Stock Market Investing 101 – How Does the Stock Market Work?

Investing in stocks has become a simple process for most people.  Technology allows you to login to your favorite online discount broker and buy and sell stocks with a click of the mouse.

What exactly happens when you click the buy button?  Who decides which stocks you can buy? Who’s buying the stocks that you’re selling? When you decide to buy stock who is selling you the shares you want? You don’t have to know the answers to these questions to trade stocks but it does help to understand how the stock market works before you use the market to invest your money.

What is the Stock Market?
There are actually multiple different stock exchanges that make up what people refer to in general as the “stock market”.  The New York Stock Exchange (NYSE) and the Nasdaq are the two largest exchanges in the United States, a stock exchange is a place where investors come together to buy and sell, or exchange, shares of a company.

Which Companies are for Sale?
The goal of an exchange like the NYSE is to make it as efficient and cost-effective as possible for investors to buy and sell stocks.  The NYSE is a publicly traded company so the value of it’s own stock depends on how well it runs the exchange.  To insure that only legitimate companies are bought and sold on the exchange the NYSE has a set of requirements all companies must meet before their stock can be traded on the exchange.  One of the main requirements is that companies comply with the rules established by the Securities & Exchange Commission (SEC), the portion of the US government that monitors and regulates the securities industry.

The listing rules are designed to protect investors.  The goal is to insure that companies who are offering shares of stock for sale are relatively stable and profitable and that they provide investors adequate financial information about the company.

Buying & Selling Stock
One of the other rules of stock exchanges is that you need a license to be able to buy and sell shares of companies listed on the exchange.  As Investopedia explains it, this is where stock brokers come into the picture:

“Brokers have the authorization and expertise to buy securities on an investor’s behalf – not just anyone is allowed to walk into the New York Stock Exchange and purchase stocks; therefore, investors must hire licensed brokers to do this for them.”

Instead of using an eBay like model where people buy and sell from each other directly, the stock market uses brokers as intermediaries to execute the transactions on behalf of shareholders in return for a fee.

Prior to the Internet, an investor would work with an individual broker to buy and sell shares of stock; the personal interaction made it more expensive to invest in individual stocks. The introduction of online brokerages such as Etrade drove down the cost of making a trade and enabled investors to buy and sell stocks on demand via a Web based interface provided by the brokerage company.

Who’s Buying the Stock You’re Selling?
When put in an order to sell 100 shares of a company, who is it that buys the stock from you? If you had to depend on a broker to find someone else who wanted to buy exactly 100 shares of the same stock you might have to wait for a while. This is why firms called market makers exist, to help facilitate transactions in the stock market. Investopedia does a good job explaining the role of market makers:

“A broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds.”

Thanks to market makers, individual investors can trade in and out of the stock market without worrying about finding an individual buyer or seller for shares of stock. Next time in Stock Market Investing 101 series we’ll look more closely at how stock prices are determined and why they rise and fall.

Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn't like the other kids... His addiction to personal finance has paid off for his family and now he's helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.

All posts by Ben Edwards