how does the stock market work

What is the Stock Market?

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Basics of the Stock Market and some really weird history

Do you know how the stock market works? What is the stock market and how does your cash get converted into shares of stock?

In this video, I’ll share the weird birth of Wall Street along with how it really works when you buy or sell shares.

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What is the Stock Market in Simple Terms?

We talk about investing in the stock market a lot on the channel, but do you really know what that means? What happens when you click buy on your favorite investing site and who are the people handling your money?

How does your cash get converted into beautiful shares of the Joseph Hogue corporation?

how does the stock market work
How Does the Stock Market Work?

Ah, so beautiful.

I’ve worked in the industry for nearly two decades, first as a venture capital analyst and investment analyst, then for private wealth customers, and what I’ve seen of the market will shock you.

In this video, I’ll show you some crazy stock market history, the weird birth of Wall Street as well as how today’s stock market really works.

Now I’m mostly going to talk about the U.S. stock market…because I’m an asshole American that thinks the world revolves around me. I’m ok with that and honestly, most stock markets work the same anyway.

What is the History of the Stock Market?

The first stock market was in Amsterdam in the early 1600s. Europeans were binging on spices from India but it was hugely expensive to compete which meant sending dozens of ships, building ports and fighting pirates. The result was the United East India Company or the Vereenigde Nederlandsche Geoc…the VOC for short.

The company was set up to sell shares that would pay a dividend but would be dissolved after 21 years and that investors could sell their shares after 10 years. The company was so successful that they decided after the 10 years that it wouldn’t be dissolved so investors needed some way to buy in and sell out of their shares. That created the need for a formal place to exchange information and the stock sales.

What is Wall Street?

Fast forward about 50 years and it’s the Dutch again that created Wall Street in America…except it’s not the Wall Street you’re thinking of. After the wars with England, Dutch settlers in Manhattan, then called New Amsterdam, built a wooden wall along the southern tip of the island. The wall stood nine feet tall and went 2,300 feet from the corner of Wall and Pearl to what is now Broad and Wall Street.

The wall was taken down in 1699 but nearly 100 years later, stock traders started grouping daily to trade under the Buttonwood tree at the corner of Wall Street. Anyone that wasn’t a formal member of the group that wanted to buy or sell shares had to work through a broker…and the stock market was born.

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How Does the Stock Market Work?

Now let’s look at how today’s stock market works, how it works when you buy or sell stocks, the players involved and some myths about investing.

So the stock market can mean different things. It can mean the physical or electronic exchange, a location where stocks are traded, like we’ll talk about now. A stock market can also mean the idea of the stocks in the market. So here we’re talking about indexes, sectors and other ways to group stocks.

Let’s first look at how the stock exchange works and then talk about the market.

The stock market is like an auction house where there’s no set price for stocks until buyers and sellers find one. Companies issue ownership through shares in an initial public offering, or IPO, where public investors get their first chance to buy in.

An important fact here about buying and selling stocks, after the IPO that first time the company issues shares on the market, after that, the company takes no part in the shares. It doesn’t make any money on the shares again.

This is why the stock market is called a secondary market, where buyers and sellers can trade their investments. Other than when a company buys its shares back or rarely issues more shares, it has nothing to do with the buying or selling and makes no money off it.

Buying stocks gives you an actual ownership of the company and most shares have voting rights for company shareholder meetings. The problem here is that even a few hundred thousand shares may only be a fractional percentage of the company so most investors really aren’t going to control much of the decision-making.

For example, at a market value over $1 trillion, you would need to own $10 billion in shares of Apple to control just 1% of the voting rights.

Besides the New York Stock Exchange on Wall Street, there are other exchanges like the Philadelphia Stock Exchange, the Chicago Mercantile Exchange where they trade commodities like oil, corn and gold and the Nasdaq which a wholly computerized exchange.

All stocks have a bid price, the price buyers are willing to pay, and an ask price which is the price sellers are willing to accept. A transaction only occurs when one of the prices meets the other or when someone places a market order. That’s when you tell the investing platform to buy you shares at the current ask price or to sell your shares at the current bid.

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What Happens When You Buy Stock?

But what actually happens when you click that button to buy or sell your shares? What’s the process and how does it work?

Most exchanges run electronically anymore but there are still some physical exchanges and open outcry. In the good ol’ days, your order would go through a broker. These are licensed and regulated dealers with membership on the stock exchange.

The broker would receive your order along with all the other orders from investors, and send a message down to one of their floor traders to buy or sell. The floor trader would then go to the place on the exchange where that particular stock is traded and would transact the order.

This brings us to probably one of the least understood players in the market but one that’s absolutely critical. Market makers are the employees of a large bank or investment firm that are contractually obligated to buy or sell a specific stock.

This person has a spot on the exchange that is designated for that stock and where all the traders know they can go to buy or sell. The market maker has an obligation to buy or sell the shares if there is anyone that wants to take the other side.

For example, if a trader comes up and wants to sell 100 shares of Microsoft, the market maker has to buy the shares if there are no other traders there to buy.

Now of course, the market maker sets their price depending on other orders as well as supply and demand. They set a fair bid and ask price for their own book, the bank’s ownership in that stock, and adjust it up or down depending on the news.

All this makes sure there is always trading available in a stock. Without market makers, and especially in times of big news or uncertainty, there might not be anyone that wants the other side to your buy or sell order. Market makers help keep stocks trading even in the face of big, price-changing news.

That’s how the market works but when most people talk about the Stock Market, they’re thinking of the idea of the market. Their talking about an index like the S&P 500 which is just a group of the 500 largest publicly traded companies in the United States, a group that is supposed to represent the entire market of shares. Another index is the Nasdaq listing of mostly tech and biotech stocks which is also an electronic exchange.

The stock market and Wall Street can seem like complicated places and ideas but it's really just an auction for investors to buy and sell stocks. Understanding a little of the history and how the stock market works will give you an appreciation for investing.

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