How does the stock market work? Shares, prices, risk

The stock market is the network of exchanges where people buy and sell shares, small slices of ownership in companies. Here is how it does that work, in two parts: a company sells shares once to raise money, and after that investors trade them with each other. Each trade happens at a price a buyer and a seller both accept, so prices move with what people expect the company to earn.

In short

• A share is a piece of ownership in a company: a claim on part of its profits and a vote on how it is run.
• Companies raise money only when they first sell shares; almost all trading after that is between investors, matched by an exchange.
• Prices move with expectations about future profits, and those expectations can swing hard, which is where the risk comes from.

What is a share, exactly?

A share, or stock, is a unit of ownership in a company. If a company has 1 billion shares and you own 1,000 of them, you own one millionth of it. That gives you a claim on part of its profits, which it may pay out as dividends or keep to grow the business, and usually a vote at its annual meeting. As FINRA, the US brokerage regulator, puts it, your return depends on how the company performs.

Most shares are common stock. Some companies also issue preferred stock, which usually pays a fixed dividend and is paid before common stock if the company fails, though after the people it owes money to. That order matters: shareholders are owners, not lenders, so they are last in line and nobody promises them their money back.

The idea is old. The Dutch East India Company sold shares to the public in 1602, and those shares changed hands in Amsterdam, which is often called the first stock exchange. In New York, 24 brokers signed the Buttonwood Agreement on 17 May 1792, which the New York Stock Exchange counts as its founding.

How does a company get onto the stock market?

A company that wants to sell shares to the public for the first time holds an initial public offering, or IPO. It hires investment banks, called underwriters, who help set a starting price and find buyers. It must also publish a detailed account of its business and finances, which in the United States is filed with the Securities and Exchange Commission (SEC). The money from the IPO goes to the company, and that is the moment the stock market funds a business.

After the IPO, the company is mostly a bystander: when you buy its shares, your money goes to another investor, not to the company. This is the difference between the primary market, where new shares are sold, and the secondary market, where existing shares trade. Almost everything people mean by "the stock market" is the secondary market. It still matters to the company, because a high share price makes it cheaper to raise money later and makes the shares it pays its staff with worth more.

How does a trade actually happen?

You don't trade with an exchange directly. You place an order with a broker, which sends it to an exchange such as the NYSE or Nasdaq, or to another trading venue. Each stock has an order book: a list of bids (the prices buyers will pay) and asks (the prices sellers will take). A computer matches orders where they meet, in milliseconds.

Here is one trade walked through, with made-up but realistic numbers. Suppose the order book for a stock looks like this:

Bids (buyers)	Asks (sellers)
300 shares at $49.98	200 shares at $50.02
500 shares at $49.95	400 shares at $50.05

The highest bid is $49.98 and the lowest ask is $50.02, so the spread is 4 cents. You send a market order to buy 300 shares, which means "buy now at the best prices available". The exchange fills 200 shares at $50.02 and the other 100 at $50.05, for $15,009 in total, an average of $50.03 a share. The last trade printed at $50.05, so that is now the stock's last price. If you had sent a limit order to buy at $50.02 or less, you would have got the first 200 shares and waited for the rest.

The trade isn't final when it is matched. Cash and shares change hands at settlement, which in the United States has taken one business day since 28 May 2024, when the SEC moved the market from two days to one.

Why do stock prices go up and down?

A share is worth what buyers expect the company to earn for its owners in the future, weighed against what else they could do with the money. When a company reports profits above what people expected, buyers will pay more and the price rises. When it disappoints, the price falls. Most of the news in a share price is a change in expectations, which is why a company can report record profits and still see its stock fall.

Prices also move for reasons that have nothing to do with one company. When interest rates rise, safe savings pay more, so future profits are worth less today and stocks often fall. Fear and enthusiasm move prices too. In the late 1990s, investors bid internet companies to prices their profits never justified, and the dot-com bubble burst in 2000.

The value of a whole company on the market, its market capitalization, is its share price times its number of shares. At $50 a share and 1 billion shares, the market values the company at $50 billion.

What are indexes like the S&P 500 and the Dow?

An index tracks a basket of stocks so people can see how "the market" did in one number. The S&P 500 follows about 500 large US companies, weighted by their size, so the biggest move it most. The Dow Jones Industrial Average follows just 30, weighted by share price, an older method. When the news says "stocks fell 2% today", it usually means one of these.

Many people own the market through index funds, which buy every stock in an index, rather than picking companies. That links to the most useful idea in investing, diversification.

How risky is the stock market?

Stock prices can fall far and stay down. After the crash of October 1929, the Dow fell from 381.17 on 3 September 1929 to 41.22 on 8 July 1932, an 89% loss according to the Federal Reserve's history, and it took until 1954 to close above its 1929 peak. The crash became part of the story of the Great Depression. On 19 October 1987 the Dow fell 22.6% in one day.

Diversification spreads that risk. If all your money is in one stock and it halves, you lose 50%. If it is spread evenly across 20 stocks and one halves while the rest hold steady, you lose 2.5%. It doesn't remove the risk that the whole market falls, which is why stocks are a poor place for money needed soon.

This explains; it isn't advice

Over long periods, stocks as a whole have earned more than savings accounts, and they have also lost a third or more of their value several times. Nothing here is a recommendation to buy, sell or hold any investment.

The stock market is one of the central institutions of capitalism: it lets companies raise money from anyone, and lets owners sell without the company having to buy them out. It is also one part of the wider study of economics, where prices carry information about what people expect.

Check yourself

• When you buy a share of a large company today, who gets your money, and why?
• Walk through what happens to a market order to buy 300 shares when only 200 are offered at the best price.
• Why can a company report record profits and still see its share price fall?

Sources

• Stocks — FINRA
• The History of NYSE — New York Stock Exchange
• SEC Chair Gensler Statement on Upcoming Implementation of T+1 Settlement Cycle — U.S. Securities and Exchange Commission, 2024
• Stock Market Crash of 1929 — Federal Reserve History
• Stock market — Wikipedia