Introduction To The Stock Market: How Does It Work?Sep 09, 2020
On the news you have heard the term “stock market” a million times, and you probably know its general functions but the stock market has a lot more gears and levers that the average person does not know about. We will be reviewing different market parameters and ratios, which will make it easier for you to understand how the stock market really works.
Let’s take a look at the diagram below.
As you can see the market is formed by two entities: primary market and secondary market. First let’s take a look at the chain of the primary market.
As an example company, let's use Tesla. The first process in the chain is the IPO (Initial Public Offering). What exactly does IPO mean? Before an IPO every company is considered private, therefore it means the company is owned by a small group of people. Through the IPO the company will offer shares in exchange for equity (raising capital), therefore opening the company to the public. So instead of a small group of people, there could be several thousands of people owning shares in the company.
The IPO comes with a significant amount of requirements. To be able to organize an IPO the company must fill a registration statement with the Securities and Exchange Commission (SEC). That statement will contain vital information about the issuing company, financial and ownership details. Once the statement is approved by the SEC, the company can then proceed with the IPO organization.
The IPO is organized by an investment bank hired by the company. The investment bank buys the shares at a lower price from the company. After this, the shares will then be sold for a higher price, so that they can make a return on their investment and earn some profits from the IPO. So, the investment bank will capitalize on the gains from the sales of the shares while providing the company with the funding they need for the IPO.
Every IPO is followed by an exchange listing (e.g. New York Stock Exchange (NYSE), NASDAQ), meaning they are now tradable on the Stock Market. At this point of the process, the company has now closed the primary market chain and has entered the secondary market chain. The process from the IPO initiation to selling the shares to the investors, closes the cycle of the primary market. It is called primary, because this is the earliest time you (the investor) could get access to the company’s shares (considering the company was private).
After the primary market cycle is done, and the company has been listed on exchanges, the company enters the secondary market cycle.
The secondary market includes the change of ownership in any stock between investors (buying & selling stocks). Different sets of rules will determine the price of a share. To make it easier to understand, let’s take a look at the diagram below.
The main principle used in the secondary market to value a share is the supply and demand principle. The principle on the surface might look simple, but below the surface it is very complex.
With that said, let’s start with the demand chain of the diagram. Let’s say lately there have been great accomplishments by the company (in our case Tesla), and as a result, investors start to buy Tesla shares. The recent increase in buying means the demand is increasing, therefore increasing the equity price of the share. But why exactly does that raise the price? Let me explain.
Let’s say the company emits 1000 shares (the supply) of the stock at $1. If there is no demand, the supply remains high and because no investors are really interested in the company, the price of the shares remain low. Now let’s say we have the same supply, but the demand is extremely high. Due to the high demand, investors are willing to pay more, therefore increasing the price per share. So to summarize, in a market with high supply and no demand, you will pay $1 per share for the stock, but in a market with high demand and low supply, you will always pay more for each share.
Now let’s take a look at the supply chain. Let’s say for a period of one year, the demand has been gradually increasing, while supply remained unchanged, and therefore pushing the price of the stock to the upside. At a certain point in time after this period of increased demand, let’s say we start to see negative news around the company (e.g. could be reduced sales, increasing operating margin). These types of events will lead to investors being concerned about the future of the company. These concerns will then cause investors to sell off their shares of the company.
To make it easier to understand let’s split the chain into smaller processes. With the negative news around the company, the supply remained the same. With rising concerns about the future of the company, we see a huge decline in the demand leading to the shareholders selling their shares (the supply). After the investors sell their shares (decline in demand), the market cap of the stock declines therefore making the price of the stock drop (increase in the supply). If you don’t understand ‘market cap’ and how it affects the price of shares, we will cover this in another article.
Now that you know how the supply and demand chain works, I will explain the entire principle in two sentences. I did not explain this in the beginning of the article because as with most things in the stock market, it is very important to understand the fundamental basics.
If the demand is high and supply is low, the price will increase. If the demand is low and the supply is high, the price will decrease.
I hope this information has helped you acquire a better understanding of how the stock market functions. If you took the time to read this whole article, congratulations you are one step closer to becoming the intelligent investor that many people wish to be.
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