How Do Stock Prices Work?
For many investors this should be an easy question to answer, right?
It is a basic bit of knowledge for stock market investors, yet you would be gob-smacked at how many private investors really do not understand the mechanics behind share price movements.
Back to basics
Let's revisit the basic principles:
Stocks, or shares of a company, represent ownership equity in the firm, which give shareholders voting rights as well as a residual claim on corporate earnings in the form of capital gains and dividends.
Stock markets are where retail, professional and institutional investors come together to buy and sell shares in a public arena. Nowadays these exchanges exist as electronic marketplaces.
Share prices are set by supply and demand in the market as buyers and sellers place orders. Order flow and bid-ask spreads are often maintained by specialists known as 'market makers' to ensure an orderly and fair market.
What is a stock?
While there are two main types of stocks, common and preferred, the term "equities" is synonymous with common shares, as their combined market value and trading volumes are many magnitudes larger than that of preferred shares.
The main difference between the two is that common shares usually carry voting rights that allow the shareholder to have a say in annual general meetings, where matters such as election to the board of directors or appointment of auditors are voted upon. Where as preferred shares generally do not have voting rights. Preferred shares are named because they have preference over the common shares in a company to receive dividends as well as assets in the event of a liquidation.
Common stock can be further classified in terms of their voting rights. While the basic idea of common shares is that they should have equal voting rights - one vote per share held - some companies have dual or multiple classes of stock with different voting rights attached to each class. In such a dual-class structure, Class A shares, for example, may have 10 votes per share, while the Class B "subordinate voting" shares may only have one vote per share. Dual or multiple class share structures are designed to enable the founders of a company to control its fortunes, strategic direction and ability to innovate.
Stock exchanges are secondary markets, where existing owners of shares can transact with potential buyers. It is critical to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis, Companies may engage in stock buy-backs or issue new shares, but these are not day-to-day operations and often occur outside of the framework of an exchange.
So when you buy a share or stock on the stock market, you are not buying it from the company, you are buying it from an existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company, you sell them to some other investor.
Hence, the stock exchange market is made up of buyers and sellers only - a very important point to note!
The advent of modern stock markets ushered in an age of regulation and professionalisation that now ensures buyers and sellers can trust that their transactions will go through at fair prices and within a reasonable period of time. Today, there are many stock exchanges in the U.S. and throughout the world, many of which are linked together electronically.