What Is the Stock Market?
The stock market broadly refers to the collection of exchanges and other venues where the buying, selling, and issuance of shares of publicly held companies take place. Such financial activities are conducted through institutionalized formal exchanges (whether physical or electronic) or via over-the-counter (OTC) marketplaces that operate under a defined set of regulations.
While both the terms “stock market” and “stock exchange” are often used interchangeably, the latter term generally comprises a subset of the former. If one trades in the stock market, it means that they buy or sell shares on one (or more) of the stock exchange(s) that are part of the overall stock market. A given country or region may have one or more exchanges comprising their stock market. The leading U.S. stock exchanges include the New York Stock Exchange (NYSE) and the Nasdaq. These leading national exchanges, along with several other exchanges operating in the country, form the stock market of the United States.
Stock markets are venues where buyers and sellers meet to exchange equity shares of public corporations.
Stock markets are vital components of a free-market economy because they enable democratized access to trading and exchange of capital for investors of all kinds.
They perform several functions in markets, including efficient price discovery and efficient dealing.
In the United States, the stock market is regulated by the Securities and Exchange Commission (SEC) and local regulatory bodies.
Understanding the Stock Market
The stock market allows numerous buyers and sellers of securities to meet, interact, and transact. Stock markets allow for price discovery for shares of corporations and serve as a barometer for the overall economy. Since the number of stock market participants is huge, one can often be assured of a fair price and a high degree of liquidity as various market participants compete with one another for the best price.
A stock market is a regulated and controlled environment. In the United States, the main regulators include the Securities and Exchange Commission (SEC) and market participants under the purview of the Financial Industry Regulatory Authority (FINRA).21 Since the stock market brings together hundreds of thousands of market participants who wish to buy and sell shares, it ensures fair pricing practices and transparency in transactions. While earlier stock markets used to issue and deal in paper-based physical share certificates, the modern-day computerized stock markets operate electronically.
How the Stock Market Works
In a nutshell, stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence, with zero to low operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and secondary markets.3
As a primary market, the stock market allows companies to issue and sell their shares to the common public for the first time through the process of an initial public offering (IPO). This activity helps companies raise necessary capital from investors. It essentially means that a company divides itself into a number of shares (for example, 20 million shares) and sells a part of those shares (say, 5 million shares) to the public at a price (for instance, $10 per share).3
To facilitate this process, a company needs a marketplace where these shares can be sold. This marketplace is provided by the stock market. If everything goes according to plan, then the company will successfully sell the 5 million shares at a price of $10 per share and collect $50 million worth of funds. Investors will get the company shares, which they can expect to hold for their preferred duration, in anticipation of rising in share price and any potential income in the form of dividend payments. The stock exchange acts as a facilitator for this capital-raising process and receives a fee for its services from the company and its financial partners.
Special Considerations
The stock exchange shoulders the responsibility of ensuring price transparency, liquidity, price discovery, and fair dealings in such trading activities. As almost all major stock markets across the globe now operate electronically, the exchange maintains trading systems that efficiently manage the buy and sell orders from various market participants. They perform the price-matching function to facilitate trade execution at a price that is fair to both buyers and sellers.
A listed company may also offer new, additional shares through other offerings at a later stage, such as through rights issues or follow-on offerings. They may even buy back or delist their shares. The stock exchange facilitates such transactions.
The stock exchange often creates and maintains various market-level and sector-specific indicators, like the S&P (Standard & Poor’s) 500 index or the Nasdaq 100 index, which provide a measure to track the movement of the overall market. Other methods include the Stochastic Oscillator and the Stochastic Momentum Index.
The stock exchanges also maintain all company news, announcements, and financial reporting, which can usually be accessed on their official websites. A stock exchange also supports various other corporate-level, transaction-related activities. For instance, profitable companies may reward investors by paying dividends that usually come from part of the company’s earnings. The exchange maintains all such information and may support its processing to a certain extent.
Fair Dealing in Securities Transactions
Depending on the standard rules of supply and demand, the stock exchange needs to ensure that all interested market participants have instant access to data for all buy and sell orders, thereby helping in the fair and transparent pricing of securities. Additionally, it should also perform efficient matching of appropriate buy and sell orders.4
For example, there may be three buyers who have placed orders for buying Microsoft shares at $100, $105, and $110, and there may be four sellers who are willing to sell Microsoft shares at $110, $112, $115, and $120. The exchange (through automated trading systems) needs to ensure that the best buy and the best sell are matched, which in this case is at $110 for the given quantity of trade.
Efficient Price Discovery
Stock markets need to support an efficient mechanism for price discovery, which refers to the act of deciding the proper price of a security and is usually performed by assessing market supply and demand and other factors associated with the transactions.
Let’s say a U.S.-based software company is trading at a price of $100 and has a market capitalization of $5 billion. A news item comes in that the European Union (EU) regulator has imposed a $2 billion fine on the company, which essentially means that 40% of the company’s value may be wiped out. While the stock market may have imposed a trading price range of $90 and $110 on the company’s share price, it should efficiently change the permissible trading price limit to accommodate for the possible changes in the share price, or else shareholders may struggle to trade at a fair price.
Liquidity Maintenance
While getting the number of buyers and sellers for a particular financial security are out of control for the stock market, it needs to ensure that whoever is qualified and willing to trade gets instant access to place orders that should get executed at a fair price.
Security and Validity of Transactions
While more participants are important for the efficient working of a market, the same market needs to ensure that all participants are verified and remain compliant with the necessary rules and regulations, leaving no room for default by any of the parties. Additionally, it should ensure that all associated entities operating in the market adhere to the rules and work within the legal framework given by the regulator.