Stock markets attract significant attention and have a profound impact on the economic lives of many people, yet they often seem like a complex maze to newcomers. In reality, the way a stock market works is straightforward. This guide explains how stock markets function, how prices are determined, and how you can get started as an investor.
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What You Need to Know
- Historically, the stock market traces its roots to the Flemish Van der Beurse family and their trading gatherings in the 16th century.
- Over time, stock markets have evolved into global hubs for trading securities, currencies, and derivatives, serving as the lifeblood of the world economy.
- Investors can trade securities, while companies can raise capital—all under standardized and regulated conditions.
- The New York Stock Exchange (NYSE) is the world’s largest stock market, with a market capitalization exceeding $31.7 trillion as of May 2025. investopedia.com 👉
How to Get Started
To trade on the stock market, you need a brokerage account with a broker or bank.
This account allows you to trade and store your securities.
Comparing brokerage options can help you find the right account for your needs.
The Origins of the Stock Market
The first stock markets emerged in the 16th century when the Van der Beurse family in Bruges, Belgium, organized trading meetings with Italian merchants, laying the foundation for modern stock markets. While capital exchange existed earlier, these transactions were among the first documented, and the term “stock market” derives from their family name.
From these early trades, primarily involving goods and promissory notes, the modern stock market evolved. Through globalization and colonialism, stock markets spread worldwide, focusing increasingly on trading shares, or ownership stakes in companies. A stock market is essentially a marketplace for equity capital (investor funds), which companies can also use to raise debt capital (borrowed funds). The following sections explain how this works in detail.
Why Stock Markets Exist
Let’s explore the key functions stock markets serve for investors and companies.
Stock Market as a Trading Hub for Investors
A primary role of the stock market is to connect buyers and sellers of securities, currencies, or derivatives. It acts as a trading hub where investors looking to sell meet those looking to buy, ensuring fair pricing for these transactions.
While trading can occur outside the stock market through over-the-counter (OTC) deals, where terms are negotiated individually, stock market trading offers significant advantages over OTC trading.
Advantages of Stock Market Trading
Stock markets provide a regulated and standardized environment for transactions, ensuring buyers know exactly what they’re purchasing and how prices are determined. Prices are set solely by supply and demand, making them transparent and understandable.
Regulatory requirements also enhance safety. For example, companies listed on major stock markets must disclose financial data regularly, ensuring transparency. In contrast, unlisted companies face fewer reporting obligations.
Additionally, stock markets standardize processes, keeping transaction costs low. Millions of transactions between buyers and sellers are processed uniformly each day, far more efficiently than if buyers had to individually seek out sellers and negotiate terms.
Stock Market as a Financing Tool for Companies
Stock markets also enable companies to raise capital. To boost equity, companies can sell shares to investors, exchanging ownership stakes for funds. While this can happen outside the stock market via OTC deals, listing on a stock market allows companies to access a broader investor base through an initial public offering (IPO), which we’ll explain later. Stock markets also facilitate debt financing, as detailed below.
How the Stock Market Works
Now, let’s dive into the mechanics of a stock market.
General Operations
Stock markets primarily earn revenue through trading commissions. For each transaction, they charge a fee in exchange for providing the technical and financial infrastructure, regulation, and standardization that enable seamless and secure trading. Many stock markets are publicly traded companies themselves. For example, some stock market operators are listed on their own exchanges.
Example of a Stock Market Transaction
Suppose you want to buy shares, ETFs, or other listed securities. You place an order with your broker, specifying which securities to purchase. If the broker doesn’t hold these securities, they buy them on the stock market, paying a commission for the transaction. This fee is typically passed on to you along with the security’s price.
How Stock Prices Are Determined
A core function of the stock market is to match buyers and sellers of securities and establish a fair price. In the past, brokers shouted prices on the trading floor, forming prices based on supply and demand. While images of frantic brokers reacting to crashing markets persist, modern trading is fully digital. Complex computer systems, such as electronic trading platforms, now set prices, significantly increasing trading speed.
Example: Stock Price Calculation
Consider a scenario with a group of buyers and sellers, each with different price expectations for a company’s stock, currently priced at $10:
- Buyers:
- Buyer 1: 500 shares at up to $11 each
- Buyer 2: 200 shares at up to $10 each
- Buyer 3: 400 shares at the best available price (no limit)
- Sellers:
- Seller 1: 600 shares at $11 or more
- Seller 2: 200 shares at $12 or more
- Seller 3: 300 shares at the best available price
The stock market aims to maximize trading volume, satisfying as many buyers and sellers as possible. Possible trading volumes are:
- At $10: 300 shares (all buyers, but only 300 sellers)
- At $11: 900 shares (500 + 400 buyers, 600 + 300 sellers)
- At $12: 400 shares (400 buyers, all sellers)
At $11, the highest trading volume (900 shares) is achieved, so the stock price rises from $10 to $11. This simplified example illustrates the core principles of price formation.
The Initial Public Offering (IPO)
When a company goes public to raise capital for investments or expansion, it conducts an IPO, making previously private shares available to the public. The IPO process is complex but highly standardized. Here are the key steps:
- Engagement: The company, structured as a corporation, hires investment banks to manage the IPO. These banks evaluate the company to set a fair initial stock price.
- Road Show: The banks and company executives meet with major investors to pitch the company and attract interest.
- Bidding Round: Investors submit bids, indicating how many shares they want and at what price. The banks, in consultation with the company, decide which investors receive shares.
- Allocation: If demand exceeds the available shares (an oversubscribed IPO), the banks and company prioritize investors offering the highest prices. This phase occurs before trading begins.
- Trading Begins: Once shares are allocated, they can be freely traded on the stock market. Traditionally, the company rings the opening bell to mark the start of trading.
The capital raised during the IPO is recorded as the company’s equity. Subsequent trading of shares among investors does not affect the company’s balance sheet; it’s purely a transfer of ownership between investors.
Capital Increase
Listed companies can raise additional equity through a capital increase, issuing new shares to acquire fresh capital. Existing shareholders typically have priority to buy these shares, often at a discounted price compared to new investors.
Raising Debt Capital
Stock markets also facilitate debt financing through corporate bonds, similar to bank loans but sourced from investors via the market. The bond issuance process mirrors an IPO, with a road show to attract large investors before bonds are traded on the market.
Stock Index vs. Stock Market
To avoid confusion, a stock index is not a stock market. An index tracks the performance of a select group of stocks based on specific criteria (e.g., region or industry). For example, the Dow Jones is a major U.S. index, not a stock market. However, stock markets often create indices, such as the DAX, MDAX, SDAX, and TecDAX.
Getting Started in the Stock Market
Thanks to market digitization and the rise of fintech and neo-brokers, participating in the stock market as an individual is easier than ever. These platforms have lowered technical and financial barriers, making trading accessible to nearly everyone.
To begin, open a brokerage account with a broker or bank. This account holds your securities and enables trading on various stock markets and OTC platforms. Researching brokerage options can help you choose the best fit for your goals.
