How the Stock Market Works

The stock market for beginners can look like a wall of flashing numbers, but it rests on a small number of simple ideas. Companies sell part-ownership in the form of shares; investors trade those shares with one another on exchanges; and indices summarise how a group of shares is doing. Once you can put numbers to each of those ideas, market news becomes much easier to read.

What one share represents

A company's ownership is divided into a fixed number of shares. Multiply that number by the share price and you get market capitalisation, the value the market places on the whole company. An illustrative company with 50 million shares trading at $30 has a market capitalisation of $1.5 billion.

Investors compare that value with what the company earns. If our example company makes $2 of profit per share in a year, its price-to-earnings ratio is $30 ÷ $2 = 15. In plain words, buyers are paying 15 years of current profit for a slice of the business. That ratio is not good or bad in itself; it reflects how fast the market expects profits to grow and how risky it thinks they are.

The stock market for beginners: two markets in one

The primary market is where a company sells new shares to raise money, most visibly in an initial public offering (IPO). After that, the shares trade in the secondary market, between investors, on an exchange. When you buy a share through a broker, the money almost always goes to another investor, not to the company. The company benefits indirectly: a healthy share price makes it cheaper to raise money later and more attractive to staff paid partly in shares.

How a price is set in the order book

Every exchange keeps an order book for each share. Buyers post bids stating the most they will pay; sellers post asks stating the least they will accept. A trade happens when the two meet. The difference between the best bid and the best ask is the spread, which is usually narrow for large, heavily traded companies and wider for small ones.

• A market order buys or sells immediately at the best available price, whatever that turns out to be.
• A limit order sets the worst price you will accept, and waits if the market has not reached it.
• A stop order becomes a market order once a trigger price is hit, and can be filled well past the trigger in a fast market.

Most major exchanges open and close the day with an auction that gathers orders and sets a single price. The closing auction produces the official closing price used by index providers and funds.

Indices: how thousands of prices become one number

An index tracks a basket of shares, and the way it weights them changes what it tells you. Most modern indices, including the S&P 500, weight companies by their market value, adjusted for the shares actually available to trade. The Dow Jones Industrial Average and the Nikkei 225 are price-weighted instead: a company with a higher share price counts for more, regardless of its size. Here is the difference using three made-up companies.

That is why the same trading day can look different depending on which index you check. In the US, the S&P 500 covers roughly 500 large companies, the Dow follows 30, and the Nasdaq Composite includes nearly everything listed on Nasdaq, while the Nasdaq-100 takes only its largest non-financial members.

Funds that hold the whole basket

An index fund buys the shares in an index in the same proportions, so its return follows the index minus costs. An exchange-traded fund (ETF) is a fund whose units themselves trade on an exchange like a share. The key number is the ongoing charge, often called the expense ratio: 0.20% a year on a $10,000 holding is $20 a year, taken quietly from the fund's value. Small percentages compound over decades, as our guide to trading fees shows with a chart.

Where returns come from

A share can reward you in two ways: the price can rise, and the company can pay dividends. Illustration: you buy 40 shares at $85, a cost of $3,400. The company pays $0.60 per share each quarter, or $2.40 a year, so your holding earns 40 × $2.40 = $96 a year. That is a dividend yield of $96 ÷ $3,400, about 2.8%. Total return is the price change plus those dividends, minus fees and any tax. Our dividend investing guide goes further into yields, payout ratios and reinvestment.

Reading a stock quote screen

Any quote page, whether on a broker's app or an exchange website, shows a similar set of figures. Knowing what each one measures is the difference between reading the screen and just looking at it.

A share up 5% on ten times its usual volume is telling a different story from one up 5% on thin trade in the last minutes of a quiet session. Volume, range and the calendar of company news usually explain more than the price change alone.

Buying, holding and settlement

You buy shares through a licensed broker, which usually holds them for you in a nominee account kept separate from its own assets. In the US, trades settle one business day after the trade date (T+1). Regular trading on the NYSE and Nasdaq runs from 09:30 to 16:00 New York time on weekdays; London runs 08:00 to 16:30 and Frankfurt's Xetra 09:00 to 17:30 local time. Many brokers also offer pre-market and after-hours trading, where fewer participants mean wider spreads and bigger price jumps. The broker checklist explains what to verify before opening an account anywhere.

Risks worth naming

• Single-company risk. One business can fail or disappoint badly. Holding many companies spreads that risk.
• Market risk. Diversification does not protect against a broad fall; whole markets can drop sharply and take years to recover.
• Currency risk. Shares priced in another currency gain or lose value as exchange rates move.
• Behaviour risk. Selling after a fall and buying after a rise is the most reliable way to turn a reasonable investment into a poor result.
• Leverage risk. Margin accounts and share CFDs magnify both directions; retail share CFDs are capped at 5:1 in the UK and EU.

Sources

• US Securities and Exchange Commission, T+1 settlement and investor bulletins on order types
• S&P Dow Jones Indices, index methodology documents
• Exchange trading-hour pages: NYSE, Nasdaq, LSE, Deutsche Börse Xetra