How The stock market works is through being a meeting place between traders wanting to buy and sell shares in publicly listed companies. Yet a common misconception is that everyone wants the stock market to go up. Some traders believe it will go down and will go ‘short’ – where they are borrowing shares with the intention of buying them back at a lower price, pocketing the difference.
Stock, or equity, gives the holder part-ownership in the company which convers rights on that shareholder. These rights will include being able to vote in general meetings as well as ask questions of management during the annual general meeting. Stocks are listed on a stock market which groups together many different companies all bidding for your investment. In many ways similar to when you go to a shopping aisle and there are many different products seeking to be bought by you. How the stock market works can be appear complicated but isn’t so different from what you do during the day.
Companies go ‘public’ by listing on stock markets. They gain new shareholders, usually by founders selling or reducing their initial holdings. Typically the amount of the company that is sold is only a fraction of its total ownership (The London Stock Exchange mandates that at least 25% of the shares should be publicly listed). The price set for the stock determines the value of the entire company. When a company is listed it is usually over-valued. This ensures that the founders earn the largest rewards possible and the investment banks get higher fees. How the stock market works means powerful investment banks ensuring they get their fees. This is above providing investors with an attractive investment opportunity.
Once the offering is completed, the stock price can move independent of the actual company’s value and success; a current example is Tesla. It is still to turn a profit and relies on borrowing regularly from its investors. Despite this, it’s share price has sky-rocketed in recent years. Price changes reflect supply and demand. When a stock is deemed desirable for whatever reason: recent success, a strong industry sector or just popularity — then its price goes up.
Arguably the biggest driver of how the stock market works is geopolitical risk. A change of political party leading a government, a new economic policy or a war – are just a few events which can drive financial markets up or down. With the advent of the Trump Presidency, US stock markets were up 5% a month later. This was driven by an expectation of lower corporate tax rates that Trump had promised on the electoral trail.
For the stock market to work there must be buyers and sellers. These buyers and sellers trade existing, previously issued shares which are offered by one investor and bought by another.
Stock trading today is done electronically. This is good news for the savvy trader and investor. This means a more efficient and predictable marketplace with much less left to chance and randomness. That said, many large orders are executed away from the stock market between dealers to ensure they get a good price. This stops other traders taking positions to profit against the buyer/seller in the market.
A key part of how the stock market works is trader psychology: the inability of humans to control their emotions and make logical decisions leads to trading mistakes. In the short-term, the prices of companies reflect the combined emotions of the entire investment community. When a majority of investors are worried about a company, its stock price is likely to decline; when a majority feel positive about the company’s future, its stock price tends to rise.
A person who feels negative about the market is called a “bear,” while their positive counterpart is called a “bull.” During market hours, the constant battle between the bulls and the bears is reflected in the constantly changing price of securities. How the stock market works during these short-term movements is to be driven by rumours, speculations, and hopes – emotions – rather than logic and a systematic analysis of the company’s assets, management, and prospects.
– Over-trading – one of threats to your trading profits is a key part to how the stock markets work as the emotional side drives many trading fears. This style of trading is especially prevalent in younger and private traders. These are unable to resist the temptation to ‘get involved’. This is apparent by constantly taking a profit or buying a new position. ‘Cutting your losses early and letting your winners run’ is a saying many experienced traders follow as it reduces losses… and trades!
– Selling the fact – Have you ever bought a stock because you are confident that it will grow its earnings only to find that when this is confirmed on the publication of its year-end results or trading reports, the share drops 5%! How is this possible you may ask? How the stock market works can also include examples where everyone has agreed with you but then done the opposite of what you expected! In this case other traders have sold on the good news (sell the fact) because they believe that the shares have become too expensive versus the future earnings growth expectations of this company.
Did you realise that famous investors such as Warren Buffett, Benjamin Graham or George Soros had different styles?
Warren buffet will concentrate his investments in a few companies with defensive moats which he is a majority controlling shareholder. Benjamin Graham seeked to identify companies which were undervalued. George Soros would take outsized positions in the hope of forcing an outcome which he had identified as inevitable but which the trader on the opposite side was defending until it was too late. One such example was Black Wednesday where the Bank of England was forced to devalue the pound.
Although stock markets have historically worked by traders taking individual positions, a new form of trader has entered the market. Large asset managers such as Blackrock who run Exchange Traded Funds (under the iShares brand) now own increasingly large positions in the market. These ETFs are rebalanced twice or sometimes four times a year. In time as passives keep growing, these rebalancing dates might influence how the stock market works. The sheer number of trades required as part of keeping ETFs in line with their respective mandates.
In conclusion, traditionally how the stock market works was by buyers and sellers meeting to trade. How the stock market works today is very different. Open outcry, where humans shout at each other across a trading pit has been replaced by the calm of electronic trading. Like any asset class, stock markets evolve. The increase in use of passives likely to herald a change in how the stock market works. There are some basics that remain the same, if more traders want to buy a stock than sell it, it will go up! Sudden, unexpected bad news will usually lead to a sell off and one should never forget that the stock market can stay irrational longer than we can solvent… so always apply risk management techniques when trading!