How Does the Stock Market Work?
The stock market works like a vast auction where traders & investors exchange stocks of companies through Bid and Offer prices. The difference between these prices is the Spread, which is the exchange’s profit. Brokers make profits from the commission charge. Investors make profits from stock price growth and dividends.
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What is the Stock Market?
The term Stock Market generically describes one or more stock exchanges. The Stock exchange exists to facilitate the buying & selling of shares of a company between investors and traders. A stock exchange like the NYSE is operated by a company that maintains the infrastructure to allow the fair exchange of shares.
In other words, the Stock Market exists to facilitate the exchange of shares of a company through buying and selling company stock; This is why there are called Stock Exchanges. The Stock Market is a generic word that collectively describes all stock exchanges. A specific stock exchange, for example, the New York Stock Exchange (NYSE) or the London Stock Exchange (LSE), is run by a company that maintains the infrastructure to allow the fair exchange of company shares.
How Does the Stock Options Market Work?
Some exchanges facilitate the buying and selling of Options Contracts, such as the Chicago Board of Options Exchange (CBOE). This is a unique exchange that enables people to buy and sell the Option of purchasing or selling stocks at some time in the future.
How Do Stock Market Indexes Work?
If we drill one level deeper, inside each stock exchange, there is an Index. So, inside the NASDAQ Exchange, you have the Nasdaq 100 (NDX), a listing of the 100 biggest companies (by capitalization) on the NASDAQ exchange. On the NYSE, you have the S&P500, a listing of the 500 biggest companies on the NYSE.
The Stock Market Works in Many Different Ways.
Depending on your role in the economy, the stock market works in different ways. There are benefits for individual investors, stock traders, investment banks, brokerage houses, and of course, the corporations themselves. We will now explore the way the market works for everyone involved.
How Does the Stock Market Work for Investors?
As an investor, you can benefit from increases in stock prices from the shares you own. You can also benefit from the regular dividend payments (usually up to 3% per year) companies make to shareholders. Investors also benefit from investing in stocks through an IRA or pension funds to build wealth for retirement.
How Does the Stock Market Work for Traders?
The market works for stock traders by enabling them to frequently buy and sell stocks based on short-term stock price fluctuations—the more volatile the stock price, the better for traders. Although riskier than investing long-term, traders must balance risk and reward with the hope of profiting over multiple trades.
How Does the Stock Market Work for Investment Banks?
The market works for investment banks by enabling them to sell services like initial public offerings (IPO), company mergers, acquisitions, takeovers, or corporate divestments/spin-offs. Finally, investment banks can also design bespoke investment vehicles for pension funds to invest in, such as derivatives or funds.
How Does the Stock Market Work for Brokerages?
The market works for brokerages by enabling them to provide access to the stock exchanges to individual investors. For a commission, Brokerages offer a trading account and a secure place to deposit money for investing. Also, they supply a complete trading platform, stock chart analysis, and screening software.
How Does the Stock Market Benefit Corporations?
Companies will float on a stock exchange to get access to a large amount of money to help finance the expansion of their business. Access to capital or the capital markets enables companies to raise money to fund expansion, research & design, innovation, and fund ongoing operations.
For example, I start up a company that helps people buy and sell Bitcoins lets call the company “BitSwap.” Business is booming; in fact, I am getting a lot of demand for the services. But my problem is I cannot fulfill all that demand because I do not have enough money or capital in the business to finance the expansion of the I.T. infrastructure. I have four choices to get money.
- A Bank Loan – Bank will only lend on already existing secured assets.
- Private Investors – may want a large share of your company for a small amount of money.
- Issue Corporate Debt – I can only do this when I have enough equity in my business
- Get Public Money by Floating on a Stock Exchange through an Initial Public Offering (IPO)
The IPO is a great way to secure a lot of money while retaining control of your business. This is a significant source of income for Wall Street Investment Banks.
The Stock Market Works by Enabling Company Takeovers
Another huge benefit for corporations is that if a company’s stock price is very high, it can use the value of the stock it owns to acquire weaker companies. A Stock for Stock Merger allows the investors in the weaker target company to swap their shares for the more valuable shares in the acquiring company.
What is a Stock or Share?
The stock or share is actually a right of ownership of part of that business and its future company profits. When launching an IPO, the company will decide what percentage of the business to sell and how many shares to issue. So, for my BitSwap company, I decide I want to raise $100 million, and I will issue 10 million shares at $10 each. For that $100 million, I will give up a stake of 50% of my business or issue shares. That essentially values my business at $200 million in total.
If my IPO is a success, my corporate balance sheet will gain $100 million to invest in infrastructure, staff, and premises.
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Why Buy Shares of a Company?
The benefit to you as a shareholder is that you should make a profit from your investment. You can gain from:
- the increase in the price of a stock – commonly called growth investing
- a share of profits issued through dividends – call income investing
You will also get a vote on the company’s leadership and be invited to annual shareholder meetings if you hold ordinary shares.
What is the Difference Between Traders & Investors?
Traders make money by buying and selling stocks on a short-term basis, potentially holding a stock for minutes to days; this is known as Day Trading. Traders also utilize leverage to turn the potentially small gain on a short-term holding into a more substantial profit. The problem is leverage can also turn a small loss into a significant loss. This means the majority of traders lose over the long term.
Investors hold their stocks over a more extended period and seldom use leverage. According to our stock market statistics, the stock market’s overall long-term direction is up; over any 20 years in history, the buy and hold strategy has never lost.
How does Wall Street Really make Money?
Wall Street Investment banks make money from the following activities:
- Initial Public Offerings – helping companies get access to capital markets
- Mergers, Acquisitions & Spin-Offs help companies buy other companies, merge with other companies, or even split up large companies.
- Fund Management – Administering Funds such as Exchange Traded Funds (ETF’s) or Mutual Funds.
- Derivative Investments – establishing innovative ways to enable high net worth (HNW) individuals or money managers to invest in exotic financial instruments – see Financial Crisis.
Contrary to popular belieF Wall Street Investment Banks & Brokerage Houses do not make their profits from having super talented money managers that beat the stock market returns. In fact, most fund managers cannot beat the market.
Why do 92% of Fund Managers Fail to Beat The Market?
Investment Banks and Brokers actually make money by:
- By taking a slice of your total investment with them – e.g., Management Charges, whether or not they make you a profit.
- Charging you per Stock Trade – e.g., a trading commission.
Should I be afraid of losing money in the Stock Market?
In the past 100 years, we have had 18 economic recessions, so it is perfectly normal to be afraid of losing money in the stock market. The term Fear and Greed certainly represent the emotions of the market participants. Fear is the panic people feel when the stock market value decreases; the natural emotion is to sell and stop losing.
Greed refers to when the stock market is rising, and people have the natural emotion to buy more because they get greedy. If the stock market is very overpriced and everyone is feeling very greedy, this can fuel booms and busts. Those who make the most money in the stock market tend to, as Warren Buffet says, “Be Greedy when others are fearful and be fearful when others are greedy.”
People do lose money in the stock market, but they also make money. It largely depends on the difference between investors and traders.
Lastly, as a long-term investor, you will still want to understand the market is in a Bull Market or Bear Market, so you can take action to secure your investments as prices go down. For precisely this reason, we have created the Stock Market Crash Detector System to help you understand if and when the next crash will happen.
You can also stay up to date with our Level Headed Stock Market Commentary & Analysis – Stock Market Today
5 Ways to Make Money in the Stock Market
Those who make money in the stock market do these things:
- Use a Buy and Hold Strategy to accumulate assets over the long term.
- Incorporate Income Investing in your strategy
- Invest in low-cost broad market Exchange Traded Funds (ETF’s) or Index Tracking Funds
- Invest for the long-term – In any given 20 year period, the stock market has made money
- Invest through a tax reduced or tax-free vehicle, like an IRA or DRIPS account
3 Ways to Lose Money in the Stock Market
Those who lose money in the stock market generally:
- Do not take the time to educate yourself in investing.
- Try to trade stocks in the short-term, e.g., Day Trading and Swing Trading.
- Get caught up in Investing Scams or follow Penny Stock Promoters.
How do I start Investing in the Stock Market?
An excellent way to get started in investing is to educate yourself in the stock market basics by taking a Free Stock Market Training Course. Then you need a higher level of stock investing education to understand how the market works thoroughly.
Once you are educated, you will need to select a good stock broker that suits your investing needs, and you will need to open a brokerage account.
Is there a Guide for Stock Market Investing?
For a complete guide to the process of learning about Stock Market Investing, including investing vehicle selection, broker selection, and software platform selection, read our Learn Stock Trading Guide.
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The Biggest Problems with the Stock Market
Should you believe Wall Street Analyst observations of company performance, or do you suspect a conflict of interest? Get the surprising inside scoop.
There are many Stock Markets globally, and they have primarily been established to allow a business to get cheap financing to aid rapid expansion in exchange for a slice of the business and an opportunity to profit with the business.
The largest stock markets are located in the wealthiest countries; this enables the business to access the wealth and capital available in these countries to finance growth.
By purchasing stock in a company, you can benefit in two ways:
- Firstly you can benefit from share price appreciation, the movement of the stock price.
- Secondly, you can benefit if the company issues dividend payments. Dividend payments are a cash distribution of profits as a reward to shareholders for holding the stock.
Wall Street analysis firms provide ratings of the companies and their stocks; however, they can be quite misguided, and they are more often than not more bullish than they should be.
1- Institutional Stock Analysis – Don’t Believe the Wall Street Analysts
Most of the investment banks and brokerage houses employ Stock Market Analysts.
Their job is to research the firms in the industry to which they are allocated to assess if the companies are worth investing in.
You can purchase the “Analyst Reports” from S&P, Moodys, The Street, Credit Suisse, or the plethora of other information providers out there. The analysts usually attend the shareholder meetings for the companies they cover and probe the management team for further information.
Wall Street analysts come under constant scrutiny for the meaningless jargon and inaccurate ratings they put on stocks.
There is no aligned meaning across the research houses as to the meaning of ratings such as:
- Strong Buy, Hold, Sell, Strong Sell
- Outperform, Perform, Underperform
- Overweight, Underweight
- Long, Neutral, Avoid
- Accumulate, Hold, Distribute
This means it is all open to loose interpretation, which means it is inherently Less Meaningful.
You need to read between the lines when interpreting analyst reports.
Institutional Conflict of Interest
The analysts tend to avoid negative opinions as they tend to receive flack from the management teams and pressure that they may lose access to the companies they cover.
Analysts are not paid for their stock ratings’ performance; therefore, they have limited motivation to be truthful.
2- Penny Stocks Newsletter Conflicts of Interest
Less experienced stock market investors get caught up with companies that shamelessly promote Penny Stocks from time to time. This industry is rife with COnflicts of interest. If you navigate to the fine print on any of the Penny Stock newsletter sites, you will typically read the following text.
DISCLAIMER EXAMPLE
“Since (Company Name Deleted) receives compensation and its employees or members of their families may hold stock in the profiled companies, there is an inherent conflict of interest in (Company Name Deleted) statements, and opinions and such statements and opinions cannot be considered independent. (Company Name Deleted) and its management may benefit from any increase in the share prices of the profiled companies. (Company Name Deleted) services are often paid for using free-trading shares. (Company Name Deleted) maybe selling shares of stock at the same time the profile is being disseminated to potential investors; this should be viewed as a definite conflict of interest, and as such, the reader should consider this.”
So let’s decipher this.
- “Company A” wants to boost its share price.
- It speaks to a purveyor of HOT STOCKS NEWSLETTERS, preferably one with a considerable email contact list.
- “Company A” may agree to give the Newsletter publishers payment in the form of “Company A’s” stock for the service of convincing its clients to buy those stocks.
- The Newsletter publishers receive these stocks; then, they recommend buying “Company A” in their newsletter.
- As the people receiving the email start to buy the stock, the stock naturally rises.
- As the stock rises, the Newsletter Publisher and perhaps even people inside “Company A” can then sell the shares to realize a profit; this is called “selling into strength.”
- The person receiving the email sees the stock rise temporarily and then fall. Of course, they cannot complain because they will be advised they should have sold sooner and that they should read the disclaimer.
To watch the full expose video on Penny Stock Scams, go here.
Discover why Penny Stocks are not the best option in our article on Cheap Stocks
3 – Alternative or Private Market Conflicts of Interest
If you decide to invest in alternative markets, such as Pink Sheets, “Over the Counter” (OTC), or even specific derivative markets like CFD’s, the operators of those markets may have a conflict of interest.
Sometimes they directly need to take the opposite side of your trade and can, therefore, manipulate the Bid & Ask prices accordingly. A high-quality mature company will have a Risk Mitigation department to try to resolve and avoid any conflicts.
I hope this has given you an insight into how the stock market works from inside Wall Street.
For more revelation and insights into this topic, see the Book Full of Bull on our Top 20 Books List.
How the Stock Market Works – Podcast
How does the Stock Market Work In Reality? Should you believe Wall Street Analysts? Why Do People Lose Money or Make Money in the Stock Market & What are the BIG RISKS?
- Published: Tue, 04 Jun 2019 13:00:00 GMT
- Duration: 00:15:44
Video: Learn How the Stock Market Works With Great Books
Summary
The stock market works by providing a marketplace for buyers and sellers of shares in a company to exchange those shares for the right price safely. The Brokers and Exchanges make money on the fees and commissions they charge per transaction. Those fees fund the security and infrastructure to make the fair exchange of stock possible.
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