The Function of Stock Markets

The main function of stock markets is to provide a marketplace for the exchange of securities. From this statement we get both “market” and “exchange.”  When we speak of the stock market or stock markets, we are speaking of all markets where stocks are exchanged, whether through a certain stock exchange or not, and stock exchanges not only offer stocks but bonds as well.

There are 60 major stock exchanges around the world, where the shares of 630,000 companies are offered for sale in the public market. On top of that, there are stocks that may be bought over the counter that are not listed on exchanges, so the size of the stock market itself is very broad, with the major stock exchanges holding about $70 trillion dollars’ worth of market capitalization.

On top of this, stock exchanges also trade a lot of bonds, and the bond market is even bigger than the equity market, in the neighborhood of $100 trillion. When you add this all up, stock markets certainly do a huge amount of business, and to put this into prospective, the total GDP for the United States is about 18 trillion, so the stock market contains 4 times this amount in stored wealth, and the bond market adds up to 6 times.

Stock markets allow for the orderly and efficient trading of these securities, and also provide a regulatory framework to go along with a country’s securities regulation. If a stock is listed on a certain exchange, the NYSE for instance, they must meet certain requirements to even be listed, and continue to meet these requirements during the period that their securities are traded on the exchange.

These additional requirements do factor into the decision of companies considering going public, which means to offer their stock to the public, and aside from having a certain number of value and shares issued, and having shown a minimum profit over the last few years, stock exchanges require companies to open their books to them and keep them open, providing a level of assurance to the public that the companies have a minimum standard of governance, among other things.

Taking Your Company’s Shares to Market

Function of Stock MarketsThere are some pretty big companies that are kept private, in other words not offering shares of their company to the public, but these days almost all big companies and a lot of medium sized companies as well list their stocks on stock markets.

The most basic reason for this and the most basic function of stock markets and stock exchanges as well is to provide liquidity. With private companies, both buying and selling shares in the company is extremely difficult, and it is unusual for people to do either, as the shares are held by the private ownership of the company and they are only given out for specific purposes like when they are looking to take on investors.

Selling privately held stock is even more unusual, as there just isn’t a market for it. There could be, but the means of offering your stock for sale is to have it listed, to bring it public, and this can also allow the current stockholders to cash in their stock, converting it to cash for other purposes.

So companies list their stock in the stock market, and start out with an initial public offering or IPO, and this is the only time where the company collects the price for the stock, when they issue stock. This is called the primary market, and after the initial stock is sold, it gets exchanged between traders on exchanges, the secondary market.

A company may issue new shares from time to time and collect more money, increasing their company’s market capitalization, the total value of their outstanding shares, or they may buy some of them back, decreasing their market cap.

When their market cap increases, the value of their outstanding shares decrease, as this dilutes it. The number of outstanding shares represents the ownership of the company, with a single share designating a certain fraction, and the more shares there are, the less of a percentage a share is worth.

Conversely, when a company buys back stock, it increases the value of their outstanding shares, at least in theory, although in secondary markets the market always decides how much a company’s shares are worth, by virtue of what people are willing to pay for them at any given time.

Valuation on the secondary market is based upon the price of the last trade, which makes the assumption that the outstanding shares would all be sold for this amount in determining a company’s market capitalization and market capitalization in the aggregate as well, even though this isn’t realistic.

This is because it uses the bid price for a stock, this is usually only for a small amount, as small as 100 shares, and a company on an exchange will have millions of shares outstanding. If they all were offered for sale this would drive the price down to nothing, and the amount received overall would only be a fraction of their market capitalization.

Market capitalization therefore doesn’t measure what selling the entire amount of stock would bring if all the stock were sold, but it does measure what people are valuing shares at marginally, multiplied by the total number of shares outstanding, a calculation which is indeed useful.

Trading on The Stock Market

At any given time, there will be a certain amount of stock that is sought to be bought and a certain amount that stockholders wish to sell. The stock market simply brings these people together, and gives them a means to buy and sell this stock, through the exchange if one is using an exchange, and most stock is traded on exchanges.

If not for the stock market, you would have to put an ad in the paper or online advertising the sale of your stock, or the fact that you wanted to buy a stock, and this would be both inefficient and illiquid, and traders would be left to their own resources as far as seeking out and having these transactions processed.

Given that there are hundreds of billions of dollars’ worth of stock that changes hands every single market day, this just won’t work or even come close without a highly organized format for trading these stocks, and this is where the stock market comes in.

Stock is generally traded through intermediaries, meaning that you would place your order through a third party who would then either send the trade to the market for execution or execute it directly with other third parties, depending on the way the particular stock market that is being traded in works.

To make this all work more efficiently, intermediaries, called market makers, will hold a certain amount of a stock in the market that they trade in for the purposes of adding even more liquidity to the market. The market makers buy and sell from people and also maintain an inventory in other words. So if you’re looking to buy or sell in an actively traded issue, you will see a bid and an ask for it, and these are all based upon a certain amount of shares.

Market makers will generally only post small amounts at a given price, and beneath this price there is generally more, at different prices, and the difference between the price being bid and the asking price is called the spread. Market makers and others who make markets make a profit on trades by making the spread, which is usually only a very small amount per share, but it adds up to a lot at the end of the day.

The Role of Stock Brokers

The brokers that people place the trades through will assist throughout the process, taking your order and making sure that the trade settles, where the money actually changes hands, which doesn’t take place until a couple of business days after the trade. They may also lend to their clients, allowing them to buy on margin, which means they put up a certain percentage of their stock holdings and borrow the rest.

Trading on margin with stocks generally requires that you put up half the money, where trading certain other types of securities allow for more leverage. If your position goes the wrong way enough, you may be subject to a margin call, where your stock is sold or bought if you went short to settle the position without you losing more than you invested, which is unacceptable.

Stock brokers may also provide advice, and historically this has been an important function of stock brokerages, but this was during a time where information about stocks and the market wasn’t really readily available.

With the coming of the internet and computers, many people make buying and selling decisions themselves, even though in a lot of cases they may be merely operating on hunches or without the information or skill they need to trade anywhere near as effectively as with at least some professional guidance.

Self-directed trading has exploded in recent years though, not only with stock trading but with other forms of securities trading as well, and it does certainly make trading more accessible and convenient as well as lowering transaction costs significantly.

People can now place their own trades online, and even do so directly to the market with certain software, where one’s trades goes straight to market makers. They can also gain access to software to help them make their decisions, as well as being able to see the market in more detail than would be available just with a standard bid and ask quote, for instance being able to see the volume at the bid and ask quotes as well as volume and price data beneath that.

There is a lot of skill that may be used in trading stocks on stock markets in fact, and smaller investors have some natural advantages over the large ones, given the ease of entering and exciting markets at certain prices with smaller sizes versus larger ones.

The stock market certainly plays an essential function in the trading of stocks, as without a market none of this would even be possible. Stock markets are built for efficiency, and are constantly evolving to better meet the needs of those who are looking to use their service.

John Miller


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