Understanding the Stock Market: How It Works

What Is the Stock Market?

The stock market is a collection of exchanges where stocks (shares of ownership in companies) are bought and sold. Think of it as a giant marketplace connecting buyers and sellers of company ownership.

The Purpose of the Stock Market

For Companies:

• Raise capital to grow their business
• Access to public funding without loans
• Provide liquidity for early investors

For Investors:

• Opportunity to own pieces of great companies
• Potential for capital appreciation
• Dividend income from profitable companies

Major Stock Exchanges

New York Stock Exchange (NYSE)

• Largest exchange by market cap (~$25 trillion)
• Founded in 1792
• Lists blue-chip companies like Coca-Cola, Johnson & Johnson
• Physical trading floor on Wall Street

NASDAQ

• Second-largest exchange (~$20 trillion)
• First electronic stock market (1971)
• Tech-heavy: Apple, Microsoft, Amazon, Google
• No physical trading floor

Other Important Exchanges

• S&P 500: Index of 500 largest U.S. companies
• Dow Jones: 30 major industrial companies
• Russell 2000: Small-cap companies

How Stock Prices Are Determined

Stock prices are set by supply and demand—it's that simple and that complex.

Basic Price Mechanics

When more people want to buy:

• Demand exceeds supply
• Price goes up
• Sellers can ask for more

When more people want to sell:

• Supply exceeds demand
• Price goes down
• Buyers can negotiate lower prices

What Influences Supply and Demand?

Company-Specific Factors:

• Earnings reports (quarterly profits)
• New product launches
• Management changes
• Competitive advantages
• Future growth prospects

Market-Wide Factors:

• Interest rates (Fed decisions)
• Economic data (jobs, GDP, inflation)
• Geopolitical events
• Investor sentiment
• Market trends

Example: If Apple announces iPhone sales exceeded expectations, more investors want to buy AAPL stock, driving the price up.

Key Market Concepts

Market Capitalization

Market cap = Share price × Number of shares outstanding

Categories:

• Large-cap: $10B+ (Apple, Microsoft)
• Mid-cap: $2B-$10B
• Small-cap: $300M-$2B
• Micro-cap: Under $300M

Bull vs. Bear Markets

Bull Market:

• Prices rising 20%+ from recent low
• Optimism and confidence
• Economy usually expanding
• Can last years

Bear Market:

• Prices falling 20%+ from recent high
• Fear and pessimism
• Often during recessions
• Historically shorter than bulls

Market Volatility

Volatility measures how much prices swing up and down.

• VIX Index: "Fear gauge" measuring expected volatility
• VIX under 15: Low volatility (calm markets)
• VIX over 30: High volatility (fearful markets)

How Trading Works

Market Hours

Regular Trading:

• 9:30 AM - 4:00 PM Eastern Time
• Monday through Friday
• Closed on major holidays

Extended Hours:

• Pre-market: 4:00 AM - 9:30 AM
• After-hours: 4:00 PM - 8:00 PM
• Lower volume, wider spreads

The Bid-Ask Spread

• Bid price: Highest price buyers will pay
• Ask price: Lowest price sellers will accept
• Spread: Difference between bid and ask

Example:

• Stock XYZ: Bid $50.00, Ask $50.05
• Spread: $0.05
• Narrow spreads = more liquid stocks

Order Execution

1. You place a buy order through your broker
2. Broker routes order to exchange or market maker
3. Order matched with seller's order
4. Trade executes
5. Settlement occurs (T+1 for stocks)

Market Participants

Individual Investors (Retail)

• People like you investing personal money
• Growing influence thanks to commission-free trading
• Smaller position sizes

Institutional Investors

• Mutual funds, pension funds, hedge funds
• Move billions of dollars
• Professional research teams
• Drive most market volume

Market Makers

• Provide liquidity by always offering to buy/sell
• Profit from bid-ask spread
• Keep markets functioning smoothly

Stock Market Indices

Indices track groups of stocks to measure market performance.

S&P 500

• 500 largest U.S. companies
• Market-cap weighted
• Best measure of "the market"
• ~80% of U.S. stock value

Dow Jones Industrial Average

• 30 large companies
• Price-weighted (higher-priced stocks matter more)
• Oldest index (since 1896)
• Less representative than S&P 500

NASDAQ Composite

• All stocks on NASDAQ exchange
• Tech-heavy
• More volatile than S&P 500

Market Cycles and History

Historical Returns

• Average annual return (S&P 500): ~10%
• Includes dividends and price appreciation
• Varies wildly year to year

Notable Market Events

| Event | Year | Impact |

|-------|------|--------|

| Great Depression | 1929 | -89% (peak to trough) |

| Black Monday | 1987 | -22% in one day |

| Dot-com Crash | 2000-02 | -49% |

| Financial Crisis | 2008-09 | -57% |

| COVID Crash | 2020 | -34% (recovered quickly) |

Key lesson: Markets always recovered. Patience pays.

Common Market Myths

Myth 1: "You Need to Time the Market"

Reality: Time IN the market beats timing the market. Missing the 10 best days over 20 years cuts returns in half.

Myth 2: "Past Performance Predicts Future Results"

Reality: Yesterday's winners often become tomorrow's losers. Diversify instead of chasing performance.

Myth 3: "The Market Is a Casino"

Reality: Short-term trading resembles gambling. Long-term investing in diversified portfolios is wealth building.

Myth 4: "You Need a Lot of Money"

Reality: Start with any amount. Fractional shares let you invest with $1.

How to Use This Knowledge

For Beginners

1. Understand you're buying ownership in real businesses
2. Focus on long-term investing, not trading
3. Ignore daily market noise
4. Stay diversified with index funds

For All Investors

1. Market drops are normal and expected
2. Don't panic sell during corrections
3. Keep investing consistently
4. Let compound growth work

Key Takeaways

1. Stock market = marketplace for buying/selling company ownership
2. Prices = supply and demand influenced by many factors
3. Long-term trend is up despite short-term volatility
4. Market indices (S&P 500) measure overall performance
5. Time in market beats timing the market
6. Diversification protects against individual stock risk