How Does the Stock Market Work? Read This Before You Invest

You might be interested in understanding how the stock market works. But then you might be thinking, it's too complicated. Trust me, it's not. Here, you'll find the stock market's working explained in a simple way. Read on.

WealthHow Staff

Last Updated: Jul 2, 2018

First things first. When a company is started, it needs a capital for start-up. Capital is all the money invested to start a business. Capital can be raised in two ways. One is by borrowing money, which will be paid back later.

The second option is issuing stocks to those interested in sharing the profits of the company. By this we mean, people who buy the stocks will help in the venture of the company in return of which they will have a share in the profits that the company makes.

By issuing stocks, the company can raise more capital and it does not have to bear the interest as in case of repayment of debt. But one of the disadvantages in issuing stocks is that shareholders share the company ownership and have a say in deciding the company policies.

Stock Market Basics

Stock: The ownership units of a company are referred to as stock.

Stock Price: The price for which a specific stock sells is the stock price. Health of the economy, and the trends that prevail in trading and spending, influence the stock prices. These prices also depend on financial and technical reports put by the company.

Offering Price: The price of the stock presented in the final prospectus at the time of issuing the stock is known as the offering price.

Underwriter

To sell its stock, the company hires an investment banker for help. The process is underwriting and the person hired is the underwriter. He mediates between the public and the issuing company. The underwriting process works in one of the given ways:

1. Best Effort Arrangement: The investment banker acts as an agent trying to sell maximum possible issues at market prices.

2. All-or-none Arrangement: The company withdraws the issue from the investment banker in case he fails to sell all the stocks previously issued to him.

3. Negotiated Underwriting: The issuing company and the issuer negotiate the terms of issue and price.

4. Firm Commitment: The underwriter buys all the stock from the company and sells it to the public.

5. The company may opt for competitive bids from the investment bankers and appoint the top bidder as their undertaker.

Prospectus

It is a legal document presenting the financial facts about the offering company.

A prospectus has the offering price, costs involved in investing, company history, its management team, legal opinions about the issue, underwriting method, and the SEC's disclaimers. They are sent to all those willing to buy the primary offering. They are provided to customers before doing any transaction. Customers must read them before buying an offering.

Broker-Dealer

A broker is the one who facilitates trade between customers. He doesn't bear any risk and charges commission. A dealer is someone who trades for his own securities and for others. He may have some risk in the transactions.

A broker-dealer plays either of the roles at a time. Brokers and dealers must be registered with the National Association of Securities Dealers and follow the rules set by it.

Stock Market Index

It is a way of measuring the stock market as a whole. Many indices are combined by financial firms and used to measure the performance of portfolios.

Market Capitalization

It is the value of the stock that is being offered. Its value is the product of the number of outstanding shares of the company and price of the stock.

Bear Market

Investors anticipate losses and switch to selling. A bear market is characterized by pessimism in the market. The period of early 1930s marked the beginning of the Great Depression and is a famous example of it.

Bull Market

It is characterized by increase in the confidence of investors in anticipation of capital gains in the future. A famous example of a bull market was the one formed in the 1990s when the U.S. and other financial markets had grown at an exceptionally fast pace.

How does the Stock Market Work?

After a company decides to sell stock, the first step it takes is to file registration statements with the Securities and Exchange Commission and wait for 20 days before the sale of stocks. When issuing the stock, a final prospectus containing the offering price of the stock is brought about.

The underwriter buys all the company stocks to sell them to the public. He decides the markup price for his offering. The new price holds his service charges. During that period of 20 days, the issues of stocks can be advertised. Representatives can send preliminary prospectuses containing information about why the stocks are being sold, to the customers.

When you want to buy stocks, you place an order. If there is a broker with a sale order at the same price as that presented by your order, your order is filled and completed. Once the order is filled, the trade details are transmitted to all the parties interested.

In 3 business days from the trade date, the brokerage firm exchanges the stock certificate and money for the stock. For selling the stocks, you should inform your broker about the number of shares of whichever company you wish to sell. You will have to enter a sale order accordingly.

To trade in shares, you will need an investment account. It can be with your share broker, who acts as a firm or it may be an online account which does not require broker mediation for transactions.

When a business makes money, the price of its shares rises. On the same lines, if the business suffers losses, its share prices fall. Buyers and sellers of shares are watchful about the company business.

Based on the financial conditions of the business and their speculations, they decide when to buy and sell company shares. This has a huge impact on the type of market, largely influencing the economy.

World Stock Markets

Some names of the North American stock exchanges are Alberta Stock Exchange and Montreal Stock Exchange of Canada or the AMEX and NASDAQ of the United States. Rio de Janeiro Stock Exchange of Brazil and Chile Electronic Stock Exchange are those of South America.

A drastic drop in share prices leads to a stock market crash. Profits and dividends affect share prices but there is no specific reason for the changes in world stock markets. The changes are often results of the thinking patterns of investors and their imaginations about market trends.

Stock markets increase the money flowing directly to the market. They cause businesses to go public. World stock markets allow investors to share company profits and get involved in company ownership. You are the one to decide stock market trends. Stock market is a key player in world economy and you are a cardinal component of this economic system.