How the Stock Market Works

The stock market can seem intimidating, especially for those new to investing. Understanding stock market basics is essential for anyone wanting to grow their wealth over the long run.

In this Investing 101 guide, we’ll discuss how the stock market works, how to invest in stocks, and everything else you need to know to get started on your investment journey.

What are Stocks?

Stocks are ownership shares in a company. When you invest in stocks, you become a partial owner of that business. The value of stocks goes up and down based on how well the company is doing and how investors feel about the company’s future potential. 

What are Stock Options?

Stock options are a type of financial contract that lets the holder buy a set number of shares in a business’s stock at a fixed price, known as the “strike price,” within a specific period of time. The holder does not have to buy or sell the stock.

There are two types of stock options:

• Call options let the holder buy the stock at the strike price. If the market price is higher than the strike price, the holder can buy the stock at the lower price and then quickly sell it at the higher price for a profit.
• Put options let the holder sell the stock at the strike price. If the market price is lower than the strike price, the holder can sell the stock at the higher strike price and avoid losses.

Different Types of Stocks

Investors have several options when it comes to the stocks they choose to invest in. Here is a list of the different types of stocks you can invest in.

Common Stocks

Common stocks have voting rights that let the shareholders of common stocks vote on company matters. Shareholders with common stock own a part of the company. 

Preferred Stocks

Shareholders with preferred stock do not have any voting rights. Preferred stock can offer shareholders higher dividends in the long term. 

Capital Stocks

Capital stock is the total amount of both common and preferred stock that a company has. It is also the maximum number of shares a company is allowed to have at one time. 

Blue-Chip Stocks

Blue-chip stocks are shares of big, financially sound companies everyone knows and trusts. They’re generally considered some of the safest and most stable investments on the stock market because the companies they come from have a long history of profits, and their stocks tend to be more stable. Examples of blue chip stocks include businesses like Microsoft, Apple, and Walmart.

Growth Stocks

Growth stocks are shares of companies experiencing rapid growth and are expected to continue growing at a higher rate than the rest of the market. Investing in growth stocks comes with higher risks. Their value can be sensitive to changes in the market, and unprofitable companies or those that fail to meet growth expectations may see their stock prices plummet.

Value Stocks

Value stocks are shares of companies that trade at prices that are low compared to their basic financial metrics, such as their profits, assets, or cash flow. People who invest in value stocks are looking for bargains and believe the market has overlooked a company's true worth. 

Small-Cap, Mid-Cap, and Large-Cap Stocks

The terms small-cap, mid-cap, and large-cap stocks refer to the size of the companies whose stocks you’re investing in.

• Small-cap stocks are from companies with market caps between $250 million and $2 billion. They’re typically newer companies that are just starting to make their mark. 
• Mid-cap stocks are from established companies in the $2 billion to $10 billion range. They have moved past the small-cap stage but still have room to grow and are a great middle-ground for investors. 
• Large-cap stocks are from companies that have market caps of over $10 billion. These are the industry leaders who have proven themselves in the market. They’re usually more steady and less risky but can still provide reasonable returns for long-term investors.

Cyclical and Defensive Stocks

Cyclical stocks tend to increase and decrease with the economy. That means when the economy is booming and consumer spending is high, cyclical stocks tend to do really well. But when the economy slows down, the companies struggle.

Defensive stocks are the opposite and tend to do better during economic dips. Their products and services are often considered essential, so demand for them stays relatively stable even when the economy is struggling.

What is the Stock Market?

The stock market is where investors, traders, and stockholders can buy, sell, and trade stocks. Companies offer stock to traders and investors to grow profits and measure their business success. The stock market might also be referred to as the stock exchange, equity market, or share market. 

There are both public and private stock markets. Stock market investing is usually done through stock brokers or electronic trading platforms. By investing in stocks, you can grow your financial portfolio, diversify your assets, and build wealth. 

How Does the Stock Market Work?

As a stockholder, you have to know how the stock market works so you can use that knowledge to your advantage when investing.

1. First, companies have to go public and offer up company shares on the stock market. 
2. Then, investors can buy and sell shares of stock in those companies. Companies will let the public know they are offering stock through an IPO, which will outline the cost of shares in that company. The company's worth and how much stock they are issuing are some factors that go into determining what the price of each stock is. 
3. After the IPO, the company's stock can eventually move to the open market, like the NYSE. In the secondary market, the value of a company's shares fluctuates according to market values.

Companies rely on the market to raise profit, so they can look to stock value fluctuations as indicators of how their business is doing. 

For stockholders, the stock market is kind of like an ongoing auction for bits of a company. By investing in these company shares, investors can grow and strengthen their own financial portfolio and assets. 

How Do Stocks Work?

When you buy a stock, you become a partial owner of that business. The stock’s value fluctuates based on factors like the company’s profits and market trends.

As mentioned above, the stock market is where these shares are bought and sold, with stock prices constantly moving up and down as investors buy and sell. The more demand there is for stock, the higher the price will go.

When investor interest decreases, the stock price falls. The challenging part is predicting which way a stock’s price will move. That’s why research, analysis, and a long-term mindset are so important when investing in the stock market. 

What are Stock Dividends?

A dividend is an allowance of a company's profit that gets paid to certain shareholders. Companies pay dividends to shareholders when they earn a surplus of profit. This surplus then gets divided between shareholders and reinvested in the company. 

What are the Different Stock Market Exchanges?

There are 4 different stock market exchanges to consider when learning how to invest for beginners. 

• The New York Stock Exchange (NYSE): The NYSE is a U.S.-based stock market in New York City. Their building is located at 11 Street and was declared a National Historic Landmark in 1978. The NYSE is one of the largest stock exchange markets in the world.
• National Association of Securities Dealers Automated Quotation System (Nasdaq): Nasdaq is another U.S.-based stock market exchange. It’s located in New York City at One Liberty Plaza and is the second-largest stock exchange after the NYSE.
• Dow Jones Industrial Average (DJIA) Stock Market Index: The DJIA, S&P Dow Jones, Dow Jones, or simply Dow is a stock market index that measures the stock performance of large U.S. companies. Stock market indexes like this one help stockholders and brokers see how the market is doing so they can make decisions about their own finances and shares. There are many other stock exchange indexes to follow, like the S&P 500 Index or Russell 3000. 
• American Depository Receipts (ADRs): When investors want to trade in foreign stocks, they can either trade directly with foreign stock markets or use receipts like ADRs. ARDs let U.S. investors buy foreign stocks through U.S. stock markets. Foreign companies offer ADRs so they can have a presence in the U.S. markets and allow their shares to be listed on U.S. markets. 

Is the Stock Market Open Today?

Stock markets like the NYSE and Nasdaq have regular trading hours and are typically open between 9:30 AM and 4 PM, ET on weekdays.

The stock market is closed on weekends and the following stock market holidays:

• New Year’s Day
• Martin Luther King, Jr. Day
• Washington’s Birthday
• Good Friday
• Memorial Day
• Juneteenth National Independence Day
• Independence Day
• Labor Day
• Thanksgiving Day
• Christmas Day

How is the Stock Market Doing Today?

The stock market can change every day. If you want to see how it’s doing, you can check major stock market indexes like the S&P 400, Nasdaq Composite, and Dow Jones Industrial Average.

They all provide stock market charts and percentages. You can also check financial news websites and apps, like Google Finance and CNBC, which provide real-time updates on major index levels and individual stock prices.

How to Invest in the Stock Market

When deciding to invest in the stock market, keep in mind that there are potential risks and rewards. At the end of the day, investing is about patience and balance. Here are a few steps to start investing.

Step 1: Open a Brokerage Account

The first thing you'll need to do is open an account with an investment company, an investment bank, a stockbroker, or an electronic investing system like an investment app. 

Step 2: Buy Stocks and Diversify Your Portfolio

Stock market investing involves a spectrum. On each end of the spectrum are the extremes of either taking risks or being conservative. High-risk stocks have the potential to be very lucrative but also run the risk of losing money. Risky stocks tend to include products and companies that may or may not do well. 

Low-risk stocks won't make as much money even when they are successful but they will grow money more steadily and securely. Safe stocks often include things that will always be in demand, like precious metals or housing. 

Diversification between the two extremes is often the best approach to investing. Instead of investing everything into one venture, consider spreading out your investments between several different kinds of ventures to improve investment stability. 

One great place to start investing is mutual funds or Exchange-Traded Funds (ETFs). These types of investment funds allow you to buy stock in bulk or join a pool of other investors rather than investing alone. 

Step 3: Monitor Your Stocks

Once you’ve invested in stocks, it’s important to stay on top of how your investments are performing on an ongoing basis. Monitor your stocks by regularly checking in on the current prices, news, and overall market conditions that could impact your stocks.

By regularly checking your stocks and the market, you can find opportunities, prevent potential problems, and make quick decisions to manage your portfolio.

Remember that the stock market can change rapidly, so don’t get too fixated on daily price fluctuations. Focus on the long-term essentials of your investments and your overall goals for investing.

How Much is the Average Stock Market Return?

The average return of the S&P index has been around 10% over the past several decades. While past performance doesn't guarantee future results, knowing this historical return rate can provide valuable context when creating investment strategies and setting expectations.