sellers

Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers.

A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer. The more narrow the price spread and the larger size of the bids and offers, the greater the liquidity of the stock. If there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth.

The original manual method of trading was based on a system known as the open outcry system,where traders used verbal and hand signal communications to buy and sell large blocks of stocks in the trading pit or the exchange floor.

However, the open outcry system has been superseded by electronic trading systems at most exchanges. These systems can match buyers and sellers far more efficiently and rapidly, resulting in significant benefits such as lower trading costs and faster trade execution.

Advantages of Stock Exchange Listing

• An exchange listing means ready liquidity for shares held by the company's shareholders.
• It enables the company to raise additional funds by issuing more shares.
• Having publicly tradable shares makes it easier to set up stock options plans that can attract talented employees.
• Listed companies have greater visibility in the marketplace; analyst coverage and demand from institutional investors can drive up the share price.
• Listed shares can be used as currency by the company to make acquisitions in which part or all of the consideration is paid in stock.

Disadvantages of Stock Exchange Listing

• Significant costs associated with listing on an exchange, such as listing feesand higher costs associated with compliance and reporting.
• Burdensome regulations may constrict a company's ability to do business.
• The short-term focus of most investors forces companies to try and beat their quarterly earnings estimates than take a long-term approach to their corporate strategy.

Many giant startups choose to get listed on an exchange at a much later stage than startups from a decade or two ago.

While this delayed listing may partly be attributable to the drawbacks listed above, the main reason could be that well-managed startups with a compelling business proposition have access to unprecedented amounts of capital from sovereign wealth funds, private equity, and venture capitalists. Such access to seemingly unlimited amounts of capital would make an IPO and exchange listing much less of a pressing issue for a startup.

Investing in Stocks

Numerous studies have shown that, over long periods, stocks generate investment returns that are superior to those from every other asset class. Stock returns arise from capital gains and dividends.

A capital gain occurs when you sell a stock at a higher price than the price at which you purchased it. A dividend is the share of profit that a company distributes to its shareholders. Dividends are an important component of stock returns. They have contributed nearly one-third of total equity return since 1956, while capital gains have contributed two-thirds.

While the allure of buying a stock similar to one of the fabled FAANG quintet—Meta, Apple (AAPL), Amazon (AMZN), Netflix (NFLX),and Google parent Alphabet (GOOGL)—at a very early stage is one of the more tantalizing prospects of stock investing, in reality, such home runs are few and far between.

Investment often depends on an individual's tolerance for risk. Risky investors may generate most of their returns from capital gains rather than dividends. On the other hand, investors who are conservative and require income from their portfolios may opt for stocks that have a long history of paying substantial dividends.

Market Cap and Sector

While stocks can be classified in several ways, two of the most common areby market capitalizationand by sector. Market cap refers to the total market value of a company's outstanding sharesand is calculated by multiplying these shares by the current market price of one share.

Large-cap companies are generally regarded as those with a market capitalization of $10 billion or more, while mid-cap companies are those with a market capitalization of between $2 billion and $10 billion, and small-cap companies fall between $250 million and $2 billion.

The industry standard for stock classification by sector is the Global Industry Classification Standard (GICS), which was developed by MSCI and S&P Dow Jones Indices in 1999 as an efficient tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered industry classification system that consists of 11 sectors and 24 industry groups. The 11 sectors are:

• Energy
• Materials
• Industrials
• Consumer Discretionary
• Consumer Staples
• Health Care
• Financials
• Information Technology
• Communication Services
• Utilities
• Real Estate

This sector classification makes it easy for investors to tailor their portfolios according to their risk tolerance and investment preference. Conservative investors with income needs may weigh their portfolios towardsectors whose constituent stocks have better price stability and offer attractive dividends through so-called defensive sectors such as consumer staples, health care, and utilities. Aggressive investors may prefer more volatile sectors such as information technology, financials, and energy.

The Bottom Line

Stock markets represent the heartbeat of the market, and experts often use stock prices as a barometer of economic health. But the importance of stock markets goes beyond mere speculation. By allowing companies to sell their shares to thousands or millions of retail investors, stock markets also represent an important source of capital for public companies.