Lesson 3: What is the Stock Market and How Does It Work


In the last lesson, we learnt what a stock is – it is simply a an ownership claim to proportion of a business. In this lesson, I will attempt to explain what the stock market is and how it works.

 

Contrary to popular belief, it is not a casino as what most people like to think. Instead, it is the biggest auction house in the world.

 

The stock market is where investors buy and sell shares in public companies.

 

It matches sellers of stock to buyers of stock so that transactions between the two parties can take place. In a sense, it acts as a giant auction house where investors meet to buy and sell their shares of stock.

 

The stock market works through a network of exchanges — you may have heard of the London Stock Exchange, the New York Stock Exchange or the Nasdaq. Companies list shares of their stock on an exchange through a process called an initial public offering, or IPO. Investors purchase those shares, which allows the company to raise money to grow its business. Investors can then buy and sell these stocks among themselves.

 

Historically, stock trades likely took place in a physical marketplace. Traders would shout out prices and deal directly with each other. These days, the stock market works electronically, through the internet and online stockbrokers and involves buyers and sellers from all across the world.

 

However, the underlying principle is still the same.

 

How Buying And Selling Of Stocks Work On An Exchange

Institutional and professional investors, such as bank traders,  fund managers, pension funds, insurance companies or individuals set a price at which they’re willing to buy and sell the asset in question. This the goes onto the exchange’s ledger — a list of all buying and selling interests — which is called the order book. The buyers and sellers are then matched up via a matching engine and orders get completed in this way. 

 

Lets look at an example to see how this works.

 

Say a buyer wants to buy 100 shares in Company X. Based on his calculations about the value of the company, he puts in an order to buy shares at £50 a piece. This order goes onto the order book. 

 

So If there’s someone who wants to sell 100 shares at £50 on the order book already then no problem at all. It all adds up smoothly.

 

Or say instead the seller is selling a 100 shares at £49. This again is straightforward as the seller is selling at a lower price than what the buyer is willing to pay.

 

And if there are two sellers of 50 shares each, but one sells at £49 and the other at £51, the matching engine can combine those two sellers for an average cost of £50 a share and ensure the buyer gets his 100 shares for £50 each.

 

Still with me? Great!

 

On the other hand, say the sellers in Company X are all holding out for £52 a share because they know the value of the company is this much. In this case, the buyer will have to put a new order at £52 a share in order to buy them. They have to pay a higher price.

 

That’s how the market price goes up or down.

 

Traders who think the company will do well bid the price up, while those who believe it will do poorly bid the price down. Sellers try to get as much as possible for each share, hopefully making much more than what they paid for it. Buyers try to get the lowest price so that they can sell it for a profit later.

 

Aggregated together, the most recent transactions like this create and shift the market price of a stock.

 

So when people refer to the current stock price, it is simply the price of the last trade.

 

It is a historical price – but during market hours, that’s usually mere seconds ago for very liquid stocks.

 

The Role Of The Market Maker

The order book is the primary method for matching buys and sells efficiently. However, a number of exchanges have alternative mechanisms to keep transactions moving smoothly and to ensure liquidity.

 

This is where market makers come in.

 

Market makers are firms that agree to take the other side of orders to buy or sell certain stocks.  Market makers are required to continually quote prices and volumes they are willing to buy and sell at. They literally “make a market” for a stock by standing ready to buy or sell a given stock at every second of the trading day at the market price. So buyers don’t have to worry about there being available sellers at the exact moment they want to purchase and vice versa.

 

Market makers quote a bid-offer spread: a lower price they’ll buy at and a higher price they’ll sell at. This is why you usually see two different prices when you look at a stock.

 


The bid price represents the maximum price that a buyer is willing to pay for a stock .

 

The ask price represents the minimum price that a seller is willing to receive for a stock. 



 

So,

  • if you are selling a stock, you are going to get the bid price,
  • if you are buying a stock you are going to get the ask price.

The difference (or “spread”) goes to the broker/specialist that handles the transaction. They need to make a profit for providing liquidity. They are essentially a middle man.

 

So there you have it. I hope this article has helped indoor understanding of what the stock market is, how transactions take place on the stock market, how prices are set and the role of intermediaries such as the middle man.

 

If you have any questions, please feel free to post them below.

 

In the meantime, stay tuned for the next article on the stock market series.