Understanding how the stock market works: a beginner's guide

Stock market

Basic knowledge of how the stock market works can give you a significant trading edge. So here is a brief guide for traders starting out in the stock market.

A brief history of stock market trading

Before we explore how the stock markets work, let's talk about how it came into being.

The merchants of Venice are credited with trading state securities as early as the 14th century, but the first real stock markets didn't appear until the 1500's.

As is generally the case, a need lead to the creation of the stock market. The East India Company, which has the distinction of being the first publicly traded company, allowed investors to invest in several ships. So instead of financing a single ship and risking a total loss to pirates, disease and storms, it allowed investors to buy shares in multiple ships, so that if one ship was lost, not everything would be lost. Their success has led to similar schemes being set up for other companies in Belgium, England and the Netherlands. Coffeeshops were their trading floor, where stocks were handwritten on sheets of paper and traded.

Antwerp was the commercial center of Belgium, and it is generally believed that it hosted the world's first stock exchange system.

The creation of the Paris stock market occured in 1725 at the Hôtel de Nevers in order to restore the French economy which had been disrupted following the bankruptcy of the Law system which recommended the use of paper money (notes ) rather than metal currency (metal coins).

Primary and secondary markets

The equity market is a common term for the issuance of securities or their trade (buying and selling). These include stocks, bonds and other assets. There are two types of markets:

  • The primary market: this is where new securities are issued and offered to the public for purchase. For example, through a new issue or a company's initial public offering (IPO).
  • The secondary market: this is where already issued securities are traded and it is the main market for buying and selling. The secondary market is generally referred to as a "stock exchange".

The basics of stock trading

The stock exchange is an organised market for publicly available securities. It matches investors who want to buy (requests) and investors who want to sell (offers). The stock exchanges keep a register of the value of the securities, including their evolution over time.

To buy and sell stocks on the stock exchange, you must place an order through a stockbroker - this is a company that is authorised to provide you with access to the stock exchange.

  • The term "order" is used to describe an instruction to buy or sell a specified quantity of securities and a spefied price (either a limit price or a market price).
  • The term "transaction" is used after an order instruction is executed on the market, i.e. someone fulfills the conditions of your order and the trade takes place (an order purchase is matched with a sell order).
  • An order can trade in multiple lots, so for the same order you can have multiple trades depending on what is available in the market. For example, if you place an order to buy 100 shares, you can have up to 100 trades, if the order is trading in lots of 1 share (although this is unlikely).

Price quotes

There are generally three standard prices that are quoted on the stock market:

  • Buy: the highest price that buyers are willing to pay to buy stocks.
  • Sell: the lowest price that sellers are willing to receive in exchange for their stock.
  • Last: The price at which the stock was last traded at.

Price options

When placing an order to buy or sell stocks, you have two pricing options to choose from:

  • The market price: this is the price set by the market at the time you are buying or selling. So, you can buy at the price offered by the cheapest seller and vice versa, you can sell at the top price a buyer is willing to offer. As a result, the market price can change quickly, sometimes for as long as it takes to place your order. You don't have to queue to place a market order - the trade is usually done immediately - but you can only place a market order during market hours.
  • Limit Price: With a limit order, you set the maximum price that you are willing to buy at or the minimum price that you are willing to sell at. (For example, if your limit price so sell a share is set at £200, your order will only be executed if a buyer is willing to pay £200 or more per share). You can place a limit order at any time.

Note: When looking for the relevant price for your order, you should look at the other side of the trade. This means that if you want to sell, you have to look at how much buyers are willing to buy at in order to determine at what price you could sell them, and vice versa if you want to buy.

When your order is queuing in the order book

The stock market operates on a "first come, first serve" basis and uses a queue system for traders that place limit orders.

  • Buyers - At the top of the queue are traders who are willing to pay the most to buy shares (this is the quoted purchase price). The queue then descends in order of price to those who are willing to pay the least.
  • Sellers - at the top of the queue are traders who are willing to receive the least for their shares (this is the listed selling price), all the way down to those looking for the highest price to sell their shares.

Note: if several traders place an order at the same limit price, they will be queued in the order they were placed on the market. For example, if you want to sell a particular stock at £200 and three other people already have sell orders in the market at £200, they are at the top of the queue and their orders will be executed before yours.

Depth of market

It can be helpful to look at market depth when placing orders to see the other orders that are also in the market. Market depth allows you to see where your order might be traded or placed in a queue, depending on the price and quantity you set.

Market depth shows:

  • The number of orders in the market at a particular price
  • The quantity of shares (volume), buying or selling at a particular price

For example:

Stock order book

If you want to buy 100 shares and don't want to pay more than a limit price of £11.124, your order will be placed in the queue behind the single buyer who has a limit price of £11.124. The first buyer of 400 shares and then you (100 shares) would then be placed in the queue until one or more sellers are ready to accept £11.124 to sell their shares. You will then have to wait for the buyer's order of 400 shares in front of you to be executed before you can also buy shares at that price.

If you wanted to buy 100 shares at the market price, you would pay £11.126 for all 100 shares and your order would be filled immediately.

If you wanted to buy 750 shares at the market price, you would pay £11.126 for 710 shares (i.e. all the shares of the two best sellers) and £11,128 for the remaining 40 shares, as you will have to buy them from the next sellers in the queue. Your order would be filled immediately.

How do I buy stock?

You can buy stocks directly from your stock brokerage account. The following platforms allow you to both buy and sell stock online using your computer and/or smartphone.

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