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How does the stock market work?

December 3rd, 2008 by jamie | Filed under Daily News, Stocks and shares.

Despite all the fancy paraphernalia that surrounds a modern-day stock market, it is based on a very simple principle: it allows the buying and selling of mainly company stocks and shares.

It’s a market place, albeit a quite complicated market place, with plenty of rules, regulations and specialist players.

But, it all comes down to the trade of publically quoted companies, or trusts, which have their shares listed on the stock exchange and are quoted at a price which represents their perceived value. 

The largest stock exchanges are found in London (the Footsie), New York (the Dow Jones) and Tokyo (the Nikkei)

Each lists a large number of national and overseas companies in a number of indices, the main one of which is used to show the market’s performance.

When you hear that the Footsie is down say 100 points, it refers to that day’s performance of the London Stock Exchange’s Financial Times top 100 companies index. In other words, it calculates, while the market is open, a minute-to-minute value of the combined 100 top U.K. companies (the blue-chips) market worth (known as their market capitalisation).

So if British Telecom, one of the U.K.’s largest companies, gains a few pence on it’s share price, it’s gain along with other gains, or other losses of the other 99 blue-chips, are added together every day and this movement is calculated on a points basis, leading to the expression that today the Footsie closed up 99 points, or maybe down 50 points. And those points represent a monetary value after a complex series of calculations.

On the London Stock Exchange (LSE) there are over 3,000 individual stocks and shares traded, and mostly are companies, or equities, although there are a number of other tradable entities. The LSE organise the stocks and shares of its Main Market into a number of groupings, each with its own performance rated index. Therefore, as well as the FTSE 100, there are the FTSE 250 (top 250 stocks), the FTSE 350 (top 350 stocks) and the FTSE Small Cap (some of the Main Markets smallest stocks). And as well as the Main Market, there is a junior market as well, known as AiM, and on which is listed generally smaller companies (although not necessary as a requirement) which are slightly less restricted in their ownership and trading rules.

A company qualifies to join a stock exchange by having at least a set percentage of its shares in public ownership (i.e. not in the hands of one, or a small number of shareholders). Thus, for a company share to be listed on a stock exchange, there has to be a degree of liquidity, in other words, there have to be enough shares in enough hands to create a theoretical market.

Prior to its entry to being listed on a stock exchange and its shares eligible for trading, a company will have to organise something similar to what is known in most markets as a flotation, in which financial institutions and private shareholders are offered shares in the new stock exchange company coming to the market. There are various mechanisms and methods, including certain flotations which only allow recognised financial institutions to take part and excludes, at the start, private investors.

Shares are bought and sold by market-makers, owned by the firms of stock-brokers. Since the Big-Bang revolution in the City in the mid 1980s, market trading is computer screen based and not on a physical stock exchange floor.

Market-makers do as their title suggests; they make markets in particular stocks and create trading spreads. You buy at one price and sell at another. The difference between the two is the spread and a wide spread usually suggests a rarely traded stock, whereas a tight spread suggests an active stock.

Firms of stock brokers are there to advise both institutional and private clients on what shares they should buy, when, and if they should hold onto them, or sell them.

A stock exchange is usually an extremely complex financial mechanism with a whole host of supportive firms and people. For many countries, it reflects their wealth, well-being and status.

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