Man looking at stocks on computer monitor.

Stock Market Guide: What Is It And How Does It Work?

Sarah Li Cain4-minute read
September 13, 2021

The stock market provides an option to purchase, sell and trade stocks as long as the markets are open (typically on business days). Essentially, stocks are a way you can own a share of a public company. Prices are based on the company’s earnings.

In other words, if the corporation has a high percentage of earnings or if experts believe that it will, the stock prices will rise. Stocks typically go up in price when the economy is faring well. That also means when a company’s not doing well (or it’s predicted it’ll lose money), its stock prices will fall.

Some companies also give out dividend payments each year (think of it as an extra bonus if the company earns more profits) to stockholders, which can add value.

Investors who purchase stocks aim to get a low price so they can sell it at a higher price later, whereas sellers aim to do the opposite. Traders want to bid the price down if they feel a company will fare poorly, and bid the price up if they think it’ll do well.

While all of the above sounds complicated, it doesn’t have to be. We’re going to look closer at what a stock market is, how it works and how you can start to invest in this arena.

What Is The Stock Market?

A stock market helps investors buy and sell company shares, known as stock. The definition of the term usually refers to major indexes like the S&P 500 or Dow Jones Industrial Average to track a company’s stock performance. This makes it easier to track stock prices since it’s pretty hard to keep tabs on every single one.

Stock market exchanges will include a portion of the stock market – typically the biggest or most significant companies – and how well they do is usually seen as representative of the whole market.

When the market closes up, it means that stocks within the index traded higher than they did in the past – the market gained value as a whole. When it closes down, it means investors could lose money because the stock indexes fell – the market lost value.

A common myth about the stock market is that it’s determined by the U.S. economy. The fact is, the stock market can be affected by the economy and even contribute to it. For example, if investors believe the economy is strong or that it’s growing, they’ll invest in stocks. In a strong economy, companies will typically see higher earnings, meaning stock prices will most likely go up, increasing earnings or number of stockholders.

If the opposite happens, or if there are potential threats to the economy in general, investors typically will put their money in safer investments such as bonds or other types of assets. Falling stock prices can also happen during a stock market crash, which can even cause a recession.

What Is A Stock Exchange?

The stock exchange refers to an organization for investors to buy and sell company shares, or stock. It essentially promotes stock trading through services, tools and systems. Compare this to a stock market, which refers to the general operation of trading stocks and includes stock exchanges, over-the-counter markets and electronic trading systems.

Currently, The New York Stock Exchange and the Nasdaq are two largest exchanges in the world. They’re both worth around $21 trillion in all of its shares, and both are located in New York City – the Nasdaq in Times Square, and the NYSE on Wall Street.

How Does The Stock Market Work?

Now that you have an understanding of the stock market, let’s explore how it works. The idea is that stock exchanges operate much like auction houses, where buyers and sellers can make trades and negotiate prices for stocks.

As mentioned, the stock market works through exchanges like the Nasdaq or NYSE. Companies will list their stock on one of these exchanges – it goes through a process called an initial public offering, or IPO. Once the stock is listed, investors can then buy its shares and the company can use the funds to grow its business. The exchange then tracks the supply and demand of listed stocks and investors can trade among themselves.

Some stock exchanges, such as the NYSE, work like an auction where the bidders interact directly with the seller. Others, like Nasdaq, have buyers and sellers work with a dealer instead of directly with each other. 

The price for each stock is determined by the supply and demand – or how much stock investors are willing to buy or sell. Most of these calculations are done through computer algorithms. Stocks can only be bought and sold by licensed brokers through designated market makers.

How Do You Invest In The Stock Market?

Now that you know how the stock market works, let’s look at different ways you can invest in it.

Most folks are already invested in the stock market through their retirement accounts, such as a 401(k) or IRA. Most retirement accounts offer mutual funds, which typically house a number of stocks.

You can also buy individual stocks – you’ll need to open a brokerage account through an online broker or a robo advisor company. If you want a bit of guidance, some financial advisors are happy to help. They will walk you through the best online brokerage to use and make suggestions based on your goals and risk tolerance (how much you’re willing to risk losing if your stocks don’t do well).

All of the above options are essentially middlemen between the stock exchanges and you. That means you may need to pay fees to your broker or financial advisor to help you purchase stocks. Also, know that any type of investment comes with risks (you may lose money) but there is potential to reap rewards. That’s why it’s crucial you assess the pros and cons before you make a decision – in most cases, investing in stocks or mutual funds is ideal for the long-term.

Sarah Li Cain

Sarah Li Cain is a freelance personal finance, credit and real estate writer who works with Fintech startups and Fortune 500 financial services companies to educate consumers through her writing. She’s also a candidate for the Accredited Financial Counselor designation and the host of Beyond The Dollar, where she and her guests have deep and honest conversations on how money affects our well-being.