Foreword
Do you ever wonder how the stock market works? It will be essential to know how the stock market works before we start trading or investing. In this article, I will illustrate how it works.
What is Stock and why companies issues them?
A stock/ share (also known as a company’s “equity”) is the basic unit we use to determine the degrees of ownership we got in a company. By purchasing stocks, we can own a part of a company. And we can profit by selling them at a higher price or collecting dividends. Often, companies issue stocks through an Initial Public Offering (IPO) to raise money for enlarging their business or paying off debts.
(Basic terms such as IPO will be illustrated in later articles)
How the stock market works?
Sometimes the stock market likes an auction. Buyers and Sellers are there to give the price that they are willing to pay or sell for items. The difference between the stock market and the auction is that the shares traded in the market are replaceable, and their amount is tremendous. On the contrary, items exchanged in the auction are usually in small amounts and unique.
In the stock market, trades and orders are all executed by computer systems controlled by stock exchanges. These systems would pair up orders from both Buyer and Seller who gives the same price for the trade. That’s how the stock market works.
How do people evaluate the price of a stock?
The old one says values are determined by people, and stocks are the same. Often, people buy shares of a company base on their growth potential. The price of stocks rises and falls due to the change in people’s attitude toward them.
The stock price could rocket to the moon or tumble to the ground in few moments depends on how people think of it. And that’s why people say stock trading is risky since you could never know or predict how the market sentiment changes.
The Zero-sum Game
You may probably hear of people depicting stock trading as a zero-sum game. A zero-sum game means that the amount of money poured into the market equals the amount of money got out of the market. In other words, you will only make a profit when someone loses.
That’s how the stock market works. There must be a winner and a loser in the game. The difference between them is that winners focus on education and losers focus on notifications (following others). That’s why we should be educated.
Why would stock price fluctuate?
As previously mentioned, the stock price is determined by people. When people are positive about a company, they will buy their shares, vice versa. This also told us the reason behind why the stock price is fluctuating all the time, Supply and Demand.
What is Supply & Demand?
In an economic model (The stock market is included), the Supply and Demand determine the price of an item in the market. It told us that if the demand for an item is greater than the supply, its price will go higher, vice versa.
(You need not know too much about the theory. All you need to know is the stock price is driven by Supply and Demand.)
Results of Supply & Demand
The stock price fluctuates due to the supply and demand vary at different times.
Often, when there is good news (also known as catalysts) released by a company, people who can’t wait to get a cake would place numerous orders to buy the stocks and hope to participate in that move. This increases the demand for the stocks and hence pumps their price when no one is selling them.
Sometimes, you may see stock prices plummet. It could be caused by various reasons such as bad earnings, the introduction of regulations, rumors, or an economic crisis. No one exactly knows what drives the stock price tumbling. The only thing we could extrapolate from the price movement (also known as price action) is that many sellers are trying to sell their shares as quickly as possible. This increases the supply of the stocks and hence lowers their price when no one is buying them.
Policies to prevent flash crashes?
To prevent the stock prices from being so volatile (Rocketing or Tumble to 0 in a few moments), the Securities and Exchange Commission (SEC), an independent agency of the U.S federal government, has introduced various policies to avoid them. These policies would be covered in the following articles. In brief, they are policies that stop buyers and sellers from trading for different durations.
Final Thought
Understanding how the stock market works is a must-learn fact when you are building your foundation for investing or trading success.
[Next Lesson: The Three Basic Trading Strategies]
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