How do stock exchanges work

Before we can get into stock markets, you need to understand stocks and how they work on a basic level. Here are a few basic concepts that can help new investors understand how the stock market works. Stocks, also known as equities or publicly traded companies, represent ownership interests in businesses that choose to have their shares available to public investors. In other words, instead of being owned by an individual or a private group, some companies choose to " go public ," meaning that anyone can become a part owner by purchasing shares of the company's stock.

So how does the stock market work? There are entire books explaining the stock market, but you don't need to get too deep into the weeds to get a good basic understanding of the stock market. Stock markets facilitate the sale and purchase of these stocks between individual investors, institutional investors, and companies. The vast majority of stock trades take place between investors. That means, for example, that if you want to buy shares of Microsoft NASDAQ:MSFT and hit the "buy" button through your broker's website, you are buying shares that another investor has decided to sell -- not from Microsoft itself.

By purchasing shares of a stock, you become an investor in the underlying company. Stock prices on exchanges are governed by supply and demand, plain and simple.

At any given time, there's a maximum price someone is willing to pay for a certain stock and a minimum price someone else is willing to sell shares of the stock for. Think of stock market trading like an auction, with some investors bidding for the stocks that other investors are willing to sell.

If there is a lot of demand for a stock, investors will buy shares quicker than sellers want to get rid of them, and the price will move higher.

On the other hand, if more investors are selling a stock than buying, the market price will drop. Taking it a step further, it's important to consider how it's possible to always buy or sell a stock you own.

That's where market makers come in. A stock's price is governed by supply and demand. If a lot of people want to own part of a certain company, then that company's stock price rises. One extremely important concept when it comes to understanding the stock market is the idea of a market maker. Specifically, there aren't always buyers to match up with sellers of stocks, so how can brokers buy and sell stocks in your account instantaneously?

To make sure there's always a marketplace for stocks on an exchange and investors can choose to buy and sell shares immediately whenever they want to during market hours, individuals known as market makers act as intermediaries between buyers and sellers.

Here's a rundown of what investors should know about the process:. The main reason for using the market maker system as opposed to simply letting investors buy and sell shares directly to one another is to be sure there is always a buyer to match with every seller and vice versa.

To build a diversified portfolio without purchasing many individual stocks, you can invest in a type of mutual fund called an index fund or an exchange-traded fund. These funds aim to passively mirror the performance of an index by holding all of the stocks or investments in that index. Stocks and stock mutual funds are ideal for a long time horizon — like retirement — but unsuitable for a short-term investment generally defined as money you need for an expense within five years. With a short-term investment and a hard deadline, there's a greater chance you'll need that money back before the market has had time to recover losses.

Definition: What is the stock market? Learn More. How does the stock market work? What is the stock market doing today? What is stock market volatility?

How do you invest in the stock market? On a similar note Dive even deeper in Investing. Explore Investing. Get more smart money moves — straight to your inbox. Sign up. List of Partners vendors. If the thought of investing in the stock market scares you, you are not alone.

It is not surprising, then, that the pendulum of investment sentiment is said to swing between fear and greed. The reality is that investing in the stock market carries risk, but when approached in a disciplined manner, it is one of the most efficient ways to build up one's net worth.

While the value of one's home typically accounts for most of the net worth of the average individual, most of the affluent and very rich generally have the majority of their wealth invested in stocks. In order to understand the mechanics of the stock market, let's begin by delving into the definition of a stock and its different types.

A stock is a financial instrument that represents ownership in a company or corporation and represents a proportionate claim on its assets what it owns and earnings what it generates in profits. Stocks are also called shares or a company's equity. Stock ownership implies that the shareholder owns a slice of the company equal to the number of shares held as a proportion of the company's total outstanding shares.

Most companies have outstanding shares that run into the millions or billions. While there are two main types of stock— common and preferred —the term equities is synonymous with common shares, as their combined market value and trading volumes are many magnitudes larger than that of preferred shares. The main distinction between the two is that common shares usually carry voting rights that enable the common shareholder to have a say in corporate meetings like the annual general meeting or AGM where matters such as election to the board of directors or appointment of auditors are voted upon while preferred shares generally do not have voting rights.

Preferred shares are so named because preferred shareholders have priority over common shareholders to receive dividends as well as assets in the event of a liquidation. Common stock can be further classified in terms of their voting rights.

While the basic premise of common shares is that they should have equal voting rights—one vote per share held—some companies have dual or multiple classes of stock with different voting rights attached to each class. In such a dual-class structure , Class A shares , for example, may have 10 votes per share, while the Class B subordinate voting shares may only have one vote per share. Dual- or multiple-class share structures are designed to enable the founders of a company to control its fortunes, strategic direction, and ability to innovate.

Today's corporate giant likely had its start as a small private entity launched by a visionary founder a few decades ago. Technology giants like these have become among the biggest companies in the world within a couple of decades.

However, growing at such a frenetic pace requires access to a massive amount of capital. In order to make the transition from an idea germinating in an entrepreneur's brain to an operating company, they need to lease an office or factory, hire employees, buy equipment and raw materials , and put in place a sales and distribution network , among other things. These resources require significant amounts of capital, depending on the scale and scope of the business startup.

A startup can raise such capital either by selling shares equity financing or borrowing money debt financing. Debt financing can be a problem for a startup because it may have few assets to pledge for a loan—especially in sectors such as technology or biotechnology , where a firm has few tangible assets —plus the interest on the loan would impose a financial burden in the early days, when the company may have no revenues or earnings.

Equity financing, therefore, is the preferred route for most startups that need capital. The entrepreneur may initially source funds from personal savings, as well as friends and family, to get the business off the ground.

As the business expands and capital requirements become more substantial, the entrepreneur may turn to angel investors and venture capital firms. When a company establishes itself, it may need access to much larger amounts of capital than it can get from ongoing operations or a traditional bank loan.

It can do so by selling shares to the public through an initial public offering IPO. This changes the status of the company from a private firm whose shares are held by a few shareholders to a publicly-traded company whose shares will be held by numerous members of the general public. The IPO also offers early investors in the company an opportunity to cash out part of their stake, often reaping very handsome rewards in the process.

Once the company's shares are listed on a stock exchange and trading in it commences, the price of these shares fluctuates as investors and traders assess and reassess their intrinsic value.

There are many different ratios and metrics that can be used to value stocks, of which the single-most popular measure is probably the price-to-earnings PE ratio. The stock analysis also tends to fall into one of two camps— fundamental analysis , or technical analysis. Stock exchanges are secondary markets where existing shareholders can transact with potential buyers.

It is important to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis. Companies may engage in stock buybacks or issue new shares but these are not day-to-day operations and often occur outside of the framework of an exchange. So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company—rather you sell them to some other investor.

The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities or trading hubs such as Antwerp, Amsterdam, and London. These early stock exchanges, however, were more akin to bond exchanges as the small number of companies did not issue equity. In fact, most early corporations were considered semi-public organizations since they had to be chartered by their government in order to conduct business.

Prior to this official incorporation, traders and brokers would meet unofficially under a buttonwood tree on Wall Street to buy and sell shares. The advent of modern stock markets ushered in an age of regulation and professionalization that now ensures buyers and sellers of shares can trust that their transactions will go through at fair prices and within a reasonable period of time. Today, there are many stock exchanges in the U. This in turn means markets are more efficient and more liquid. These shares tend to be riskier since they list companies that fail to meet the more strict listing criteria of bigger exchanges.

Larger exchanges may require that a company has been in operation for a certain amount of time before being listed and that it meets certain conditions regarding company value and profitability. Market Volume. Lita Epstein, Grayson D. Japan Exchange Group. Stock Markets. Stock Trading. Career Advice. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.

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Investopedia Investing. Table of Contents Expand. What Are Stock Exchanges? How Stock Exchanges Work. Auction Exchanges. Electronic Exchanges. Electronic Communication Networks. Over-the-Counter OTC. Other Exchanges. Stock Exchanges FAQs. The Bottom Line.

Key Takeaways A stock exchange is a centralized location that brings corporations and governments so that investors can buy and sell equities.

Auction-based exchanges such as the New York Stock Exchange allow traders and brokers to physically and verbally communicate buy and sell orders. Electronic communication networks connect buyers and sellers directly by bypassing market makers.