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Apr 25, 2022

What Is the Stock Market and How Does It Work? Everything You Need to Know

By Stash Team
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When people say “the stock market,” what do they mean? And how does it work, anyway? If you’re not sure, you’re not alone. This guide covers the key concepts you need to understand how the stock market works and how you can start investing.

What is the stock market?

The stock market generally refers to a physical exchange or electronic trading platform where people can buy and sell stocks. That said, the specific meaning of the term varies in different contexts. When you hear someone refer to the stock market, they might be referring to:

  • Stock exchanges generally, often in a geographic area. A stock exchange is a place to buy and sell shares of stocks. There are many such exchanges around the globe; there are even multiple exchanges just in America. When people speak about the stock market in general, they may be referring to all global exchanges, all the exchanges in the U.S., or the specific exchanges in another country or region.
  • A particular stock exchange. The New York Stock Exchange (NYSE) and the Nasdaq are the two largest exchanges trading stock in the U.S. It’s not uncommon for people to discuss the U.S. stock market in terms of just one of these exchanges. Stock exchanges only allow members to buy and sell stocks, and individual investors are not eligible for membership. That means you’ll need a brokerage as an intermediary. Today, many brokerages are entirely online, so investors can trade stocks via a brokerage’s website or app.
  • Stock indexes like the S&P 500 or the Dow Jones Industrial Average. Stock indexes aren’t actually markets; they are measuring tools. They aim to describe the behavior of the whole market, or part of it, by tracking particular stocks. Sometimes people say “the stock market” as a shorthand when referring to the performance of a stock exchange. 

Note: The Nasdaq is a bit unique, in that it operates both an exchange where you can trade stocks and several stock indexes. When people talk about the Nasdaq as an index, they’re usually referring to the Nasdaq Composite Index, which includes most of the stocks listed on the Nasqaq stock exchange.

How does the stock market work?

A stock market, or stock exchange, is a forum where companies sell stock and people trade stock amongst themselves. 

Where does stock come from?

Most stock currently in the market originated from initial public offerings, or IPOs. An IPO is when a company first offers an opportunity for investors to buy shares of stock; this is also known as going public. 

Through an IPO, companies raise capital to fund their growth, and they often offer millions of shares when they first go public. And after the IPO, a business can make a follow-on offer, or FPO, to raise additional money. Companies that are already publicly traded can issue new shares of stock too. 

Who trades stock? 

After stock enters the market, people buy and sell shares, or “trade stocks,” among themselves. For instance, if you buy a share of stock today, you’re buying it from another investor, and it could have changed hands many times since the company’s original IPO.

Investors are often categorized as retail or institutional:

  • Retail investors are generally individuals who buy and sell individual stocks, operating through a brokerage. 
  • Institutional investors are organizations, such as mutual funds or exchange traded funds, pension funds or agencies that manage pension/retirement accounts, and companies that operate many different funds. 

Many individuals have shares of individual stocks and funds in their portfolios. When you buy shares in a fund, you’re not directly purchasing stock like a retail investor. Instead, you’re providing money to the fund, which actually makes the purchases as an institutional investor.   

How are stocks traded?  

When you place an order to buy or sell stock on an exchange, it goes to your brokerage, not the exchange itself. Remember, individual investors can’t trade on exchanges directly. Once you place your order to buy or sell, your brokerage executes the transaction, which happens either through an online interface or in person, depending on the exchange. 

Brokers can generally choose which market to use and when to execute your trade, meaning the exact time they make the trade. Brokers can also choose what kinds of orders to accept.

For example, Stash accepts only simple buy/sell orders, known as market orders, and executes trades four times a day. Why? Because Stash is designed for buy-and-hold investors seeking long-term returns. As a result, the share price at execution may be somewhat higher or lower than when you place the order.

A brokerage geared toward day traders, on the other hand, might offer intraday trading and accept limit or stop-loss orders, which authorize the broker to trade only at certain prices. But day trading comes with significant added risk, especially for newer investors.

How are stock prices determined? 

Stock prices constantly fluctuate based on supply and demand: the push-pull between what buyers want to give and what sellers want to get.

Buyers “bid” the highest price they’ll pay, and sellers “ask” for the lowest price they’ll accept. The difference between the two is the “bid-ask spread.” For the trade to occur, the buyer or the seller must yield. It may sound complicated, but in practice most price-setting is computerized. When you actually go to purchase a share of a company’s stock, you’ll be presented with the current share price at that moment. 

What hours are the stock market open?

The NYSE and the Nasdaq are typically open Monday through Friday, 9:30 a.m. to 4:00 p.m. Eastern Time, except on holidays and during special closures.

When does the stock market close?

The NYSE and NASDAQ close on evenings, weekends, and holidays. Disasters like severe storms, terrorist attacks, or other major disruptions to commerce can also shutter markets. And markets temporarily suspend trading when potentially catastrophic drops in stock prices occur.

What is the average stock market return?

Historically, the U.S. stock market as a whole has seen an average annual return of just over 10% per year. From day to day, however, stock prices rise and fall based on many factors; the volatility of an investment is determined by how much and how quickly prices change. 

Generally speaking, stocks tend to be relatively volatile compared to bonds. And, of course, some stocks are more volatile than others. Because a high degree of volatility can lead to more risk, many people employ investment strategies intended to reduce risk, such as holding a diversified portfolio of different kinds of stocks, bonds, and other assets.  

How do you invest in the stock market?

If you are looking to invest in the stock market, you can buy individual stocks and shares of funds using a brokerage account. You’ll find many options for both traditional and online brokerage firms. 

Once you have a brokerage account, you’re ready to start investing. You may wish to explore your risk profile and research investment strategies to determine how much you want to invest and which securities have a place in your portfolio.

A brief history of the stock market

With the daily news full of reports on the ups and downs of the S&P 500 or the Dow Jones, it can be easy to forget that the stock market as we know it today is a relatively recent phenomenon. The Dutch East India Company was the first publicly-traded company, making its IPO in Amsterdam in 1602. Modern U.S. stock markets date back to the late 1700s. The NYSE, for example, has its roots in the 1792 Buttonwood Agreement between two dozen stockbrokers, named for the Wall Street buttonwood tree they signed it under. 

U.S. stock exchanges, trading on curbs, street corners, and coffeehouses in the early days, slowly grew into the formalized, computerized systems we use now. In 1971, the Nasdaq became the first electronic-only exchange.
What is the stock market today? In addition to functioning as a crucial part of the economic system, it can also be an opportunity for individuals to invest money in the hopes of earning a return. And with an investing app like Stash, it could be a wealth-building tool that fits in your pocket.

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