What Is the Stock Market and How Does It Work?

The stock market describes the formal arena where investors buy and sell stocks. Investors and business owners are not the only ones who need to know about the stock market. Individuals who want to generate wealth and participate in the world economy must also understand the basics of investing in the stock market. 

Whether it is up, down or fluctuating, the stock market always seems to be in the news. It plays a major role in the economy and can help individuals generate wealth. But how does the stock market work? Answering this question is an essential first step to learning how to invest in the stock market.

What Is a Stock?

A stock is a type of security, also known as equity or equity security, that represents ownership in a corporation. Here’s how it works:

• Public corporations, or those that operate in the stock market, issue stocks to raise money.
• Stocks represent the company in which the stockholder invests, giving them the right to a fraction of the issuing corporation’s profits and assets. 
• Shares are the actual unit of measurement that determines how much of that stock they own. 
• Someone might say they own “stock” in a company as a general term, but when referring to the specific amount, they would say they own “100 shares.” 
• Shareholders share in the success and challenges of a business and can re-sell their shares on the stock market if they desire.

What Is the Stock Market?

The stock market, also called a “stock exchange,” is a formal arena where investors and traders buy and sell stocks. Here are the basics:

• The term “stock market” refers to a group of exchanges where buyers and sellers meet. 
• The government regulates these exchanges to help facilitate the selling process and to protect buyers from unfair practices. 
• The major markets in the U.S. are NASDAQ and the New York Stock Exchange (NYSE). 
• Various major cities, as well as free-market economies around the world, also have their stock markets.

How Does the Stock Market Work?

Trading stocks used to involve in-person transactions at a physical venue, for example, the NYSE building near Wall Street in New York City. With the dawn of the Internet, most trading moved online and now works like this:

• A private company “goes public” via an initial public offering, which means offering its shares for sale on the stock market.
• Investors and traders, represented by brokers, can then buy those shares for a set price.
• The market sets the price based on supply and demand.
• The investor tells the broker how many shares to buy, and the broker relays the request to the exchange. 
• A “market maker,” or stock wholesaler, makes the sale and transfers the shares to the investors’ account.
• The investor can use the same process to sell their shares if they wish.

Why Is the Stock Market Important?

The stock market is a hallmark of a free economy and has several benefits:

• It helps drive economic growth by allowing investors to make profits and earn income, which they reinvest in the economy. 
• It helps companies fund their growth by offering shares for sale.
• It serves as a barometer of the health of a given company, plus the overall economy.
• Because it is regulated, it ensures that prices are transparent, stocks are liquid (able to be sold) and trades are fair.

What Drives Stock Market Movements?

When the general public wonders why the stock market is down, they’re generally referring to the overall share prices as tracked by one of the market indexes. The most common market indexes are the Dow Jones Industrial Average, the NASDAQ composite and the S&P 500. These indexes track the price of a group of stocks and serve as a benchmark for the health of the stock market in general. But what drives those prices?

Supply and Demand

The answer to why the stock market is down nearly always goes back to supply and demand. Trading stock is a negotiation between investors and issuers, which works like this:

• The “bid price” is the maximum amount of money investors are willing to pay for a certain stock. 
• Investors set bid prices by looking at the overall financial health of the company, as well as the available supply of stock.
• The “ask price” is the amount of money the stock issuer wants to receive for its shares.
• Issuers set ask prices based on the demand for a stock. 
• High demand and low supply give the issuer the upper hand, resulting in high ask prices.
• High supply and low demand give the investor the upper hand, resulting in low bid prices.

Explaining Volatility

Supply and demand explain stock prices — but what explains supply and demand? Many factors can affect stock market prices:

• Natural economic cycles, which fluctuate between bull markets (when investment is high) and bear markets (when investors pull back).
• Rising interest rates, which make borrowing more expensive and lowers demand.
• Inflation, which results in less consumer spending and lowers demand.
• Supply chain issues, which can decrease a company’s earnings and therefore demand for its stock.

Stock Market Regulation

In the U.S., the Securities and Exchange Commission (SEC) regulates the stock market. The SEC:

• Is a regulatory authority, but is independent of the government and is not affiliated with a political party.
• Monitors the dealings of the stock market, looking for discrepancies in pricing or violations of fair trade practices.
• Requires publicly traded companies to file quarterly financial reports, as well as other reports when certain important developments occur.
• Can suspend a company’s ability to trade in the market or impose fines and other disciplinary actions.

Other Types of Markets

A stock is one security that investors can trade within a market. Other markets include:

• Over-the-counter: OTC (over-the-counter) trading takes place outside the central stock exchanges. OTC markets are less regulated and less transparent, so stocks may be less liquid.
• Bonds: The bond market, also called the debt market or credit market, is where investors trade debt securities. Governments issue bonds to fund public projects. Investors then buy that debt, which the bond issuer will repay with interest. 
• Cryptocurrency: Cryptocurrency is a digital currency that is based on blockchain or a shared ledger distributed across a large network. Investors buy cryptocurrency on various crypto exchanges.
• Foreign exchange: The foreign exchange market is a conglomeration of banks, businesses and other organizations that determines the currency exchange rate. It is the largest financial market in the world.
• Derivatives: Derivatives are financial contracts involving underlying assets, like stocks, bonds or commodities. They can be complex and require investors with expertise and experience.
• Commodities: Commodities are raw materials, including energy, metals, agricultural products and livestock. Investors trade commodities on futures exchanges, where they make agreements based on the future price of the commodity.

Final Thoughts: Investing in the Stock Market 

Investors often don’t need a lot of money to get started and can easily open an account with an online brokerage, many of whom don’t have an account minimum. 

Still, those wondering how to invest in the stock market should first learn everything they can about how it works so they can make good decisions. As investors gain experience, they can invest more money or branch out into different types of securities. Remember that while the stock market fluctuates, it results in good returns over time.

Top Takeaways

• A stock is an asset that represents ownership in a company. A share is the measurement unit of a stock.
• The stock market is the exchange where buyers and sellers meet to trade stocks. 
• Supply and demand drive stock market prices. Various factors, including inflation and interest rates, drive supply and demand.
• The SEC regulates the stock market to ensure fair practices and pricing.
• Other types of markets include OTC trading, bonds, cryptocurrency, foreign currency, derivatives and commodities.

(Reporting by NPD)