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Anyone coming across the phrase “stock market” for the first time may have so many questions. And that is understandable. What should they think about this market? And, what kind of “stock” is being sold or bought here?
Markets have been around for as long as humans have swapped berries for meat. The idea of exchanging things, be it food, services, or stocks, is rooted in the same concept: a market.
So what Exactly Is the Stock Market?
Let’s start from a more familiar place: defining a market. A market is anywhere (it doesn’t have to be a specific building or place) where people buy and sell things. So, when two people meet to exchange a sack of potatoes and one head of cattle, that location becomes a market.
In modern times, you can log onto a website, such as Amazon.com, and purchase an item. That online platform is a market. The bottom line is that a market enables a buyer who demands an item to obtain it from a seller who supplies it.
Markets, regardless of what is being sold or bought, operate on one mechanism: supply and demand. Something interesting happens whenever there is a change in the balance of supply and demand. And this interplay is what generates activity in the market.
Suppose there is a market where participants trade berries for meat. When more people with berries want (demand) meat, those who sell (supply) meat will start asking for more berries for the same amount of meat. In other words, those selling meat raise prices when more buyers want a piece of their product, whose supply is limited.
Figure 1 Higher prices lead to lower demand.
Source: Investopedia
This rule flips when fewer people want meat, and there is quite a lot of meat available. There’s a lot of meat, but fewer buyers, and sellers want to get rid of it because holding onto it for longer will lead to loss due to spoilage. What do they do? The sellers reduce prices (the amount of berries required to acquire the meat) low enough to attract as many buyers as possible.
Figure 2 Lower prices lead to lower supply, higher prices lead to higher supply
Source: Investopedia
So, too little meat in the market? More berries are required to acquire the meat. And too much meat in the market? Fewer berries needed to purchase the meat. This principle applies in all markets, including the stock market.
First, let’s get the basics of the stock market out of the way.
Stock Market?
A stock market is a place where participants exchange shares in companies. We learned earlier that a market has three key features: buyers, sellers, and the item being exchanged. In the stock market, buyers and sellers are investors, and the item being exchanged is a stock.
In investment language, a stock is a claim on a company’s profits (and risks). It is a share in the company, which is another way of saying that you have bought a small fraction of the company. So, when you own a stock, you are part-owner of that company.
But, unlike the market where participants barter berries for meat, the stock market is much more specialized. This is to say that you can only buy or sell stocks. You can’t find cans of milk or sacks of potatoes. Also, this market isn’t a physical place. In fact, some estimates show that more than 80% of the trading in the United States stock market is automated. What this means is that the majority of buyers and sellers in the US stock market don’t meet physically. They only express interest to buy or sell a specific stock, and the order is fulfilled whenever possible.
This is a great time to learn how the stock market works.
How Does the Stock Market Work?
In a few words, the stock market allows one investor to purchase a company’s shares previously held by another investor. A particular stock’s price rises when its demand is high, and falls when more investors want to sell it. That’s it.
But dig a little deeper and you’ll realize why this market is referred to as “specialized”. For starters, the market operates in two distinct layers. There is a primary market and a secondary market.
The Primary Market
So far, we’ve seen that stock trading involves one investor selling shares to another. But before any shares can be traded, they have to come from somewhere. That somewhere is the company itself. This first sale directly from the company to investors is described as an initial public offering (IPO).
Imagine that a meat seller from the primitive market we described earlier becomes so advanced that they abandon the barter trade and set up a company. This company becomes so successful that the owner wants to open branches nationwide. To fund this expansion, the owner splits the business into one million shares and sells 500,000 of them to outside investors. This first sale is an IPO, and it happens in the primary market.
The Secondary Market
After the IPO, investors who bought the brand-new shares can keep them or sell them to others at a premium. If they decide to sell, they will make this intention known via a stock exchange. This trading of existing shares happens in the secondary market.
Think back to the meat seller’s company. Suppose that an investor named Maya bought 1,000 shares during the IPO. Later, she trims 500 shares from this holding and offloads them to Ben. This trade between Maya and Ben happens in a secondary marketplace such as the New York Stock Exchange (NYSE). The meat company gets no money from this sale; it’s just investors trading ownership.
The secondary market is what many refer to when talking about the stock market. This is to say that you are engaging with the secondary market when you check stock prices, follow market news, or use trading apps like Robinhood.
Other than the primary market, there is another market that you’re unlikely to hear much about: the over-the-counter (OTC) market. The OTC market provides a platform for stocks not listed on stock exchanges, such as the NYSE, to change hands. Trades here happen directly between buyers and sellers. The stocks in this market are often from smaller or newer companies that are ineligible to list on exchanges.
Who Participates in the Stock Market?
We know so far that the stock market has three layers: the primary and secondary markets, and the OTC market. Each of these layers involves different players.
The company selling shares is the biggest player in the primary market. Through the IPO, the company kicks off a wave of activities that will reverberate in the secondary market. The IPO process is made possible with expertise from investment banks. These firms underwrite the IPO and also set the initial price for the shares. The other key players are institutional investors, such as large asset managers, pension funds, and mutual funds, who are often the first buyers of the shares.
Investors, exchanges, market makers, and brokers make up the participants in the secondary market. Regular people who buy stocks in very small quantities are typically referred to as retail investors. On the other hand, the big organizations that manage large amounts of money, hence capable of buying huge chunks of shares, are institutional investors.
Brokers are the middle parties that take orders from investors and execute them. Put simply, they match buyers and sellers. On the other hand, market makers help keep the market running smoothly. They make sure there’s someone on the other side of a trade; so if you want to buy, they’ll sell, and if you want to sell, they’ll buy. Then there’s exchanges. These offer platforms for shares to move from one investor to the next.
The OTC market has three key players: companies (those issuing the shares), investors, and broker-dealers. The companies choose this platform because, for one reason or another, they are unable to list on major exchanges. Investors in this layer of the stock market have a higher risk appetite and can be individual or institutional. Broker-dealers, on the other hand, are firms that connect the two sides of trades. They are “broker-dealers” because they can play “middleman” as well as trade themselves with their own money, hoping to generate a profit.
Conclusion
The stock market is basically a platform that matches companies seeking capital with investors seeking to grow wealth. Like any other market, the stock market operates on simple supply and demand principles. However, funds put into stocks face risks, especially because stock prices can swing a lot as they respond to catalysts, such as company news, earnings reports, or economic changes.
Nonetheless, many investors continue to participate because, historically, stock markets have delivered strong long-term returns. Smart investors work hard to hedge the risks through diversification and patient, long-term planning.
