How does the stock market work?
Unlike the exchange of money for a car or SUV that happens at competing dealerships or used car lots, the trade in stocks happens at markets called stock exchanges. The stock market is where companies go to raise money to fund their operations by selling shares of stock. It’s also where individual and institutional investors come together to buy, sell, and trade those shares.
What happens when you buy or sell a stock?
The process of buying and selling shares helps sustain wealth for investors. When you buy a share of stock on the stock market, you don’t typically buy it directly from the company. Instead, you buy it from an existing shareholder – an individual who owns shares and wants to sell them. When you sell a stock, rather than selling your shares back to the company, you sell them to another investor on the stock exchange.
Why do companies trade on the stock market?
Companies go to the stock market to raise money by selling ownership stakes in their company to investors. These equity stakes are known as shares of stock. How do companies enter the stock market?
Listing shares: Listing shares means that a company can officially trade its shares on a stock exchange.¹ To be listed, a company typically must meet financial requirements and follow precise rules that are set by the stock exchange where they are listed.
For example, to list shares on the New York Stock Exchange (NYSE), a company must issue a minimum of 1 million shares of stock worth at least $100 million, and the company must have earned more than $10 million over the previous three years.¹
Raising capital: By listing shares on a stock exchange, companies sell shares and get access to the capital they need to operate and expand their business without having to take on the debt associated with borrowing money. In exchange for the privilege of listing shares and raising capital by selling stock to the public, a company must disclose detailed information about its finances and operations. In return, shareholders have a say in how the business is run.
IPO vs SPAC: An initial public offering (IPO) is the process of offering shares of a private company to the public. An IPO allows public investors to invest in a company and typically includes a share premium for the existing private investors.² It lets a company raise significant amounts of money to grow and expand, but also makes it subject to stricter regulations and controls.
A special-purpose acquisition company (SPAC) is a shell corporation without any commercial operations that is listed on a stock exchange to raise money for the purpose of acquiring an existing private company.³ Often called 'blank check companies,' they are subject to fewer regulations than an IPO but have to return funding to investors within two years if they are unable to complete the planned acquisition.³
Stock exchange or stock market?
The stock market is the umbrella term for all the securities traded in a particular region or country. It can be thought of as encompassing the very broad universe of stocks, preferred shares, REITs, exchange traded funds and options.
On the other hand, stock exchange is the term used to describe a specific marketplace and infrastructure where shares are bought and sold.⁴ Think of an individual stock exchange as a part of the whole. The stock market in North America is comprised of many different stock exchanges, such as the Toronto Stock Exchange (TSX), the New York Stock Exchange (NYSE), and/or the National Association of Security Dealers Automated Quotations exchange, better known as NASDAQ.
When people talk about how the stock market is performing, they mean the thousands of public companies listed on the many different stock exchanges across the country, the continent, or around the world. Unlike an IPO, stock exchanges are secondary markets, where existing shareholders transact with potential buyers and sellers rather than directly with the company that issued the shares.
What can you buy on the stock market?
Here is a list of types of investment products available on an exchange:
- Stocks are shares of a company divided up for investors. Each share represents fractional ownership in the company.
- ETFs or exchange-traded funds are groups of different assets that are pooled together and overseen by a fund manager, either directly or indirectly. A share in an ETF represents partial ownership of the assets in that pool and are traded on an exchange in the same way as stocks.
- Options are contracts that give the buyer the right to buy or sell a security at a chosen price sometime in the future.⁵
- REIT is a real estate investment trust. It is a security that lets investors have a stake in the management of real estate property and see regular returns from the rental income that the property generates.
- Preferred shares are a class of stock that gives the owner more rights than a common stock owner. For example, a preferred share owner may receive higher dividend payments.⁶
- Debentures are investment instruments used by large companies and governments to borrow money at a fixed rate of interest. They are backed by the creditworthiness and reputation of the issuer, and like bonds, debentures periodically payout interest to investors called coupon payments.⁷
- Depositary receipts are certificates issued by a local bank. These certificates hold shares in a foreign company or enterprise. Traded on a local exchange, they let individuals have equity in companies outside their local jurisdiction. They make it possible, for example, for Canadian investors to indirectly own stock in a US company without having to buy shares on a US exchange using US dollars.
What do you get when you invest in the stock market?
Buying a share in a company offers both potential risks and potential benefits. Though positive returns are never guaranteed, investors who make money on their investments typically do so in two ways – capital gains and dividends – in addition to having voting rights.⁸
Capital gains / losses: A capital gain is an increase in the value of a stock over time. When the price goes up, your gains are unrealized. It is only once you sell and get the money that the gain is 'realized.' A capital loss happens when the stock loses value.
Dividends: If you own shares in a company that is profitable the company may pay out a portion of those profits to shareholders on a regular basis. Dividends are usually paid out by more established and mature companies.⁸ The amount that the company distributes to shareholders is called the dividend yield. It is usually dispersed at the end of every financial quarter, or four times a year.
Voting rights: When an investor buys shares in a company, ownership of the stock may entitle them to voting rights. This means that they can have a say in the way the company is run by voting on corporate actions, such as a merger or acquisition, electing members to the board of directors, or approving the payment of dividends.⁹
It is important to remember that companies also issue non-voting shares. This gives investors the benefit of capital gains and dividends but not voting rights. As a result, they have far less ability to influence a company's policies and decisions.
How are the stock prices set?
The price of a stock is set by supply and demand.¹⁰ Factors such as management and business performance and environmental or geopolitical events like natural disasters and wars influence price by altering the demand or affecting the supply. To account for all the potential factors that can influence the price of a stock, investors use a tool called an index.
An index assesses the performance of a group of different stocks on an ongoing basis. Tracking the performance of stocks deemed important gives investors a benchmark they can use to compare individual stock performance. An index is also a way to measure the overall performance of the stock market and the economic health of a sector or region.
Some well-known indices include¹¹:
- DJIA: Dow Jones Industrial Average tracks the performance of 30 large American corporations.
- S&P 500: Standard and Poor's 500 is an index of the 500 largest public companies in the US.
- S&P/TSX Composite Index: Tracks the performance of 230 to 250 major Canadian public companies trading on the Toronto Stock Exchange.
- CAC 40: Follows the performance of the 40 largest companies that trade on the Euronext Paris Stock Exchange.
How to place a market order on a stock exchange?
Buying or selling stock on a stock exchange is called placing an 'order', and there are several different types of orders that an independent investor can place when buying or selling securities on the NBDB trading platform. The way an order is executed has an effect on the final price. Here are some important points to keep in mind.
- 1. Price: A buy order with a higher price has priority over one with a lower price. In other words, a sell order at a lower price is executed before a sell order at a higher price
2. Order execution: Stock exchange orders follow the basic
rule of ‘first come, first served’. An order must indicate the type
of transaction (a buy or a sell), the number of securities that are
being traded, for how long the order is active, the price, and the
type of order. Here are some different order types¹²:
- Market order is an order to buy or sell a security immediately. It guarantees that the order will be executed, but it does not guarantee the price. A market order price may shift up or down because of the time delay between the last traded price, your place in the queue, and the execution of the order. Not knowing a trade's exact final price is a market order's major downside.
- Limit orders set a specific price to buy or sell a security in advance. Typically, a buy limit order can only be executed at or below the “ask” or set limit price. In contrast, a sell limit order is placed above the current bid price. The trader also sets a timeframe on the trading platform to indicate the duration of the limit order. If the security does not reach any of the set thresholds in the prescribed time period, the order will not be executed.
- Stop loss orders are another type of conditional market order. They allow investors to fix a sell price for their shares. If the security hits the set price, it will be sold automatically. For example, assume you buy a share at $50 per unit and are anticipating an increase in value. To protect your position from a decrease in case the market takes a turn in the opposite direction, you could place a stop loss order on the stock at $45. If the stock hits $45, it will automatically become a sales order and be sold on the market, limiting your potential losses.
- Buy stop order enables an investor to buy a security if its price reaches a predetermined level. Investors that short sell may use this order to manage the risk.
It is important to remember that some orders can also be restricted based on quantity. A “fill or kill” occurs when a partial buy or sell order will not be accepted, and the entire size of the order must be traded.¹³ If these conditions aren't met and all the trades in the order are not filled, the order is cancelled.
We all know that whatever goes up must come down. This also applies to the stock market. Shifts in supply and demand can have a dramatic effect on the value of securities. Events generated by humans or by nature that impact supply and demand will be reflected in the value of securities being traded on a stock exchange.
Bull and bear markets are part of the up and down cycle of market activity. Investors call periods of extended growth bull markets and periods of extended decline bear markets. Bull markets typically represent a 20% increase in market value over an extended period and can last from several months to many years. Bear markets are the exact opposite and represent periods of extended decline.
Historically, the stock market has grown in size and value over time. However, the past century of stock market trading has seen a small number of market crashes. These are significant economic events caused by some major shift or collapse where the value of securities has fallen dramatically within a very short period. Major crashes include the Stock Market Crash of 1929, Black Monday in 1987, and the onset of the COVID-19 pandemic in 2020.
Why invest in the stock market?
The main reason to invest in the market is the potential that it offers to make your money grow at a faster rate than keeping it in your bank account. Over the long term, the stock market generates higher returns than holding cash or even investing in bonds.
Investing in the market also helps protect money from inflation. Money kept in a safe will have less buying power ten years into the future than it has now because, as we all know, inflation drives prices up for most goods and services over time.
Investing in a diversified portfolio of assets across different regions and sectors can provide protection from inflation. The value of stocks will often grow at a rate that typically meets and often exceeds the rate of inflation and take into account spikes in the inflation rate over time.¹⁴ Owning a diversified portfolio of securities is one of the best strategies to protect investments from inflation and other kinds of market volatility.
Whether you're an independent investor or a Wall Street trader, the key principle underlying all stock trading is the same: buy low and sell high. The challenge for any investor, big or small, is choosing and timing investment decisions so that they generate positive, money-making returns.
The stock market represents the heartbeat of the market and serves as a barometer for economic health. It is a way for companies to raise capital to fund their day-to-day operations and a way for individual investors to build wealth. Nevertheless, there are risks involved, which is why it is essential to map out your investment goals and do proper research. Accessing the stock market is as simple as opening a self-directed brokerage account.
- Wikipedia. Listing (Finance).
- Fernando, J. Initial Public Offering (IPO): What It Is and How It Works. April 5, 2023.
- Young, J. Special Purpose Acquisition Company (SPAC) Explained: Examples and Risks. March 15, 2023.
- Harper, D. Getting to Know the Stock Exchanges. April 10, 2022.
- Mirzayev, E. Options Trading for Beginners. April 5, 2023.
- Ganti, A. Preferred Stock. April 23, 2023.
- Chen, J. Debenture Explained, With Types and Features. April 24, 2023.
- Young, T. How does the stock market work? March 8, 2023.
- Hayes, A. What Are Stockholder Voting Rights, and Who Gets a Vote? March 21, 2021.
- Wikipedia. Market Trend.
- Hayes, A. How Does the Stock Market Work? May 24, 2023.
- Investor.gov. Types of Orders.
- Ganti, A. All Or None (AON): Meaning and Examples of the Trading Order. April 21, 2022.
- Peters, K. 9 Asset Classes for Protection Against Inflation. January 7, 2022.