How the Stock Market Works: Shares, Exchanges, Crashes and Booms

What a Stock Market Actually Is

A stock market, also called an equity market or share market, is not a single building. It is the whole network of buyers and sellers who trade stocks, also known as shares. A share is a small slice of ownership in a company. If a company is divided into one million shares and you own one thousand of them, you own one tenth of one percent of that business, including a matching claim on its profits and assets.

Most shares people hear about are traded on public stock exchanges, such as the New York Stock Exchange or the London Stock Exchange. But the stock market in the broad sense also includes shares that change hands privately, for example shares of young private companies sold to investors through equity crowdfunding platforms. What unites all of these is the same basic idea: ownership of a business can be split into units, and those units can be bought and sold.

Why companies sell shares

A company that wants to grow needs money to build factories, hire staff, or develop new products. It can borrow that money, which means paying it back with interest, or it can sell part of itself to investors. Selling shares brings in money that never has to be repaid. In exchange, the new owners get a say in how the company is run, usually through voting at shareholder meetings, and a share in its future success.

Why people buy shares

Shareholders can benefit in two main ways. First, some companies pay out part of their profits as dividends, regular cash payments to every shareholder. Second, if the company becomes more valuable, the price of its shares may rise, and an owner who sells for more than they paid makes a capital gain. Both rewards are uncertain: dividends can be cut, and share prices can fall as well as rise.

From Coffee Houses to Computers: A Short History

People traded debts, goods and shares of ventures long before modern exchanges existed. Merchants in medieval Italian city-states and in Flanders met regularly to deal in bills and commodities, and the Belgian city of Antwerp opened a purpose-built exchange building in the sixteenth century.

The Dutch East India Company

The story of the modern stock market usually begins in Amsterdam. In 1602 the Dutch East India Company, known by its Dutch initials VOC, was founded to run trade with Asia. It sold shares to the public, and those shares could be resold to other people. Trading in VOC shares made Amsterdam the home of what is often described as the first modern stock market. Many tools still used today, such as buying shares on credit and betting on falling prices, were already being practiced there in the seventeenth century.

London and New York

In London, stockbrokers were not welcome in the formal Royal Exchange, partly because of their rough manners, so they gathered in coffee houses instead. One of them, Jonathan's Coffee House, became a regular meeting place for traders, and this informal market eventually grew into the London Stock Exchange.

Across the Atlantic, in 1792, a group of 24 brokers signed the Buttonwood Agreement, named after a buttonwood (sycamore) tree on Wall Street in New York under which they are said to have met. The agreement set common rules for trading and is regarded as the origin of the New York Stock Exchange.

Ticker tape to electronic trading

For a long time, prices were shouted across crowded trading floors in a system called open outcry. From the late 1860s, the stock ticker, a machine that printed prices on a long paper strip, carried trades to offices far away. That is why the short codes used for companies, such as AAPL for Apple, are still called ticker symbols. In 1971 Nasdaq opened as the world's first electronic stock market, and today almost all trading around the world is done by computers matching orders in fractions of a second.

How Prices Are Set

A share price is not decided by the company or the government. It is set by supply and demand: the price at which the most recent buyer and seller agreed to trade.

Bids, asks and orders

At any moment, some people want to buy a share and state the highest price they will pay, called the bid. Others want to sell and state the lowest price they will accept, called the ask. The exchange keeps all these offers in an order book. When a bid and an ask meet, a trade happens. A market order says "buy or sell right now at the best available price", while a limit order says "only trade at this price or better".

What moves prices

Prices change when people's expectations change. News that a company earned more than expected, launched a popular product, or won a big contract can make more people want to buy. A scandal, a failed product, or worries about the wider economy can make more people want to sell. Because investors are trying to guess the future, prices often react to what people think will happen rather than to what has already happened.

Primary and secondary markets

When a company sells new shares to the public for the first time, this is called an initial public offering, or IPO, and it takes place in the primary market. The money goes to the company. After that, investors trade those shares with each other in the secondary market. Most daily trading is secondary: when one investor buys a share from another, the company itself receives nothing from that trade, although a healthy share price still makes it easier for the company to raise money in the future.

Measuring the Market: Indices and Big Numbers

With thousands of companies trading at once, people use stock market indices to see the big picture. An index tracks the prices of a chosen group of shares and combines them into a single number.

• The Dow Jones Industrial Average, first published in 1896 by journalist Charles Dow, is one of the oldest. It started with 12 companies and today follows 30 large American firms.
• The S&P 500 follows about 500 of the largest companies listed in the United States and is widely used as a measure of the American market as a whole.
• Other well-known indices include the FTSE 100 in London, the Nikkei 225 in Tokyo and the DAX in Frankfurt.

The value of a company on the market is called its market capitalization. It is calculated simply: the share price multiplied by the number of shares that exist. A company with 100 million shares priced at 50 dollars each has a market capitalization of 5 billion dollars. The New York Stock Exchange and Nasdaq, both in New York, are the two largest exchanges in the world by the total value of the companies listed on them.

Bulls and bears

A long period of rising prices is called a bull market, and a long period of falling prices is a bear market. A common way to remember this is that a bull attacks by thrusting its horns upward, while a bear swipes its paws downward. Statues of bulls stand outside several exchanges, and the bronze Charging Bull near Wall Street has become a famous tourist sight.

Booms, Bubbles and Crashes

Because prices depend on human expectations, markets sometimes swing to extremes. When excitement drives prices far above what companies can realistically earn, people speak of a bubble. When the bubble bursts, prices can fall very quickly.

Famous crashes

• The South Sea Bubble (1720): shares of Britain's South Sea Company soared on promises of trade riches and then collapsed, ruining many investors.
• The Wall Street Crash of 1929: after years of rapid gains, often bought with borrowed money, American share prices collapsed in October 1929. The crash was followed by the Great Depression, the most severe economic downturn of the twentieth century.
• Black Monday (1987): on 19 October 1987 the Dow Jones Industrial Average fell by more than 22 percent in a single day, still the largest one-day percentage drop in its history.
• The dot-com bubble (around 2000): prices of many internet companies rose enormously in the late 1990s, then fell sharply when it became clear that many of these businesses were not making money.
• The 2008 financial crisis: problems with risky home loans in the United States spread through banks worldwide, and stock markets fell steeply.

Lessons learned

Each crisis led to new rules. After 1929, the United States created the Securities and Exchange Commission in 1934 to supervise markets and require companies to publish honest information. After 1987, exchanges introduced circuit breakers, automatic pauses in trading when prices fall too fast, giving people time to calm down. History also shows that markets have recovered from past crashes, though recovery has sometimes taken many years.

Rules That Keep the Market Fair

A stock market only works if people trust it. For that reason, most countries have a regulator that watches over trading. Companies listed on an exchange must publish regular financial reports so that every investor can see the same basic facts.

One of the most important rules bans insider trading: buying or selling shares using important secret information that the public does not have, such as knowing about a takeover before it is announced. Spreading false rumours to push prices up or down, known as market manipulation, is also illegal. These rules exist because a market where a few people secretly know more than everyone else would quickly lose the trust of ordinary investors.

Why the Stock Market Matters to Everyone

Even people who never buy a single share are connected to the stock market. Many pension funds, which pay people an income after they retire, invest part of their money in shares. Universities, charities and insurance companies often do the same. When share prices rise or fall, the value of these savings changes too.

The market also helps the economy decide where money should go. Companies with promising ideas can raise funds to grow, which can create jobs and new products. At the same time, the stock market is not the same thing as the economy: share prices can rise while many people are struggling, or fall while businesses are still working normally, because prices reflect expectations about the future.

Risk and diversification

Every share carries risk. A company can fail, and its shares can become worthless. One idea that economists stress is diversification: spreading money across many different companies and industries so that the failure of one does not ruin everything. This idea led to index funds, which simply buy all the shares in an index. In 1976 John Bogle's company Vanguard launched one of the first index funds open to ordinary investors, and such funds have since become very popular. Diversification reduces risk but never removes it.

Surprising Facts About Stock Markets

• The word bourse, used for exchanges in many European languages, is often traced to the Van der Beurze family, whose inn in the Flemish city of Bruges was a meeting place for merchants in the late Middle Ages.
• Shares were once printed as decorated paper certificates. Today almost all shares exist only as electronic records, and old certificates have become collectors' items.
• Modern trading computers can send and cancel orders in millionths of a second. Some firms place their computers physically close to an exchange's servers just to save tiny fractions of time.
• Many exchanges open and close each day with a ceremony, such as the ringing of the opening and closing bell at the New York Stock Exchange.
• Some countries also have small exchanges for young, growing companies, with lighter rules than the main markets.

The stock market began as merchants meeting in inns and coffee houses and has become a global system linking millions of people. Understanding how it works, from how a single share is priced to why whole markets sometimes crash, helps explain many headlines about the economy. This article is for learning only and is not advice on buying or selling any investment.