How the stock market works

Related: Stock market trading guide, the first stock exchange, the first Joint Stock Company

Stocks or shares are ownership claims on a company. When companies are planning on a venture that cannot be raised realistically through borrowing, it can issue stocks privately or go public in the stock market. Funds are initially raised publicly through an Initial Public Offering or IPO. An underwriter which is usually an investment bank valuates the company and then issues an appropriate number of shares to be offered to the public. Sometimes, when the demand for the stock is more than the total of shares, the company can start another round of issues to satisfy the demand. However, depending on the strength of the demand, another round of new issues can lower the value of the initial issues. The proceeds from the sale of shares are registered as profits for the company and can now use the funds for its operations. Since the first shares were offered to the public in 1602 in Netherlands by the Dutch East India Company, the purpose of selling shares is to raise enough funds that will last for more than a single venture, therefore, the sharing of profits are postponed for 10 years, afterwards the profits would be distributed in the form of dividends, the company is in no obligation to buy back the shares from investors. Investors may sell or transfer their share to another party. Today, companies may elect to either distribute dividends or keep it for expansion. If companies distribute profits to shareholder, its growth may be compromised. On the other hand, a company that does not distribute dividends may see their shares go up in value faster than the company that distributes dividends. The incentive depends on the shareholders, if their purpose is to buy and sell the shares at a higher price in a short period of time they will buy a growth stock. If a shareholder’s goal is a regular income, they will go for the dividend paying one.

Once the shares are successfully floated in the market, the supply and demand for it decides its current market value. Floor traders which are usually employees of an equities broker would try to match buy and sell orders for it. Floor traders are usually trading in round lots, which is a rule that depends on each exchange. A round lot can be a group of 100 shares of a particular stock, if a floor trader has 20,000 buy orders for a particular stock, he will try to find sellers for the stock that matches the volume at hand. If there are no sellers, the floor trader might offer a higher price for it. The higher price offered may contribute to the current market price of the stock displayed on the ticker. On the other hand, if the same trader has 20,000 sell orders for the same stock the next day, the floor trader would find buyers for it that matches the volume, if there are no buyers, he will bid on a much lower price in order to execute the sell order as quickly as possible. The lower the bid price the more buyers would soon appear and take the 20,000 shares the floor trader has. This much lower price now contributes to the current market price of the stock which is now much lower.

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