How the Stock Market Works

Investing in the stock market can seem like a scary prospect for a generation of young adults that have 2 cents in their pocket and a 100,000 dollar loan for a degree they don’t use. But when it’s done right, you can take that 2 cents, turn it into three cents, and well, that’s more than you had yesterday – and isn’t that the goal?

In all seriousness, the stock market is often perceived as a big scary abyss of money that eats unsuspecting investors alive and is the path to a magnitude of wealth for those that understand it. While those perceptions can be true, understanding the stock market and succeeding in making money with it is far easier than you might expect.

In order to understand the stock market, we need to understand just what a stock is.

What is a Stock?

A stock, otherwise known as a share, is a financial token or instrumet that signifies ownership of a company in some proportion. Basically, if Amazon had 1000 shares and you bought 1 share, you would own 1/1000th of Amazon. In reality, Amazon and companies alike have millions of shares, but that sums up the point.

When you own a stock, it means that you own a portion of a company, and when you own enough of a portion of a company’s stock, you get a larger pull to vote on how that company is run, whether that be through board elections, mergers, etc.

There are also common and preferred stocks, which refer to the voting rights we just mentioned. Common shares have voting rights, preferred shares don’t. However, preferred shares are called that because they get preference when a company pays a dividend or basically splits the profit with a shareholder, or preference in other financial situations.

Stocks can get much more complicated than that, but these simple understandings will serve enough to the basic investor.

Why do Companies Sell Stock?

The next thing you might be wondering is why exactly companies sell stocks? And the answer is simple, to get money. Stocks allow a company to raise massive amounts of operating capital with essentially no extra effort or product. The modern stock market often bases the value of a company off of its earning potential down the line. This means that relatively small companies can earn millions – or even billions – if investors think they can succeed in the future.

So then, if a company wants to sell their shares, they need a place to do it. Enter the stock market.

How Companies List Shares

Companies list shares by selling them through an initial public offering, or IPO. This essentially changes the status of the company from a privately held business to a publically traded one. IPOs can let company founders cash out their stake or just let the company raise money.

Once a company’s stocks are listed on an exchange, the public can trade. Usually prices will fluctuate based off of public opinion, but the more concrete trends in fluctuation are usually dependent upon company earnings and operations. These can be measured by PE ratios, or price to earnings ratios, as well as a variety of other accounting metrics.

This is usually where casual investors get scared and their eyes start to glaze over. But fear not! It’s not as complicated as it sounds.

Why and How Shares Fluctuate

The stock market is composed of millions of investors and individual traders who all feel different ways about a company. They all make independent choices and the net of those choices result in the positive or negative movement of a stock. If more people buy, then the price has to climb. If everyone wants out of a company, then the price falls due to excess demand.

An example might be this: Say you post something on craigslist for $100. After posting you get 100 emails saying they’ll come to purchase your item, all cash, right now. Most people at this point might start thinking they priced their item too low and raise thus raise the price until, in theory, it reaches the most one buyer will pay for. Conversely, if you recieve no offers, you’ll likely keep dropping the price until someone bites. This is similar to how the stock market moves, except the price rise and drop isn’t done consciously, rather by millions of transactions every second – supply and demand.

Supply and Demand

For every stock purchase or sale, there has to be a buyer and a seller. If there are more buyers, then the price will go up. If there are more sellers, the price will go down. Traders often might talk about the bid-ask spread, which basically means the difference between the bid, or what someone is willing to pay to buy a share, and the ask, or what someone is willing to sell the share for.

It’s all fairly simple at the end of the day: if more people want something, that thing, in this case a stock, will be more expensive.

Matching Buyers to Sellers

At the start of the stock market, matching buyers to sellers was done manually on the trading floor. Now, it’s mostly done manually by trading systems. This allows the market to move much much faster and creates the breakneck pace that any casual onlooker notices when watching the stock market.

Why Invest?

Now after, you might be wondering, well I don’t have time to understand this and why should I even invest anyway? Well, it’s simple really. Because if you do it right you can make a lot of money. Using a common example, if you bought $1000 of Amazon stock in 1997, you’d have roughly 1.5 million dollars today. While that’s a long investment timeline, I think most people would agree that that purchase would be worth it. Other companies often provide return rates like 30-70 percent each year, which is still going to build you a lot of wealth. In essence, as long as you’re able to make more than around 3 percent or more in the stock market, you’re doing better with your money than just keeping in the bank.

How to Invest

Now that we understand the stock market to be a real time marketplace where you can purchase a part of companies you think will succeed, the next step is to figure out how. The first thing you’ll need is a trading account. You can start one with common providers like E-Trade or other major banking institutions, but you can also use free trading services like Robinhood. Some trading services will charge fees for every trade you make, but new tech companies like Robinhood have made everything completely free. You can get a free stock by signing up with Robinhood here.

Once you have an account in any trading service you have to decide what company’s or multiple companies’ stocks to purchase, which is arguably the hard part. You also have to have a certain amount of money.

Stock range from a few cents to many thousands of dollars. The key thing about stocks is that you can’t purchase part of one, it’s either all or nothing. So if you want to invest in Amazon, you’ll need at least $1800 to get started.

Before you make a purchase, you’ll want to do extensive research to make sure you understand what a company does to make money, whether they’re in good financial standing, and al see what the experts think about whether you should buy it. At the end of the day, you do have to assume some risk, so it’s important you only invest money you’re capable of surviving without for a little while, at least until a stock comes back up if it does fall.

What we Didn’t Cover

In this article, we covered the basics of the stock market, how it functions, and ways to get started with it. We didn’t cover much of the technical analysis that goes into evaluating a company, much of the terminology around stock trading, or even ways to trade without actually having the money you’re purchasing stocks with, called margin. That’s okay, for the beginning investor, the best way to learn all of this is to start getting your hands dirty and invest wisely.

Trevor is a civil engineer (B.S.) by trade and an accomplished writer with a passion for inspiring everyone with new and exciting technologies. He is also a published children’s book author and the producer for the YouTube channel Concerning Reality.

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