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Listening to Bloomberg’s or CNBC’s latest stock market news can be intimidating. Some terms may be all “Greek” to the uninitiated.
However, if you understand the language people use in the financial world, specifically in the stock market, you’ll find business news interesting.
This article tackles the fundamentals of the stock market and how it works. It also discusses the different types of stocks and stock exchanges available for traders and investors.
Furthermore, this piece explains the stock index, its purpose and how it helps traders understand market data, which is crucial for financial decision-making.
What Is a Stock?
A stock represents ownership of a fraction of the issuing company. A company’s stock is comprised of shares.
When you buy shares from a company, you become a shareholder, which entitles you to a proportion of the company’s assets. The number of shares you’ve bought is the amount of a company’s stock you own.
Stock Market Basics
A stock market is a group of exchanges where publicly traded companies, not private companies, buy and sell their shares.
What’s the difference between a publicly traded company and a private company?
A private company is your typical business operated by an entrepreneur and their staff. The ownership of private companies is limited mainly to the founders, employees and investors.
On the other hand, a public company is a business that has opened up to the public, allowing anyone to buy its shares.
For a company to buy and sell shares in the stock market, it should register with the U.S. Securities and Exchange Commission (SEC) as a publicly-traded company.
What Is Stock Market Called?
The stock market is also called a share market or an equity market. It’s called a market because it’s a venue for buying and selling stock. Investors and traders go into the stock market to find new securities they can place their money to profit.
A stock market is a specific type of capital market that only trades shares of corporations.
Companies come into the capital market to sell their stock and get needed capital to fund their expansion and growth. Suppliers in capital markets usually include banks and investors.
Did you know that there are other types of marketplaces where investors and traders journey to earn profit? Here are different types of markets in the financial world.
- Over-the-counter market: This market lies outside the major financial market exchanges. Securities are bought and sold directly between sellers and investors.
- Commodities market: This is where raw materials like coal, oil and steel are traded. Over 50 major commodity markets cover this wide range of raw materials and goods.
- Foreign exchange market: Commonly known as forex, this market is a borderless and international market for currency exchange.
- Derivatives market: This is a market for financial contracts whose value is connected to the performance of an underlying asset within an agreed period.
- Cryptocurrency market: This is a marketplace for cryptos like Bitcoin and Ethereum.
- Bond market: This is a market where bonds are traded. Types of bonds include corporate and government bonds, like those issued by the U.S. Treasury.
How Does the Stock Market Work?
The stock market works similarly to a regular marketplace. Imagine you’re in a bazaar or flea market, and you see many stalls selling wares and products. You may also see people buying, selling, negotiating and bargaining in the flea market.
Now, instead of them selling products, they’re selling a fraction of their company with a promise that, in time, their business will expand and the shares sold will increase in value.
Add a few auction areas where brokers bid for the best possible share prices a company will accept, and you’ve got yourself a stock market.
Companies selling their shares in a stock exchange are tapping into a source of capital that they can use to expand their business without going into debt. All a company needs to do is convince the public that buying their shares is worthwhile.
What Are the Four Types of Stocks?
You can classify stocks traded in an exchange into four major types. If you’re a newcomer to the stock market, you’ll find it helpful to know how these stock types differ from one another.
- Growth stocks: These stocks are sold and bought for capital growth.
- Dividend or yield stocks: These stocks perform well during a booming market (bull market) and provide partial protection during market downturns (bear market).
- Initial Public Offerings (IPO): These are stocks from a company that has transitioned from a private business to a publicly traded company.
- Defensive stocks: These are stocks that don’t get seriously affected by economic downturns because they sell consumer staples.
The types of stocks are further subdivided into these categories.
- Common stock: This is the basic ownership stock or shares which you can buy from a company. Owning common stocks gives you a vote in company decisions that require stockholder consensus.
- Preferred stock: This type of stock gives you dividends, although it does not necessarily give you company voting rights.
You can categorise stocks depending on the market capitalisation size. A company’s market capitalisation refers to the total market value of a company’s outstanding stock in dollars.
- Large-cap stock: A company is considered to have a large market capitalisation if it has a market value of over $10 billion. Multi-billion dollar companies like Apple, Amazon and Tesla are examples of large-cap companies.
- Mid-cap stock: A company is considered to have mid-capitalisation stock when it has a market value of between $2 billion and $10 billion. Examples of mid-cap companies are Super Micro Computer Inc. (SMCI) and Wingstop Inc. (WING).
- Small-cap stock: A company is considered to have a small market capitalisation if it has a market value of $250 million and $2 billion. Examples of small-cap companies are Prometheus Biosciences Inc. and Akero Therapeutics Inc.
- Micro-cap stock: A company is considered to have a micro-market capitalisation if it has a market value of $50 million to $300 million.
How Are Prices Determined on a Stock Market?
Stock prices are determined through supply and demand. People buy stocks from companies they’re familiar with or believe to be successful.
Naturally, companies with an excellent track record tend to attract many investors resulting in high demand for their shares. High demand tends to increase share prices.
Meanwhile, low demand means only a few people are buying shares, resulting in a decrease in share value and price.
However, supply and demand is only one factor that determines stock prices. External and internal factors that impact the company’s productivity also determine its financial success and contribute to its stability.
Here are other examples of factors determining stock prices:
- Company activities or events that happen to a company can affect share prices.
Examples of company happenings that could lead to a sudden surge or dip in stock price include the following:
- Loss of a huge and important account or client
- Rollout of a global expansion
- Approval of a patent for a novel product or service
- Sudden death of the CEO
- Economic factors are economic situations that affect a country or company at a particular time. One example of economic factors is the rise and fall of oil prices or the fluctuating real estate prices.
Economic factors include the following:
- Wages and tax rates
- Exchange rates
- Labour supply and demand
- Inflation is the rate by which prices of goods and services increase, usually because of a decline in purchasing power.
In general, the market price of value stocks is directly proportional to the rate of inflation. When the inflation rate increases, value stocks perform better.
- Interest rates determine the specific amount lenders charge borrowers. The interest is a percentage of the principal (the amount loaned) that a lending body is willing to give borrowers.
Data has shown that interest rates and stock prices have an inverse relationship. As interest rates rise, stock prices go down.
- Consumer spending is the total money individuals, and households spend on final goods and services in an economy.
Investors and policymakers monitor published statistics and reports on consumer spending to forecast and plan investments and decide on policies.
- Rippling factors from high investor activities or the actions of big companies can affect stock prices.
- Major events outside a business owner’s control, like disasters, geopolitical turmoil and economic downturns, can also impact stock prices.
Market Makers Ensure There Are Buyers and Sellers Always
A market maker is a person or a company who creates a market for specific goods and services by actively quoting bids and offers (asks) for buyers and sellers or the two-sided market.
Market makers are often brokerages that provide services for clients and, in the process, keep the market liquid and flowing. They may also make principal trades by buying and selling securities for their own accounts.
Three types of market makers are responsible, in part, for ensuring that there are always buyers and sellers for a specific security.
- Retail market makers are responsible for servicing orders from retail brokerage customers. Large retail brokers often use in-house market makers.
- Institutional market makers provide a market for securities like pension funds, mutual funds, insurance, and management companies.
- Wholesalers specialise in trading shares for institutional clients and broker-dealers not registered as market makers for a specific security.
What Happens When You Buy a Stock?
You become a shareholder when you purchase a share from a particular stock. Usually, you purchase stock through a stockbroker or the person who does the heavy work of buying and selling shares in a stock market.
Stock Markets, Stock Exchanges, and Stock Indexes
Stock exchanges are marketplaces where securities like stocks and bonds are traded. Each country has its stock exchange, where all securities are bought and sold.
Examples of popular stock exchanges in the world are the following:
- New York Stock Exchange (NYSE)
- London Stock Exchange (LSE)
- Tokyo Stock Exchange (TSE)
Today, stock exchanges can happen remotely on electronic trading platforms, where you can monitor market movements in real-time. You can find apps that provide these services, gaining popularity with beginner and experienced traders.
Other niche exchanges include crypto exchanges like Bitcoin and Ethereum and forex exchanges. These exchanges are part of a regional or national financial market, which is also part of the global market.
How Does a Stock Index Track the Stock Market?
A stock index is a handy tool for monitoring and tracking the stock market’s performance. An index measures the value of some or all shares in a stock market.
Stock indices are created by index providers that use weighted averages to calculate a measurement that reflects the relative size and value of different stocks. Investors use indices as benchmarks for the performance of individual stocks or the entire portfolio.
Examples of stock indices are the following:
- Standard and Poor’s 500 index (S&P 500 index) is a U.S. stock index that tracks the market performance of America’s 500 largest publicly-traded companies.
- Dow Jones Industrial Average tracks 30 of the largest blue-chip companies trading on the New York Stock Exchange.
- NASDAQ (National Association of Securities Dealers Automated Quotations) Composite is a U.S. stock index that tracks the market performance of over 3,000 NASDAQ securities.
- VIX (Chicago Board Options Exchange Volatility Index) is the Wall Street fear meter. Investors look at market volatility or price change rate to determine the best course of action.
- Financial Times Stock Exchange Group (FTSE Russel Group) in the U.K. tracks global financial markets and provides different indices. Its most popular index, FTSE 100, follows the top 100 corporations by market capitalisation in the U.K.
- Hang Seng Index is a market cap-weighted stock market index in Hong Kong that tracks the largest businesses in the Hong Kong stock market. The Hang Seng is also the primary indicator of Hong Kong’s economic performance.
- Nikkei (Nihon Keizai Shimbun) 225 belongs to the Tokyo Stock Exchange (TSE). Japan’s Nikkei 225 Stock Average is the leading and most-respected index of Japanese stocks. This price-weighted index comprises Japan’s top 225 blue-chip companies traded on the TSE. The Nikkei is the go-to index for Japanese stock averages.
Aside from buying and selling company or commodity stocks, you can also place your money in exchange-traded funds (ETFs). An ETF is a pooled investment security that tracks a particular index. You can buy and sell ETFs similar to other kinds of stock.
Each country has its stock market index, which usually reflects the economic state of a nation. A crashing stock market index demonstrates a country’s financial problems. On the other hand, a rising stock market index can mean the country’s economy is improving.
- Stocks: What They Are, Main Types, How They Differ From Bonds
- What Is the Stock Market, What Does It Do, and How Does It Work?
- What Are Capital Markets, and How Do They Work?
- The Bond Market (aka Debt Market): Everything You Need to Know
- What Is The Stock Market? How Does It Work?
- Market Capitalization: How Is It Calculated and What Does It Tell Investors?
- What Is a Large Cap (Big Cap) Stock? Definition and How to Invest
- Mid-Cap: Definition, Other Sizes, Valuation Limits, and Example
- Market Maker Definition: What It Means and How They Make Money
- Financial Times Stock Exchange Group (FTSE): Definition
- Nikkei: How it Works, Special Considerations
- Consumer Spending: Definition, Measurement, and Importance