How Does the Stock Market Work?

Advantages, Components,Trends

how does the stock market work
A trader checks to see if he's making money in the stock market. Photo: Spencer Platt / Getty Images

The stock market works by buyers and sellers (traders) who bid on shares of stocks. These are a small piece of ownership of a public corporation. Stock prices usually reflect investors' opinions of what the company's earnings will be.

Traders who think the company will do well in the future bid the price up, while those who believe it will do poorly bid the price down. Sellers try to get as much as possible for each share, hopefully making much more than what they paid for it.

Buyers try to get the lowest price so that they can sell it for a profit later.

Average investors can't trade on the stock market directly. Instead, they must hire a broker-dealer to execute the trades. There's a wide variety of choices:

  • Fee-only financial advisers who charge an annual fee (usually 1% of assets).
  • Online dealers like E-Trade, who charge a small fee per transaction. 
  • Large banks, like Goldman Sach or Well Fargo Advisers, provide financial planning in addition to executing trades. 
  • Small brokers just execute orders. For more, see Stock Market Components.

Advantages 

Companies sell stocks because it's a good way to get an enormous sum of financial capital. However, the company itself must be generating a lot of income to make it worthwhile. Issuing an Initial Public Offering (IPO) is very expensive. After that, there is no privacy, as investors review the company's profits and strategy every quarter.

The other ways of obtaining financing are private, through personal loans or private investors, or through bonds, which are loans traded publicly. The advantage of stocks vs. bonds is that a stock doesn't require a monthly repayment of interest.

Individuals use the stock market because the returns, on average, outpace those of other investments, such as bonds or commodities.

Stock market investing is an excellent way to make sure your investments do better than inflation.

Components

The U.S. stock market mainly operates on the two largest exchanges: the NASDAQ and the New York Stock Exchange. A third exchange, the BATS Global Marketplace, was formed to create a more efficient technology that would avoid a flash crash like the one that hit the NASDAQ in August 2013.

There are also many small exchanges to serve specific types of traders. For example, "Dark Pools" like Liquidnet, cater to high-volume, frequent traders like hedge funds. Dark Pools hide their client's strategies from the competition. They not only ensure their anonymity but can also match up large orders to avoid suspicion. (Source: "How Stock Markets Work," Forbes.com.)

Indices

The stock market is tracked by the Dow Jones Industrial Averages, the S&P 500 and the NASDAQ. Every country has its exchanges and indices. Follow them to find out how investors think the economy is doing. 

Trends

If investors believe the economy is growing, then they will invest in stocks. That because a strong economy helps companies improve their earnings. That's known as a bull market. It usually occurs along with the expansion phase of the business cycle.

Most commodities also do well. That's because expanding businesses will demand more oil, copper, and other natural goods.  The most recent bull market occurred from March 2009 until August 2013.

If investors think the economy is slowing or stagnant, they will invest in bonds, which are a safer investment. That's because bonds give a fixed return over the life of the loan. Bonds do well during the contraction phase of the business cycle. When bonds do well, stocks lose value. That's known as a bear market, and it typically last 18 months. The last bear market was from December 2007 to March 2009. For more, see Dow Closing History.

If there are threats to the global economy, investors also move toward gold and other safe havens. That usually happens along with a stock market correction, when share prices drop 10 percent or more.

It's even more apparent in a stock market crash when stocks can lose that much in a day. Keep in mind that these are general trends, not hard and fast rules. 

Stock Market FAQ