The stock market is as much a part of our economy as it ever was – and since online trading began, it has become even more important to everyday traders. Stock market basics are things just about anyone interested in investing for retirement or for extra income should know, from what a market is to how stocks are actually traded and what it all means.
In this article, I’ll give you a basic overview of the stock market and show you how it works today.
Taking a Look at the Market Itself
The stock market, as we know it, is a global community that consists of four different groups: public corporations; market makers; buyers; and sellers.
Public corporations are businesses that offer shares, or ownership, in themselves to anyone willing to pay money for them. Buyers are investors who want to purchase ownership; sellers are shareholders who want to get rid of their stock in exchange for cash. Market makers are companies or individuals who basically match orders from buyers and sellers to ensure liquidity in the market.
All four of these groups interact with each other on stock exchanges. These exchanges – such as the New York Stock Exchange and London Stock Exchange, to name a couple – are like giant virtual markets. Here, shares are bought and sold between investors based on their bid price – how much it costs to buy a share of a company – and their ask price – the lowest price for a share that a seller is willing to accept. The difference between the two is called the spread.
The Mechanics of Buying and Selling
When you place an order to buy a share through a brokerage, you are telling the system that you want to purchase a share of Company ABC for X dollars. If there is a seller willing to sell you ABC for X dollars, then the system matches the order and you receive your shares. If you then want to sell your shares for Y dollars, the system matches you with a buyer who will accept that price.
This all happens thousands of times per second, all over the world. We measure the level of activity with a particular stock by volume, or the amount of shares that have been traded with that stock at any given point. Price fluctuates according to volume and many other technical and fundamental factors, but largely is a factor of supply and demand; as more people think a company will be worth more than what it is, buyers will be willing to pay more for the shares.
The method you use to buy or sell your shares is called putting in an order. There are several types of orders:
- Market orders: Buy or sell a share at whatever the current price is. This type almost always guarantees execution but not price, since the price can go up or down before the trade is executed.
- Limit orders: Buy or sell a share only after it rises above or falls below a certain price. This can guarantee price but not execution. If you want to buy at $10 or better and the stock is currently at $11, you can place a limit order to buy at $10. If the stock dips to $9.99, your order goes through; if it goes down to $10.01, it is doesn’t. Limit orders are usually used to lock in profits and benefit from a trend.
- Stop orders: Also known as a stop-loss order, a stop order buys or sells shares once a certain price has been reached. It then turns into a market order. A Buy Stop is above the current price; a Sell Stop is below the current price. Stop-loss orders are usually used to cut your losses and exit a position before it costs you even more money if the trade doesn’t go your way.
- Stop limit orders: Buy or sell a share only after the share has reached a certain price; at this point, the order turns into a limit order for another price. With a stop limit, you set two prices (the stop price and the limit price). For example, your stop price is at $10.50 and your limit price is at $11. If the price hits $10.50, then your order is turned into a limit order, which is then filled if the price hits $11. The downside to stop limit orders is that they may not get filled.
You can also arrange your orders by when – and how – you want them to be filled based on certain conditions:
- Fill-or-kill (FOK) orders: Orders (usually limit orders) that require the entire amount of shares desired to be bought or sold , or the order is cancelled. For example, a FOK limit order to buy 100 shares at $10 would require that all 100 shares are bought once the price hits $10; if only 50 shares can be found at that price, the order does not go through.
- Immediate-or-cancel orders: Execute the order immediately or cancel it. You can partially complete an order by accepting, say, 50 shares instead of 100.
- Good-until-cancelled (GTC) orders: This order is valid until you cancel it.
- Good-for-day (GFD) orders: This order is valid only through the current trading session. Most orders are GFD orders.
- One-cancels-others (OCO) orders: Used when you want either of two trades to go through, depending on what happens in the market. You may want to purchase Company A at $20.00 or Company B at $15.00. If Company A’s stock hits $20, the limit order for Company A goes through and you buy those shares, while the order for Company B is cancelled.
Market orders are filled first, followed by limit orders. Conditional orders – like stop orders or OCO orders – are next. All other things being equal, your order is filled based on when it was given.
So, to recap, the basics of stock trading involve supply and demand between mass groups of traders who are trying to buy and sell shares for certain prices. Either market makers or stock exchanges try to match buyers with sellers so that people get the shares they want when they want them, hopefully for the price they want. There are more complicated order types, rules, and mechanisms, but the above basics should give you a good idea of how the market works at a fundamental level.