What is the stock market and how does it work?

The stock market is an important part of a stock market. It facilitates transactions between traders of financial instruments and between buyers and sellers. It is also an important part of the capital raising process that many companies need to have access to in order to grow successfully.

A stock exchange, securities exchange or exchange is an exchange where stock brokers and traders can buy and sell securities, such as shares, bonds and other financial instruments. Exchanges may also provide facilities for the issue and redemption of such securities and instruments and capital events including the payment of interest and dividends on investment products and bonds. Exchanges often operate as “continuous auction” markets with buyers and sellers completing transactions via open outcry at a central location such as the floor of the exchange or by using an electronic trading platform.

In order to trade a security on a particular exchange, the security must be listed there. Usually there is a central location for record keeping, but trade is increasingly less linked to a physical location as modern markets use electronic communication networks, giving them the benefits of increased speed and reduced transaction costs. Trading on an exchange is restricted to brokers who are members of the exchange. In recent years, various other trading venues such as electronic communication networks, alternative trading systems and dark pools have taken much of the trading activity away from traditional exchanges.

IPOs, so-called initial public offerings of shares and bonds to investors are made on the primary market and subsequent trading takes place on the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors that, as in any free market, affect the price of shares.

There is usually no obligation for shares to be issued through the exchange itself, nor can shares be traded afterwards on an exchange. Such trading can take place off-exchange or over the counter. This is the usual way of trading derivatives and bonds. Stock exchanges are increasingly part of a global securities market. Stock exchanges also perform an economic function by providing liquidity to shareholders by providing an efficient way to dispose of shares.

The history of the stock market goes back hundreds of years to 13th century Europe, but the US stock market did not become an established part of economic life until much later, in the 18th century. Today, the performance of different stock markets in the US and around the world is used daily to measure the health of different parts of the economy. But the history of the stock market is a long, winding road, with many twists and turns.

The idea of a stock market

A stock exchange or stock market is a physical or digital place where investors can buy and sell shares, or stocks, of listed companies, among others. The price of each stock is determined by supply and demand, as well as investor sentiment and domestic and global economic trends.

As more people want to buy shares, the demand increases and the price goes up. When there is less demand, the price of a share drops. Stock markets now exist in most countries, but the first stock exchange appeared in Amsterdam in the 17th century. Amsterdam is currently seeing a huge boost after Brexit. In fact, the Dutch stock exchange is now larger than the London Stock Exchange.

Stock market timeline

Here is a timeline of some of the major events in the history of the stock market:

– Late 15th century: Antwerp, or today’s Belgium, becomes the center of international trade. Traders buy goods in the expectation that prices will rise to give them a profit. Some bond trading also takes place.

– 1611: The first modern stock exchange was created in Amsterdam. The Dutch East India Company is the first publicly listed company and for many years was the only company whose shares were traded on the stock exchange.

– Late 18th century: A small group of merchants entered into what was called the Buttonwood Tree Agreement. The men meet daily to buy and sell stocks and bonds, a practice that will eventually form the New York Stock Exchange. Buttonwood is a reference to the fine-grained wood of the American sycamore, sometimes also called sycamore, which was often used to make wooden buttons, hence the name Buttonwood.

– 1790: The Philadelphia Stock Exchange is established, helping to stimulate the development of financial sectors in the US and the country’s westward expansion.

– 1896: The Dow Jones Industrial Average is created. It initially had 12 components that were mainly industrial companies.

– 1923: The early version of the S&P 500 was created by Henry Barnum Poor’s company, Poor’s Publishing. It starts by tracking 90 shares in 1926.

– 1929: The US stock market crashes after the decade-long ‘Roaring 20s’, when speculators made leveraged bets on the stock market, inflating prices.

– 1941: Standard & Poor’s is founded when Poor’s Publishing merges with Standard Statistics.

– 1971: Trading begins on another US exchange, the National Association of Securities Dealers Automated Quotations, also known as NASDAQ.

– 1987: Corporate purchases and portfolio insurance helped market prices rise until October 19, which became known as ‘Black Monday’.

– 2008: The stock market crashes following the boom in the housing market, along with the proliferation of mortgage-backed securities in the financial sector.

Where were shares first created?

The concept of trade in goods goes back to the earliest civilizations. Early companies would combine their funds to take ships across the sea to other countries. These transactions were carried out either by trading groups or individuals for thousands of years.

Throughout the Middle Ages, merchants would gather, often in the middle of a city, to trade and exchange goods from countries all over the world. Since these merchants were from different countries, it was necessary to establish a currency exchange, so that these trade transactions were fair.

As mentioned, Antwerp, or Belgium today, became the center of international trade at the end of the 15th century. It is believed that some traders started buying goods at a specific price with the expectation that the price would rise so that they could make money.

For people who needed to borrow money, rich merchants would come to lend money at high interest rates. These merchants would then sell the bonds backed by these loans and pay interest to the others who bought them.

The first stock market

The first modern stock market was created in Amsterdam when the Dutch East India Company was the first listed company. To raise capital, the company decided to issue shares and pay dividends on the shares to its investors. In 1611, the Amsterdam Stock Exchange was created. For many years, the only trading activity on the exchange was in shares of the Dutch East India Company.

At this point, other countries started creating similar companies, and buying shares was popular for investors. The excitement blinded most investors and they bought into any company that became available without researching the company. This resulted in financial instability and eventually, in 1720, investors got scared and tried to sell all their shares in a hurry. However, no one bought and the market crashed.

Another financial scandal followed soon after in England, around 1720. At its center were the South Sea Company, formed in 1711 to conduct English trade with South America, and the Mississippi Company, focused on trade with France’s Louisiana colony and championed by transplanted Scottish financier John Law, who effectively acted as France’s central bank. Investors bought up shares in both companies, and anything else that was available. In 1720, at the height of the mania, there was even an offer of “a company to perform an undertaking of great advantage, but none to know what it is”.

By the end of that year, stock prices had begun to collapse, as it became clear that expectations of imminent prosperity from America were exaggerated. In London, Parliament passed the Bubble Act, which stipulated that only royally chartered companies could issue public shares.

But even though the idea of a market crash concerned investors, they got used to the idea of trading stocks.

Economist Ulrike Malmendier of the University of California at Berkeley claims that a stock market existed as far back as ancient Rome, originating from the Etruscan ‘argentari’. In the Roman Republic, which existed for centuries before the empire was founded, there were societates publicanorum, organizations of contractors or tenants who performed temple construction and other services for the government.

One such service was the feeding of geese on Capitoline Hill as a reward to the birds after their honking warned of a Gallic invasion in 390 BC. Participants in such organizations had shares, a concept mentioned several times by the statesman and orator Cicero. In a speech, Cicero mentions ‘shares that had a very high price at that time’. Such evidence, in Malmendier’s view, suggests that the instruments were interchangeable, with fluctuating values based on an organization’s success. The societies sank into obscurity during the time of the emperors, as most of their services were taken over by direct agents of the state.

The first US stock exchange

Although the first stock market started in Amsterdam in 1611, it was only at the end of the 18th century that the first stock exchange started in the United States. It was then that a small group of merchants made what they named the Buttonwood Tree Agreement. This group of men met daily to buy and sell stocks and bonds, which became the origin of what we know today as the New York Stock Exchange (NYSE).

Although Buttonwood traders are considered the founders of the largest stock exchange in America, the Philadelphia Stock Exchange was the first stock exchange in the United States. Founded in 1790, the Philadelphia Stock Exchange had a profound impact on the city’s place in the global economy, including helping to stimulate the development of the US financial sectors and its westward expansion.

In 1971, trading began on another exchange in America, the National Association of Securities Dealers Automated Quotations or otherwise known as NASDAQ. In 1992, it merged with the London-based International Stock Exchange. This link became the first intercontinental securities market.

Unlike the NYSE, a physical stock exchange, NASDAQ allowed investors to buy and sell shares on a network of computers, as opposed to in-person trading. In addition to the NYSE and NASDAQ, investors could buy and sell shares on the American Stock Exchange or other regional exchanges such as those in Boston, Philadelphia and San Francisco.

How was the US stock market created?

The New York Stock Exchange took centuries to become what it is today. In 1817, Buttonwood traders visited the Philadelphia Merchants Exchange to emulate their exchange trading model and created the New York Stock and Exchange Board.

Members had a dress code and had to get a place on the exchange. They also had to pay a fee, which increased from 25 to 100 dollars in 1837.

After the Great Fire of 1835 destroyed 700 buildings in lower Manhattan, Wall Street suffered a significant loss of property. Fortunately, Samuel Morse opened a telegraph demonstration office, which allowed brokers to communicate remotely.

In 1903, the doors of the NYSE opened with hundreds of stock certificates held underground in vaults.

The stock market rose, reaching a peak of 50% in 1928 despite indications of an economic downturn. In 1929, the market fell by 11% in an event known as Black Thursday. The market decline caused investors to panic, and it took the stock market the entire 1930s to recover from the crash. This period is known as the Great Depression. Since then, the market has experienced several other crashes, such as the subprime mortgage crash in 2008.

Different stock exchanges in the world

The NYSE is the largest stock exchange in the world. Yet there are now stock exchanges in major cities around the world that trade domestic and international shares.

These include the London and Tokyo stock exchanges. Some of the other world’s largest stock exchanges are in China, India, Canada, Germany, France and South Korea. In Sweden we have two stock exchanges, Nasdaq Stockholm, commonly known as the Stockholm Stock Exchange, and NGM. Spotlight is not an exchange, but a Multilateral Trading Facility (MTF), as is NGM Nordic SME.

The history of stock market indices

When you read about the stock market, you come across names like OMXS30, Dow Jones Industrial Average and S&P 500 Index. These are two of the stock market’s most famous benchmarks, or barometers that try to capture the performance of the whole market and even the whole economy.

Founded in 1896 by Charles Dow and Edward Jones, the Dow is a price-weighted average. This means that stocks with higher price-per-share levels affect the index more than those with lower prices. The Dow consists of 30 major US-based stocks. It was designed as a proxy for the overall economy.

Dow’s 12 initial components were mainly industrial companies, such as producers of gas, sugar, tobacco, oil, as well as railway operators. It has since undergone many changes and now includes technology, health, financial and consumer companies. General Electric was one of the original Dow members. Meanwhile, Procter & Gamble was added in 1932 and remains in the benchmark today.

Meanwhile, the S&P 500 index was created in 1923 by Henry Barnum Poor’s company, Poor’s Publishing. It started by tracking 90 shares in 1926. Standard & Poor’s was founded in 1941, when it merged with Standard Statistics.

Today, the S&P 500 is a market capitalization-weighted index, which means that companies whose market value is larger have more influence. Market value or market capitalization is calculated by multiplying the price per share by the number of outstanding shares. More than the Dow or other gauges like the Russell 2000 Index, the S&P 500 has become synonymous with the stock market among investors.

What are the functions of a stock market?

The stock market ensures price transparency, liquidity, price discovery and fairness in trading activities.

The stock market ensures that all interested market participants have access to data for all buy and sell orders, contributing to the fair and transparent pricing of securities. The market also ensures efficient matching of appropriate buy and sell orders.

Stock markets need to support price discovery where the price of any stock is determined collectively by all its buyers and sellers. Those who are qualified and willing to trade should have immediate access to place orders and the market ensures that orders are executed at a fair price.

Stock markets have multiple roles in the economy

This may include the following:

Providing capital to companies: In addition to the lending capacity that the banking system provides to an individual or company, in the form of credit or loans, a stock exchange allows companies to raise capital for expansion by issuing shares to investors.

Capital-intensive companies, especially high-tech companies, usually need to raise large volumes of capital in their early stages. For this reason, the public market provided by the stock exchanges has been one of the main sources of funding for many capital-intensive startups.

In the 1990s and early 2000s, high-tech listed companies experienced a boom and bust on the world’s major stock exchanges. Since then, it has been much more demanding for the high-tech entrepreneur to take their company public, unless either the company is already generating sales and profits, or the company has demonstrated credibility and potential from successful results: clinical trials, market research, patent registrations, etc.

This is quite different from the situation in the 1990s to early 2000s, when a number of companies (especially internet boomers and biotech companies) were listed on the most prominent stock exchanges around the world overall. absence of sales, revenues or any kind of well-documented promising results. Although not as common, highly speculative and financially unpredictable high-tech start-ups are still listed for the first time on a major stock exchange.

Mobilizing savings for investment: When people withdraw their savings from the bank and invest in shares, it usually leads to a rational allocation of resources as funds, which could have been spent, or deposited with banks, are mobilized and redirected to help company boards finance their organizations. This can promote business activities with benefits for several economic sectors such as agriculture, trade and industry, resulting in stronger economic growth and higher productivity levels for companies.

Facilitate acquisitions: Companies see acquisitions as an opportunity to expand product lines, expand distribution channels, hedge against volatility, increase their market share or acquire other necessary business assets. A takeover bid or mergers and acquisitions through the stock market is one of the easiest and most common ways for a company to grow by acquisition or merger.

Profit sharing: Both casual and professional stock investors, as large as institutional investors or as small as an ordinary middle-class family, share in the wealth of profitable companies through dividends and share price increases that can result in capital gains. Unprofitable and troubled companies can lead to capital losses for shareholders.

Create investment opportunities for small investors: Unlike other businesses that require huge capital expenditure, investing in shares is open to both large and small share investors, as the minimum investment amounts are minimal. Therefore, the stock exchange allows small investors to own shares in the same companies as large investors.

Raising capital for development projects: Governments at different levels may decide to borrow money to finance infrastructure projects such as sewage and water treatment plants or housing estates by selling another category of securities called bonds. These bonds can be raised on the stock exchange, with the public buying them and lending money to the government.

The issuance of such bonds may in the short term avoid direct taxation of citizens to finance development – but by securing such bonds with the full faith and credit of the government instead of with collateral, the government will eventually have to tax citizens or otherwise raise additional funds to make any regular coupon payments and repay the principal when the bonds mature.

Economic barometer: In the stock market, share prices rise and fall largely according to economic forces. Stock prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. A recession, depression or financial crisis can eventually lead to a stock market crash. Therefore, the movements of stock prices and, more generally, stock indices can be an indicator of the general trend in the economy.

How does a stock exchange differ from the stock market?

The stock exchange is a physical infrastructure – although digitally accessible – that allows buyers and sellers of shares to meet in a common place where their transactions can be settled.

The stock market, on the other hand, is an all-encompassing term that refers to the non-physical place where financial transactions of listed companies take place. Stock market transactions are carried out through an exchange or an OTC marketplace.

The two terms are often used interchangeably; however, they represent two different things. The stock market works because there are stock exchanges. Investors can track real-time price information from the exchange and then choose whether to buy or sell the shares on the market.

How are share prices set on stock exchanges?

The supply and demand for shares determines the market price. The seller of a share will present the initial value and – as in an auction – there will be bids from buyers for the shares until they settle on the price.

The initial share price is determined based on various factors, such as the company’s expected long-term earnings potential, which can attract or repel buyers. Over time, the company’s performance can increase the price, especially when there is high demand. Even news has a big impact on the price of a share.

Conversely, poor performance will have a negative effect, where investors may choose to sell their shares.

While internal events in the company can affect the share price, such as a change in management and quarterly performance, external changes in the market can also affect the value of the share. For example, political and economic events may limit or enhance the company’s potential to meet its expected returns, which may affect the share price.

Stock market participants

Exchanges can be complex and require a variety of roles to facilitate the sale of securities. Here is an overview of the main players:

– Broker: an individual or company that represents the interests of external investors on a stock exchange. Since only members of an exchange are allowed to buy and sell assets on it, brokers act as agents who find buyers and sellers to fill orders for outsiders, like you. Brokers generally charge commissions or fees for their services, and some are employed by an exchange to help keep things moving.

– Traders: A company or individual who buys and sells securities for themselves. A dealer always seeks to profit from the difference between the prices at which it can buy and sell securities. In other words, it aims to buy a stock at a certain price, not because it expects to hold it for the long term but because it believes it will be able to turn around and sell it for more than it paid. In this way, although a broker does not represent outsiders on the exchange, it may end up indirectly facilitating trades with them in its quest for profit.

– Broker-traders: The roles of broker and trader are sometimes combined in one company. They buy and sell shares on behalf of external investors, and they can also trade for their own account.

– Market makers: This role is filled by dealers who buy and sell shares for their own benefit, specifically to increase the liquidity of an exchange as a whole. This extra liquidity helps to facilitate more efficient trading and ensure orderly markets. The NYSE has a class of market makers called specialists who only trade one or a few individual stocks.

How to buy shares on a stock exchange

By opening an online brokerage account, you can start buying and selling securities listed on leading stock exchanges. If you want more personalized advice and guidance, you can choose a financial advisor as your stock broker, or you can choose a full-service brokerage firm.

Whichever model you choose, your broker will transmit buy and sell orders to broker-dealers trading on an exchange. They always try to find a buyer or seller who can meet the price you have indicated in your order, although it may take more or less time to fill your order depending on the relative levels of market liquidity.

In Sweden, shares can be traded through most major banks, but there are also companies that focus solely on share trading, such as
DEGIRO
,
Nordnet
,
Aktieinvest
and
Avanza.