How Stock Markets Work

The function of stock markets is an important element of making shares and equities investible, and traders that are looking to generate any serious level of return should take steps to become as familiar as possible with how the markets work and the various factors that play in to determine market pricing. For those that truly understand the stock markets and their behaviour, it can be possible to identify more opportunities for profitable trading, and make it easier to highlight trends and directions of underlying movement in a given market. Thus those that understand what they're doing in stock markets more intimately have a better chance of identifying viable trades.

Stock Markets at Work

The stock markets are a complex construct, and there is ample scope for error and confusion, with a terminology all of its own making to get to grips with. But at its most basic level, how do the stock markets actually work, and what can traders do to weigh the odds more heavily in their favour?

Stock Market Participant

Buyers

On one side of the stock market are share buyers. These are the investors looking for opportunities to buy into a market, or the short sellers looking to close out their positions. When a share is bought, the price of the share rises incrementally per share in proportion to the total market cap of the company. These pricing effects are usually too small for traders to notice directly, but it is the accumulation of many multiple similar actions across a market that creates the ups and downs of the price curve. Buyers are usually expecting markets to rise with time in order to generate their entitlement to a growth in the capital position, and therefore buyers tend to scout out companies with the capacity for growth or potentially strong performance before deciding where and how to trade.

Sellers

On the other side of the market are sellers. When a buyer wants to buy, he can't complete the transaction until a seller is found in order to match the position at the current market rate, and much of the job of markets is in finding corresponding counterparties to trading agreements. In markets where there is more liquidity, traders can benefit from quicker execution of their orders, which translates into making it easier to buy and sell respectively. When a share is sold it has a negative impact on market price, thus downwards trends are a market reflection of traders selling their exposure to a company en-masse. This is as a result of the effects of supply and demand, which produce an elegant mechanism for determining pricing in markets of this kind.

Supply and Demand

Stock markets are the perfect forum for the forces of supply and demand to take hold. Because shares are by definition scarce, and because they have inherent demand as a result of the business impact of owning shares, prices can respond perfectly to bouts of supply and demand by phasing through market highs and lows. When there is an excess of supply, the value of any asset falls because it is easier to acquire. Similarly, when an asset is in demand its value rises because the scarce resource is desired by an increasing number of buyers. In share markets, these forces of supply and demand work to push prices up and down in relation to market activity, and provide the perfect forum for traders to buy and sell shares respectively throughout their price cycle.

Market Makers

In order to make markets more liquid, an additional trading layer is required to ensure that positions are always able to be bought and sold. To match a position there needs to be a willing counterparty, but in some situations is would be difficult to find traders willing to part with their capital for a seemingly sliding investment, for example. This is where the role of market makers comes to the forefront - trading parties that both buy and sell shares across the markets with a view to generating their profits from the bid ask spread. Market makers provide the liquidity necessary for smooth trading, and provide the final piece in the puzzle to ensure that stock markets work without disruption.