What Is the Stock Market and How Does It Work?
A stock market, also known as a stock exchange, is a venue to trade securities, such as bonds and shares. Sellers of securities are matched with their buyers in a stock market and they trade with each other using rules imposed by the market’s governing authority. For example, the New York Stock Exchange (NYSE) matches the Best Bid Offer (BBO) with the lowest sale price. If there are not enough buyers of the security, then an assigned market maker steps in to make up for the difference and accomplish the sale.
Stock markets began as physical locations where traders gathered buy and sell shares but most trades are now conducted online. Some markets like the National Association of Securities Dealers Automated Quotations (NASDAQ) do not have physical trading floors at all and all transactions occur online. Others, like the NYSE, have a hybrid system in which physical trading comprises a small portion of the market’s overall volume.
Stock markets serve an important function in the economy by enabling entrepreneurs to raise capital and companies to expand their operations using funding from the markets. On the other side, stock markets generate profits for buyers of securities by making informed bets on growth prospects for these companies. These tasks are accomplished with the help of extensive regulation that govern trades and enforce mandatory disclosure of details from both sides.
Depending on trading volume and economic conditions, stock markets can be bellwethers of the broader economy. For example, the Great Depression began with the stock market crash of 1929. Similarly, major indices at major stock markets plunged during the financial crisis of 2008 and rose to new heights after the Great Recession of 2008, reflecting the American economy’s period of sustained growth.
But there have been times when the market is disconnected from the mainstream economy’s problems. For example, despite an almost-complete economic shutdown and reports of record losses and unemployment numbers, markets in the United States reached new records during the coronavirus epidemic.
As of 2020, NYSE was the biggest stock market in the world. It had a market capitalization of more than $25 trillion. With a market cap of $11 trillion, NASDAQ is the world’s second-biggest market. The Tokyo Stock Exchange ($5.1 trillion), Shanghai Stock Exchange ($4.67 trillion), and Hong Kong stock exchange ($4.23 trillion) make up the remaining top five.
How Do Stock Markets Work?
Understanding Participants in a Trade
To understand the working of a stock market, it is important to understand the stakeholders involved in its operations. Broadly, there are three parties involved in the process: buyers or those interested in purchasing shares either individually or in large blocks, sellers or those interested in making a sale of their shares at a profit or loss (as the case may be), and market makers or the intermediaries responsible for matching buyers with sellers and vice versa. Interactions between these three participants are governed by a complex set of rules and regulations that are necessary to maintain order and fairness in the market.
Other market participants influence trading activity or help clear trades by verifying and validating transactions. For example, broker-dealers charge buyers and sellers for providing capital and conducting trades. Investment advisers and analysts influence buy and sell decisions by issuing periodic reports about a stock’s prospects after investigating its balance sheet.
The numbers for market makers varies depending on the stock market. For example, NYSE is an auction-driven market in which Designated Market Makers (DMM) and specialists are responsible for providing liquidity to hundreds of securities at a time. In contrast, NASDAQ has a system of broker-dealers who compete to provide market making services for a given security. Each security in NASDAQ reportedly has fourteen market-makers assigned to it.
How Are Stocks Traded?
The basic math of a stock trade consists of the difference between the bid and ask prices. After a stock is listed at an exchange, market forces take over. It is traded multiple times in a day. Some investors purchase the stock, or bid for it, at a low price. Other traders sell it, or ask for it, at a high price. The difference between the purchase and sale price is known as a bid-ask spread.
This spread is important for several reasons. First, it is an important source of revenue for market makers who make money off the price difference between these prices. Second, it is an indicator of the liquidity and interest in the stock. The narrower the spread, the more the stock’s liquidity because it means that traders are interested in owning or selling it. In general, liquid stocks are less susceptible to wild price swings because of the higher number of traders that make up their market. Illiquid shares, on the other hand, are more liable to display steep increases or decreases in their price because a single large transaction has the potential to draw investors into the company or drive them out of it.
Understanding Broad Market Movements
There are thousands of companies listed on a stock market and each company undergoes multiple price gyrations in a day. Therefore, it is impossible to gauge the market’s broad movements by tracking individual stocks. Instead, indices are used as tokens of the market’s mood.
A stock market index consists of a cross-section of the market’s most important stocks, weighted either by price or market-cap, from multiple sectors. The two most common indices in use today are the S&P 500 and Dow Jones Industrial Average (DJIA). The former has 500 members selected from various sectors, such as energy and information technology, and weighted by market capitalization. The latter consists of 30 stocks weighted by price. In general, the two market indices are reflective of stock market sentiments. For example, investors are considered to be optimistic about the economy’s prospects if the indices move upward and vice versa.
The terminology for market movements over a period of time is drawn from the animal kingdom. A bear market is said to occur during a prolonged period of stress that moves stock prices downward and investors become averse to risk. For reverse situations, that is when prices move upward for a significant stretch of time and investors embrace risk, the market is said to be in bull territory.
For example, the 1929 stock market crash resulted in the Great Depression and a bear market that lasted for almost three years. During this period, the S&P 500 lost almost 84% of its value. In contrast, prices trended upward for ten years after the financial recession of 2008, resulting in the longest bull run in market history.
History of Stock Markets
The oldest stock exchange in the world is located in Antwerp. But the Amsterdam Stock Exchange (ASE), which was established in 1602 by the Dutch East India company, is credited with popularizing stock trading. Its growth was closely linked to the business of trans-continental spice trading that occurred between Europe and Asia. Issuance of equity was one of the means by which trading companies could offset the risk of dangerous voyages that could result in significant capital and human losses. A successful voyage could result in magnificent profits and riches for stockholders. At its peak, the Dutch East India company was valued at $7.9 trillion in today’s terms. For context, Apple – the market’s richest company – recently crossed the $2 trillion mark.
On the back of the maritime trading success of the British East India company, the London Stock Exchange became the world’s biggest stock market by the nineteenth century. The twentieth century, however, belonged to American exchanges. The NYSE began as an informal group of traders exchanging shares at a coffee house in Lower Manhattan. It had a formal inauguration in 1817 and, more than two centuries later, had become the world’s biggest exchange. For almost two centuries it was the preferred venue to list stocks in America. The launch of NASDAQ in 1971 provided entrepreneurs with another prominent option. NASDAQ is tech-heavy, meaning it is home to a growing list of technology companies while NYSE skews towards more traditional sectors.
Asia’s oldest stock exchange is the Bombay Stock Exchange in India. It was started in 1875. But it is not the largest. It has been eclipsed in volume by the more-recent Shanghai Stock Exchange, which was established in 1990.
In the early days, trading stocks was considered a form of gambling and had an unsavory reputation. The development of scientific techniques to analyze price movements and individual equities and sophisticated modeling has transformed the stock market and it has become a means to generate and multiply wealth. Disclosures have become mandatory and companies are required to file quarterly earnings reports that detail their expenses and borrowings. Agencies, such as the Securities Exchange Commission (SEC), oversee the markets and prosecute those involved in defrauding lay investors.
Stock Market FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.