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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.

How does the stock market workHow does the stock market workHow does the stock market work
The rundown
  • The stock market is a marketplace where you can buy, sell and trade stocks at any time during the business day
  • The stock market operates in the same way as an auction house, with investors negotiating on the price of shares by bidding
  • The price of a stock on the stock market is set according to supply and demand

Definition: what is the stock market?

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

Where is the stock market?

The UK stock exchange is located in the City of London and is known as the London Stock Exchange

The world’s two largest exchange markets are in the US: The New York Stock Exchange, located on Wall Street and created in 1792, and Nasdaq, which was created in 1971 to deal with tech companies such as Apple and Facebook.

How the stock market works

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. 

What is the stock exchange?

Stock exchanges are secondary markets, meaning existing shareholders make transactions with potential buyers. When you purchase a share, you’re not buying it from the company that listed the share; you’re buying it from an existing shareholder. This transaction is the same when you sell your shares; you’re not selling it to the company, but another investor.

What are stock market indexes?

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:

How are share prices set?

When a company first lists its shares on the stock market, it undergoes a process called initial public offering (IPO). Once the pricing details and IPO are finalised, the company will set a date to open up its shares to the public.  

Once investors purchase shares, the market tracks the performance of their shares and determine the prices based on the supply and demand of investors willing to buy or sell each share. The prices of shares in the stock market are often set through an auction process in which buyers and sellers place bids on shares

How volatile is the stock market?

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.

What are the risks of investing in the stock market?

The biggest risk of investing in the stock market is there is a chance of losing your entire investment if the price of the stock you own falls to zero, for example, if the company you own stocks in goes bankrupt. 

When the value of the stock market decreases to less than 10%, this is known as a market crash. A bad market crash may even cause a recession. In the history of the stock market there have been several infamous crashes, such as the Wall Street crash of 1929, also known as ‘Black Tuesday’, and the 2008 financial crisis that followed the US housing bubble.

When a stock market decreases by 20% from its highest price, this is known as a bear market. Bear markets can occur in any asset class and can potentially wipe out years of gains. 

If you’re buying and selling stocks, you stand to lose money. Some consider day trading to be risky because it’s impossible to guarantee you’ll make a profit. However, in contrast to short-term trading, investing in the stock market over the long-term may prove more profitable, but you still have to be aware of the risks of market crashes.

Why should I invest in the stock market?

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. 

Pros and cons of investing in the stock market

Pros Cons
The value of shares in the stock market can grow with the economy. The market is volatile, which can be very risky for your investments.
Making the right trades at the right time can give you high returns on your investments. There’s a risk of losing all the value of your investment if, for example, the company you’ve invested in goes bankrupt.
It’s easy to buy and sell shares because you can do everything online. The prices of shares can fluctuate, which makes it hard to earn gains on short-term investments.
It allows you to stay ahead of inflation if you plan on investing over the long-term. You’ll need to invest a lot of time researching companies and the performance of shares in the stock market.

What are the other types of financial markets?

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.

Opening a savings account vs investing in the stock market

As you now know, there are many risks involved in investing your money in the stock market. If you’re looking for an investment option where the risks are minimal, and your returns are guaranteed, you might want to consider saving into a fixed rate bond instead.

Fixed rate bonds provide competitive interest rates from the day you open the account until the end of your agreed fixed term. 

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