A basic understanding of how the stock market works is important for any potential investor who wants to trade stocks.
That's because a lot about how the stock market works is misunderstood.
You may think it's as easy as calling up a broker and purchasing stock at a quoted price, then watching as your trading account either goes up or down.
But for a rather simple marketplace, there are a lot of complexities undergirding it.
The first question is what is the stock market?
It sounds rather simplistic, but it is the marketplace for selling stocks - a claim of ownership on a company.
Now, how exactly does a company go public? How does an ownership stake go from the company's owners to you?
It begins with an initial public offering...
How the Stock Market Works: The IPO
We'll start from the beginning.
Let's say an entrepreneur has an idea for a company. To fund themselves, they can take out a business loan. But that will then tie the company down with a debt liability that must be repaid.
He or she can instead get funding by selling ownership stakes in the company, or shares.
He or she can approach an angel investor, a venture capital fund, friends, and family - anybody who he or she thinks will be interested in the underlying business and wants a stake in its potential future growth.
At this stage, a company is still private. Ownership is issuing shares in what's called the "primary market."
You'll hear a lot about the valuation of private companies like Uber and Pinterest. Those valuations are based off of what funding has come to the company through private investors.
At some point, private investors, including the company's owners who are likely to hold ownership in their own company, will want to cash in on their company. An IPO can help make it easier to monetize ownership stakes, while providing a further leg of funding.
This is done with an initial public offering (IPO).
In an IPO, a company will first begin to sell its stock to the public, or on "secondary markets."
It will almost always require the company to approach an investment bank, like Morgan Stanley (NYSE: MS) or Goldman Sachs (NYSE: GS), to underwrite the IPO deal.
The role of these investment banks is to make a market for ownership stakes in the company. After a company decides how much it wants to raise, a period of negotiating funding and share price will begin, and the market maker will eventually begin selling those shares to the public.
And this is where you as an individual investor will come in...
How the Stock Market Works: Buying and Selling Stock
After the IPO, the shares in that particular company can be freely traded on an exchange - typically the New York Stock Exchange or the Nasdaq.
As an individual investor, there is very little opportunity to make gains on an IPO.
That's because the underwriters make low offer prices for shares at the IPO and hold on for a jump that comes on the day the company goes public.
The owners will collect their cash proceeds at the sale to fund the company, and from there the onus is on them to invest in the business, grow sales and profits, and ultimately build shareholder value so the market continues to buy the stock.
Stocks in a company are sold through market makers - those same investment banks who first brought the company to the secondary markets.
Market makers have the all-too-important role of making a market liquid - that is, helping to ensure there is always a buyer and a seller. They buy and sell a company's stock in large volumes to ensure liquidity.
These market makers make money by offering to buy the security at a low price, the "bid," and sell at a higher price, the "ask." This bid/ask "spread" is how these market makers make money, and it's an important part of understanding how the stock market works. If volume is low, market makers are going to see a profit opportunity in selling shares at a high price and buying low to maximize the spread.
A lot of times when you see a stock price quote, it's not that actual price at which you can buy and sell it.
Rather, it's quoted in the middle of the spread.
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The larger the spread, the bigger the liquidity risk - that is, the risk that there won't be a buyer to buy your shares when you look to sell the stock.
If you want to buy stock in a company like Apple Inc. (Nasdaq: AAPL), this is less of a problem. High demand for Apple stock tightens the bid/ask spread, as investment banks buy up AAPL shares to meet demand.
But small-caps and over-the-counter stocks don't have big markets like Apple stock. They carry bigger risks for investors.
A big spread also means fewer market makers are buying or selling a stock, because market makers will want to be compensated for taking on such liquidity risk.
It's important to understand market making and to understand the bid/ask spread. The quoted price is not always the price you'll be buying or selling the stock, and you could be left with a bigger tab for a buy order, or a lower profit off a sell order, than you expected if you don't grasp this concept.
So, what becomes of a stock as it trades in secondary markets?
How the Stock Market Works: What Determines Share Prices?
After the IPO, the stock will continue to trade on one of the exchanges. Its share price will move depending on demand for the stock.
As shares will trade on the secondary market, buyers and sellers will determine the price of the stock based on the underlying value of the company that ownership represents.
The Securities and Exchange Commission (SEC) is the primary government regulator and overseer for the public exchanges. Public companies are required by law to report out earnings every quarter, as well as certain corporate events to ensure shareholders are adequately supplied with information that's used for the market to value a company.
If the company is posting meaningful profits or growing sales at a rapid pace, or even promising to bring a ground-breaking product to market, more buyers will pile in. That demand to own a stake in that company will boost the stock price.
But if the company is struggling and investors are wary of holding the stock of a company that offers little value, they won't want to be in it too long. That will erode the stock's value as investors flee what they perceive to be a less than worthwhile investment.
And that's how the stock market works.
Jim Bach is an Associate Editor at Money Morning. You can follow him on Twitter @JimBach22.
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