How does the stock market work?

Investing in the stock market can seem complex, and first-time investors are often unsure how to approach it. Don’t worry, everyone is in the same position at first. The most important step to take as a beginner to investing is to understand how the stock market works, so you’re better able to manage your investments. On this page, you’ll learn everything you need to know, from the definition of the stock market to how it works and the pros and cons of investing.

The stock market is a marketplace where people buy and sell shares, or stock, in companies based on how much they think they will be worth in the future. There are stock markets all over the world, with some of the bigger ones, including America’s New York Stock Exchange and the UK’s London Stock Exchange. Each piece of stock you buy means you own a share of the company you’re buying it from.

The performance of each stock market is best observed by looking at the value of large indexes within the stock market. An index contains the top-performing companies within the stock market, examples being the S&P 500 in the US, the FTSE100 in the UK and the Nikkei Index in Japan.

You’ll frequently hear on the news headlines that the stock markets have moved up or down, which typically means that the stock market indexes have moved. This movement refers to the value gained or lost by the index as a whole, and investors who make stock market transactions look for profits through the movement of stock prices.

The stock market operates in basically the same way as an auction house, where buyers and sellers negotiate prices and make trades. Companies that plan to go public list their shares on the stock market and investors purchase those shares, allowing the company to generate money which they usually use to grow their business. This type of stock offering is known as an initial public offering (IPO). 

Investors can buy and sell their stocks to other investors, and the stock market will track the performance and set prices depending on the supply and demand of each stock. 

Buyers offer a bid or the highest amount they’re willing to pay for stock owned by another investor. These offers are usually lower than the asking price. For trades to occur, a buyer and seller must agree on the amount they’re willing to pay or sell for. 

The stock market works electronically and online with prices often automatically calculated, unlike traditional marketplaces where you’d need to be physically present to make bids. 

Since it’s difficult to track every single stock, indexes such as the S&P 500 and FTSE 100 represent sections of the stock market and make observing them a little easier.

For example, the FTSE 100 is the share index of the top 100 companies listed on the London Stock Exchange. These 100 companies represent the performance of all the other companies.

The following graph is the current stock market index of the FTSE 100:

From https://uk.investing.com/indices/uk-100

The stock market is volatile by nature, and many factors affect its volatility. Regional and national economic factors, such as tax and interest rate policies, may contribute to a change in the market. For example, if a bank sets short-term interest rates for overnight borrowing, this can violently influence the stock market.

Other factors, such as a change in inflation trends, may influence long-term stock market trends and its volatility. For example, a huge weather event affecting a major oil-producing area may suddenly increase oil prices. This increase can also spike the prices of oil-related stocks.

Political uncertainty is another contributing factor to stock market volatility. The US election in November 2020 had a swift impact on stock markets around the world, and trade deals between major powers can also move stock markets up or down.

Finally, a global event can make the stock market swing wildly. The below graph shows how the coronavirus pandemic affected stock markets worldwide.

https://www.bbc.co.uk/news/business-51921420

The main reason for investing in the stock market is the potential to earn substantial returns. When it comes to long-term performance, there are usually no other types of investment that perform better. However, because of volatility and the amount of risk that comes with investing in the stock market, you’ll need to weigh up how much you’re willing to invest, as you can’t rule out the fact you might lose your money.

There are several other types of financial markets, including the following:

• Bond market: bond markets offer opportunities for companies to acquire large amounts of money to finance major projects or investments. In a bond market, investors buy bonds from a company that wants to borrow a lump sum, and the company will return the amount of the bonds within an agreed period with interest.
• Commodities market: this is where companies buy and sell natural resources such as oil, corn and gold. Since the prices are unpredictable, a company can purchase resources and can lock in a known price. If the value of those commodities increases, they stand to acquire great returns in what is known as a future commodities market.
• Derivatives market: derivatives are complex products that base their value on underlying assets. The futures in a commodities market is an example of derivatives.