How does the Stock Market Work?

Overview of How the Stock Market works

Stock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset (stock, in this case) and they are willing to sell off something they have at a certain price. Therefore, each asset has a value – which is the individual’s preference and price – which is the market’s determination of the asset’s value.

This means that the stock market works on the principle that one person’s selling price might be another person’s buying price and it tries to match it.

Terms used in the Stock Market

To understand how the stock market works, let us first dwell somewhat into the economics of supply and demand. After all, the stock market is a demand-supply matcher and without proper demand and supply, there is no stock market.

#1 – Demand and Supply

The line ‘D’ is the demand and ‘S’ is supply with a horizontal axis being the quantity (q) and the vertical axis (p) being the price. We can see that, as price increases, supply increases, and demand decreases. The point of the stock market is to find a midpoint and proceed with the transaction.

#2 – Market Price

The current price of the stock.

#3 – Auctioning

The stock market works like an anonymous auctioning machine – one-person auctions his assets and waits for another person to bid the right amount. When the selling price matches the buying price, the transaction happens and the stock market gets a cut.

#4 – Bid Price

When multiple buyers want to buy a stock, they bid for the stock and the highest price is called as the bid price.

#5 – Ask Price

When multiple sellers start selling the stock, they ask for a certain price. The lowest of such price is called as Ask price. The transaction happens when the highest bid price and the lowest ask price meets.

#6 – Tick Size

Tick size is the smallest amount by which the stock price can move. For example, the current price of Apple Stock is 204.24 USD. If I want to bid for 204.241 USD, I cannot do that. Because the minimum amount by which I can increase the stock price is 204.25 USD, which is 0.01 USD more than the market price. This 0.01 USD is called as the tick size. Smaller the tick size, slower the growth of stock price would be, but smoother the flow.

#7 – Liquidity

The more the difference between the bid and ask price (known as bid-ask spread), the lower the liquidity. If the difference between the bid and ask price is small, the transaction happens soon and it means that the liquidity of the market is high.

#8 – Open Price

The market price at which stock opens at the beginning of the day.

#9 – Closing Price

The last price at which the stock has been traded on the previous working day.

#10 – Stock Exchange

The marketplace where the stocks are traded. There can be multiple exchanges where the stock can be traded and there might be price differences in each exchange.

#11 – Lot Size

The number of stocks being offered for sale, or being asked for at a certain ask price.

Example of a Stock Being Traded

• Let us take an example of one of the most traded stocks ever – Apple on NASDAQ. NASDAQ is the exchange we are looking at. The reason why exchange is important while we are looking at ask and bid prices is each index has a different set of ask and bid prices.
• The current trades price for Apple (AAPL) is 204.23, but on June 3^rd it closed for 204.41 and opened for 203.35 on the next day. On July 3^rd the highest price of the stock is 204.44 and the lowest is 202.69 – once should take into consideration that these are the traded highs and lows, not the ask and bid highs and lows.
• These details are taken from Ameritrade as the broker, and the bid and ask spreads are as follows for a certain point on July 3^rd

•  In the above table, 203.84, 203.87, 203.88 USD is not available, this is because no one has bid at that price specifically. The bid sizes are the number of stocks that are being asked for at that price. The same is the case with the asking price. If the 203.90 (highest bid price) and 203.97 (lowest ask price) matches, then the stock market executes the transaction and the respective lot sizes are deleted.
• So, if the demand is more, the bid prices go up and as the transactions are conducted, the prices raise and the transaction is conducted at the highest available rate.
• The difference between the highest bid and lowest ask prices is called the bid-ask spread, this gives a gauge about the liquidity of the stock. Since Apple is a highly traded stock, such situations where the bid and ask are about 6 ticks (each tick in the USA is 0.01USD) is rare.

Advantages of Stock Market Working

The way stock market works have been greatly improved over generations and it matches the demand and supply perfectly. The utilization of auctioning mechanism, with anonymous nature, brings out the information in the best possible way.

Limitations of the way Stock Market Works

• The stock market uses demand and supply as the driving force. As good as this is, there are other derivatives that are dependent on stocks and people can change the supply of stocks to move the option prices in the direction they want. The anonymity makes it tough to trace back to the owner.
• The complete flow of information is not yet possible in a current way. If the information flow is complete, there should be no sudden drops or surge in stock prices – which is not the case currently.
• When machines take over trading, incidents like Flash Crash can make the market go haywire.
• The closer the exchange is to the trader the faster the stock price data and that can make things difficult for traders in a different location
• The stock Market encourages active investments rather than passive ones.

Conclusion

Like many things in finance, stock markets are useful and close to perfect. There are so many things that can be done using such auction-based markets – companies can raise funds, people can own a percentage of companies, hedge fund managers can get information about public opinion and so on. However, they still do not foolproof, but soon, they will be – with improvement in technology.

Recommended Articles

This has been a guide to How does the Stock Market Work? Here we discuss common terminologies used in the stock market along with its example, advantages, and disadvantages. You can learn more about accounting from following articles –

• Liquidity in Accounting Definition
• What is Stock Index?
• Calculate Price-Weighted Index
• Compare – NASDAQ vs Dow Jones
• Compare Stock vs Mutual Funds