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Published On: Fri, Feb 7th, 2014

How The Stock Market Works

The way the stock market works, you have three general categories of people involved. Of course, you have to have buyers or investors to buy the stocks. You also need people or entities that want to sell stocks, the vendors. And finally you have to have the enablers, or middlemen, who take care of all the transactions for the first two categories.

Investors

Investors come in all shapes and sizes. The term can be applied to anyone who comes with money, looking for an opportunity to spend it somewhere in the hopes of greater returns later.

It is easy to think in terms of the single investor, looking for somewhere to place their nest egg until it is needed, and hopefully increasing its worth in the meantime. But there are many other types of investors, including financial corporations such as life assurance companies who make investments to grow the money that we pay them so that we may have a pension in retirement.

In this category we also have to include the short-term traders who bring money to the markets. Even though they do not intend to leave it in place for very long, they are buyers of what the stock market has to sell.

Vendors

Vendors or sellers are the ones who come to the market with something to sell. They want or need cash. In the context of the stock market, these are often not individuals, but corporations or government entities.

The majority of sellers for the enormous amount of trading that goes on every day have something to sell because they bought it in the first place. In other words, they were investors at some time, and have decided for whatever reasons they are now moving on from whatever stock they hold. They may be looking to reinvest some or all of the money in stocks, or simply want to take the money out to meet bills.

There is another special class of vendor, and that is the company which is going public for the first time, or issuing additional shares to raise more funds. This does not happen often, and may indeed occur only once in a company’s life. As it is a large and expensive task, it is not entered into lightly so there must be a good reason that the company in the form of its current owners wants to raise funds.

Companies can issue shares, certificates of ownership in the company, and the main topic of this guide. The value of shares is intrinsically tied up in the success of the company, and provided a company is doing well it is reasonable though not certain that share prices will increase. As mentioned previously, shareholders may also receive regular payments known as dividends. However, the shares come with no guarantees but simply an idea that the company will continue operation and generate income.

This may sound more risky than it actually is. Over the years the system of stock ownership has proved to be reliable and in general lucrative. Indeed, if the company sold shares and then walked out on the deal, there could be all sorts of legal repercussions. It is in everyone’s interest to continue using the current share trading system.

As was mentioned above, there are in fact two ways that companies can ask for cash from outsiders. If they don’t want to sell part ownership of the company, they can always issue bonds, which are promises that if you give them money they will pay the amount back with interest over time. Governments do the same thing when they need more cash, and in the UK they are known as “gilts”. It is basically the government asking for funds in exchange for an assurance that they will pay back the money with interest.

Naturally, government bonds are considered the safest type, as you do not expect the government to go bankrupt or to welch on its debts. Company bonds are often split into different categories, depending on the creditworthiness of the company. Bonds for major companies are still pretty safe, and you will get paid as agreed. Some bonds are labelled “junk bonds”, the idea being that these are riskier as the company may default or go into liquidation. In return, you will find that the interest offered on junk bonds is higher to compensate for the increased risk. There are rating systems for bonds using the letters A, B, C to grade how risky the commentators think they are.

As mentioned in the beginning, bonds should still be considered safer than stocks. If a company goes belly up, its debts will be paid out of what money is left, then the bondholders are paid. It’s only after the company’s commitments are paid off that any money left over is divided amongst the shareholders. Still, bondholders will only ever get back their money with interest as agreed; shareholders have the prospect of greater returns.

Middlemen

The third type of person involved is the middleman, defined as people who bring together the investors and vendors so that the system works. There are several different types of middlemen, each of which performs a certain function with and for the stock market.

Some middlemen are specialists in finding finance for companies at the best possible rates, and in accordance with their needs. These are called corporate financiers.

Others are fund managers. These are experienced people, knowledgeable in finance, who specialise in investing other people’s money. As an individual, if you have ever put money in a mutual fund you have expected the fund manager to invest it wisely. The fund manager has more avenues of investment available to him than an individual has because of the large sums of money that he controls. He is also paid to spend all day studying the markets. Thus in theory he is at an advantage and can grow your money more than you could on your own.

The fact is that most fund managers don’t outperform the general index for the market that they are trading on. This is disappointing news, I know, and you are buying some sort of peace of mind that a person is watching what your money is doing, and hopefully avoiding the bigger losses. But still, you might have hoped for more. Then again, bear in mind that someone has to pay the fund manager for his expertise, and all his staff who answer the phones and write you letters, so perhaps you shouldn’t expect to make too much profit from investing in a fund. Don’t forget, the fund charges you every year for the privilege of leaving your money with them, and that is something you do not have to pay if you invest directly in stocks.

To attract people to invest their money in funds or in individual stocks, you have salesmen who work for the financial houses or banks. The chances are that you have been solicited in the past by some of them, pointing out the apparent advantages of using their company’s services. They of course represent another overhead charge for the investor, though in this case it may be an indirect charge.

If you as an individual decide to buy and sell stocks, then you will use a stockbroker. There are several different types of stockbroker. Some are called full-service brokers, and they will “hold your hand” buying and selling stocks, providing research which they will discuss with you, and giving you advice if necessary. Other brokers, typically the online brokers, concentrate on providing an efficient and reasonably priced service that simply allows you to buy and sell as you want. Whatever the type of broker, they act as the interface between the buying public and the floor traders on the stock exchange.

To access the stock market at all, you must use a broker, so this is a built in charge that you will not be able to avoid. However, modern electronics and computing being what it is you can find online brokers who levy only a few pounds for each transaction. You’ll find this is much cheaper than the overhead cost of many other investments.

And finally, the facilitators of the stock market action are the floor traders whose job it is to match buyers and sellers, and ensure that the market functions in an efficient and financially sound way. These are the people that you see in the movies about stock markets, waving their arms and shouting all day long. They have to know what they are doing, as there’s a lot of money at stake if they get it wrong. Some traders specialise in the stocks of a single company, if it is particularly actively traded, and some take on more than one. They are known as “making the market” in the shares.

The Market

For the UK investor, most of your transactions will go through the London Stock Exchange (LSE). This was founded in the late 17th century and began in the Starbucks coffee houses of London. London has long been a major commercial area so it is only natural that the LSE is Europe’s most important stock market, and one of the major stock markets of the world.

Although the values of shares are always changing, at the moment the Main Market on the LSE is worth more than £2 trillion with 926 UK companies, and also has an internationally listed section with more than 300 companies and a separate valuation of nearly £2 trillion.

The Alternative Investment Market (AIM) was launched in 1995, and caters for companies that are smaller and in the early stages of development, so do not qualify to enter the main market. The techMARK market focuses on innovative and health care companies. The techMARK market has 67 companies valued at £345 billion, and the AIM has well over 1000 companies with a total value of £73 billion.

The values of the shares are combined in different ways to give indices for quick reference to the economical health of market sectors. The most common index, as mentioned before, is the FTSE 100, the top 100 companies. The publisher of the FTSE Indices, the FTSE Group, was set up as a company by the Financial Times and the London Stock Exchange to manage the different indices. The FTSE Group is itself quoted on the stock market.

The FTSE 100 was started in 1984, and the value was arbitrarily set to 1000 as a baseline level, simply by putting in a divisor. This was necessary, otherwise the number would be unmanageably large. It represents the hundred largest qualified UK companies, and is weighted according to their capitalisation, so the largest ones have the greatest influence on the value. The list of companies is reviewed and may be changed a little every quarter, if some have gained and some have lost value. This review is automatic, and driven by the share valuations.

Although the FTSE 100 represents only 100 companies, it accounts for more than 80% of the entire market capitalisation of the LSE. The top five companies are so large, that they alone account for 30% of the FTSE 100 index. In fact the top company, Royal Dutch Shell, makes up nearly 10% of the value of the index.

The formula used for calculating the FTSE 100 includes a “free float factor”, which is an adjustment for the number of shares that are readily tradable and not restricted. An example of restricted shares would be shares held by company insiders, where trading is subject to certain controls. But principally, it is based on the company share price times the number of shares that have been issued, a simple calculation.

Other indexes include the FTSE 250, the FTSE 350, the FTSE Small Cap Index, and the FTSE All Share. The FTSE All Share represents more than 98% of the market capitalisation, with nearly 1000 companies represented, but the FTSE 100 still seems to be the index that everyone uses to assess the state of the UK economy.

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About the Author

- Robert is a private trader with over 15 years experience trading the financial markets.

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