How Does The Stock Market Work?

We often hear about the stock market reaching new highs and lows every now and then. There are statements like the Dow Jones Industrial Average rising 2 percent on a particular day, with advances leading declines by a margin of..."

The question arises: How does the stock market work?

You need to understand certain basic terms about stock market before understanding how it works.

What is stock?

The meaning of 'stock' can be better explained through an example. Suppose you want to start a grocery business. You buy the premises, the groceries, employ some staff, advertise and start your business. Let us say that you have invested $ 400,000 in buying the premises, building the racks and other sundry items. You spend, say, $ 200,000 on procuring supplies. At the end of the year, your gross income is, say, $250,000. Your net profit is $ 250,000 (income)-$200,000(expenses on supplies) = $50,000.

At the end of the second year your gross earnings are $260,000 and your net profit increases to $ 60,000. Your expenses remain unchanged. Now you assess that your net earnings are likely to remain around this figure at your present amount of investment in procurement of supplies.

You think of expanding your business. You calculate the total value of your investment that includes your investment on premises, sundry expenses, supplies and staff.

Going by the present inputs, the total value of your business is $ 400,000(premises)+ $200,000(groceries)+$60,000 (profits)=$660,000. Since you are in the business of making money and your business is also making reasonable profits, you may price your business at say $1,000,000 when you invite shareholders in your business.

Suppose your invite 10 or 20 shareholders. Each shareholder will have to shell out $1,000,000 divided by 10 or 20 to be an equal partner in your business. When deciding the business matters, each shareholder will have one out of 10 or 20 votes and will own the same ratio of its assets and profits.

Or, you may even like to keep half the shares to yourself and sell the remaining half shares to others. In this case, you will have greater say in business decisions and get the half the ownership and profits as well.

You may divide the total value of your business in still larger number of shares, say, 100, 1,000 or even 10,000.

Stock or share, at its basic, is really that simple. It represents ownership of a company's assets and profits.

Stock Exchange

While earlier you were running a private business, but with the participation of public at large, your business has become a public company. Moreover, the shareholders may not be interested in carrying on their partnership in your company and may like to sell off their shares to others.

Selling shares in this case may not be easy.

So in order to facilitate the trading in shares of such big public companies, stock markets or stock exchanges were set up. We have the examples of New York Stock Exchange (NYSE), NASDAQ and American Stock Exchange. They are the supermarkets for buying and selling shares.

There are two types of stock exchanges, one is the physical stock exchange and the other is virtual stock exchange.

Physical stock exchange

New York Stock Exchange-NYSE-- is an example of a physical stock exchange. In order to trade your shares, you need to open an account with a stock broker or a brokerage firm. The NYSE is a wild kind of place where the stock traders can be seen trying to out-shout each other while gesticulating with their hands trying to buy or sell the shares. These persons are called floor brokers. Your stockbroker actually contacts these floor brokers at the NYSE to buy or sell your shares. Millions of shares are bought or sold daily.

Virtual stock exchange

The advent of computers and broadband Internet has facilitated the trading in shares online through the Internet.

But, as said earlier, you cannot directly buy and sell the shares even online in the stock market. You need the services of stockbrokers or brokerage firms who also work online. The stock exchanges where online trading is carried out are called virtual stock exchanges. National Association of Securities Dealers Automated Quotations System or NASDAQ is an example of virtual stock exchange.

Share prices

The prices of the shares or the stock are determined primarily by the supply and demand position of the stock in question. The supply and demand of the stock, further, depends upon numerous other factors, which include the financial prospects of the company whose stock you are trading.

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