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How Does the Stock Market Work?

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Last editedNov 20213 min read

If you’re new to investing, it can be hard to wrap your head around all the terminology involved with stock market trading. How are prices determined, and what is the primary function of the market? We’ll break down how it all works in this guide, starting with stock market basics.

What is the stock market?

When people refer to ‘the stock market’, they’re referring to the global equity market which includes dozens of exchanges scattered across the globe. The biggest UK stock market is the London Stock Exchange, for example.

Each stock exchange operates as a platform for buying and selling shares in publicly held companies. Stocks, shares, or equities represent partial ownership in a company. Companies benefit from the capital gained by selling this partial ownership, while investors benefit from sharing in the company’s profits. Investors can also make money through selling shares when the stock price increases from its initial purchase price.

Stock market functions

In addition to serving as a simple trading platform, the stock market performs several important functions.

  1. It ensures a fair, uniform process with transparent pricing for both buyers and sellers. A stock market should match appropriate buy and sell orders, giving relevant data to all participants.

  2. It supports price discovery to accommodate for supply and demand as well as any relevant news related to company pricing. This gives traders the information they need to make a fair trade.

  3. It supports security for all transactions by verifying participants and ensuring everyone plays by the rules. For example, no parties are allowed to default.

  4. It offers investor protection for traders who might have less experience, shielding them from loss with actions such as categorising stocks by risk.

Stock market players

To understand how the stock market works, you must look at all the players that take part in its daily activities.

  • Stockbrokers are third-party professionals who buy and sell securities on behalf of their clients, or investors. They serve as an intermediary between the stock exchange and the investor.

  • Portfolio managers help track and maintain portfolios for their clients. They track market trends to make buy and sell decisions that will be financially advantageous. Portfolio representatives represent individuals as well as hedge funds and mutual fund companies.

  • Investment bankers represent the companies that decide to start selling shares. They might support a private company when it wishes to go public or facilitate mergers and acquisitions.

These are a few of the participants that help keep the market running, working on behalf of investors and companies.

How does stock market trading work?

The stock market listing process begins when a company decides that it wishes to start shelling shares to investors. It goes through the IPO, or initial public offering, stage at this point. The IPO process begins when a company lists shares on the primary market at a fixed price. Big-scale investors, (typically banks or other financial institutions), purchase these shares at a bulk rate.

The company’s shares then become available on the secondary market, where individual investors can buy and sell using their broker service of choice. At this stage, share price will be determined by supply and demand.

You can follow along with stock market performance by tracking or trading the relevant stock market indexes. These include the Standard and Poor’s 500, Financial Times Stock Exchange 100, NASDAQ, Hang Seng, and Dow Jones Industrial Average, among others.

What causes a stock market crash?

It’s natural for the stock market to experience bear and bull periods to match natural economic fluctuations. However, in periods of severe downturn you might see a stock market crash. This means that stock prices suddenly plummet across the board, leading to a massive loss of wealth for investors. One example is the crash of 1929 on the cusp of the Great Depression. There are numerous causes of a stock market crash, including economic decline. However, outside forces combine with mass panic to cause a crash. Because investors are worried that they’ll lose money, they sell all at once creating a positive feedback loop. Investors sell, prices drop, and more investors sell until the market bottoms out.

Fortunately, UK stock market crashes have been far and few between. By understanding how the market works along with the natural ebb and flow of stock prices, you can make more profitable investments over time.

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