The Basics of How the Stock Market Works

Written by: Andrew Briesacher – Wealth Manager

Many times we get asked by prospects and clients “how does the stock market work?”,  the simple answer is that the stock market is a complex auction system where shares of publicly traded companies are bought and sold. For this article, we will focus on the fundamental mechanics of stock trading.

For our more seasoned investors, this information may seem to be a bit pedestrian; however, it’s important to start with the basics:

1. Stock Exchanges: Companies list their shares on stock exchanges like the New York Stock Exchange (NYSE), NASDAQ, London Stock Exchange (LSE), etc. These exchanges provide the platform where buyers and sellers come together to trade stocks and ETFs.
   
2. Participants: There are various participants in the stock market:
   • Investors: Individuals or institutions who buy and sell stocks to achieve financial goals.
   • Brokers: Intermediaries who execute trades on behalf of investors. Many times, investors think of this term synonymously with “Financial Advisor” but a broker is simply someone that is licensed to assist in purchasing or selling securities, and they are not required to act in your best interest.
   • Market Makers: Entities that facilitate trading by buying and selling stocks to ensure liquidity, they act as the “auctioneers” to the auction market and help facilitate trades. These Market Makers receive compensation from “markups” and “markdowns” to get their cut from the trading action.
     
3. Trading Mechanisms: Stocks are traded through various mechanisms.
   • Auction Market: Trades occur at specific times, at prices determined by supply and demand. Here are those determining functions:
     • Bid – When selling a stock, investors look at the Bid which tells them the highest available price market makers have for the investor to sell their stock. 
     • Ask – When purchasing a stock, this is the lowest available price that markets makers have available for the investor purchase a stock.
   • Continuous Trading: Most trading occurs continuously throughout the trading day, with prices changing based on orders placed by buyers and sellers. Higher volume of trading is what can cause the stock price to move significantly, especially if there is a higher weight on one side of the market. (I.E. If there is a much larger amount of sell orders than buy orders, this will move the stock down in price significantly to fill those orders at prices lower than it is currently trading since there aren’t as many investors willing to buy the stock).
     
4. Order Types: Investors place orders to buy or sell stocks. Here are the main examples of the types of orders they can place:
   • Market Orders: These orders execute immediately at the current market which is the current Bid price if the investor is selling the stock or the Ask price if the investor is buying the stock.
   • Limit Orders: Execute at a specified price or better. If the limit price is away from the current market prices, it will not fill until the market moves back to the price the investor is willing to buy or sell at. It will be immediately activated if there is a more advantageous price available and fill at that better price.
   • Stop Orders: Trigger a market order when the stock reaches a specified price. This doesn’t mean the stock will fill at that price, it is simply activated once the stock hits the price, but if the market is moving quickly due to high volume it could be filled significantly lower than the Stop or “activation” price. Stop orders are the most frequently misunderstood types of orders and many times have unintended consequences.
     
5. Market Regulation: Stock markets are regulated to ensure fair trading practices, transparency, and investor protection:
   • Regulations prevent insider trading, market manipulation, and ensure companies disclose relevant information to investors.
     
6. Clearing and Settlement: After a trade is executed, it goes through clearing and settlement processes:
   • Clearing: Matching trades and ensuring both parties have the ability to fulfill their obligations.
   • Settlement: Transfer of securities and funds between buyers and sellers, in the past typically this occurs at what’s known as T+2 (two business days after the trade date); however, the “Role of Technology” has brought recent changes.
     
7. Role of Technology: Increasingly, trading is conducted electronically via trading platforms and systems that match buy and sell orders quickly and efficiently; however, it has also made way for much riskier forms of investing like day trading. Using the term investing for day trading can also be dangerous as it can realistically be closer aligned with gambling than a disciplined investment philosophy like we employ at Wheelhouse.

Understanding how the stock market works involves grasping these concepts/components and how they interact to determine stock prices and facilitate trading activities. It’s a dynamic system influenced by economic factors, investor sentiment, corporate earnings, and global events.

It’s important to note that individual stock investing can carry a high amount of risk and takes careful consideration. When purchasing an individual stock, investors are not only taking on the risk that the company itself could struggle, but also that it may simply underperform the indexes of the markets with which they are investing. In these cases, a simple ETF strategy would be more diversified and give investors a higher probability of success with similar growth and less overall risk. 

As always, don’t hesitate to reach out to our team if you have questions about these market functions and why here at Wheelhouse we typically lean towards cost-effective ETF strategies for our growth investments.