Before you pick your first stocks, you need to understand the playing field. This article walks through the basics of how the stock market works - from what you are actually buying, through how the price comes about, to the differences between types of companies and instruments. These are exactly the topics that make up the first area of the Stock Analyst certification exam.
A stock is a stake in a company, not a lottery ticket
By buying a stock you acquire an ownership stake in a company. You become a co-owner: you have a share in future profits (for example through dividends), usually a vote at the general meeting, and you bear the company's business risk. Nobody guarantees you will get your money back.
That makes a stock fundamentally different from a bond. A bondholder is a creditor: they lent the company money, receive the agreed interest, and are entitled to repayment of the principal at maturity. A stock has no maturity date and its return depends purely on how the company performs. Both, however, can routinely be sold on the market before the company ceases to exist or the bond matures.
The exchange, the broker and a stock's path to market
An exchange is an organized marketplace where the orders of buyers and sellers meet. As an investor you cannot reach the exchange directly - your orders are passed on by a broker. The broker does not set prices and guarantees nothing; it is an intermediary. The securities you buy remain your property - the broker merely holds them in your client account.
Every stock trades on the exchange under a short code called a ticker - the unambiguous identifier of the security in the trading system.
A company reaches the exchange through an IPO (initial public offering) - the first public sale of its shares. There, the company itself sells the shares and the proceeds go into its business; this is called the primary market. Everything that follows - the ordinary daily trading where you buy the stock from another investor - is the secondary market. The money from your purchase there goes to the selling investor, not the company.
How the price comes about
A stock's price is not set by the company, the exchange or any authority. It emerges from the continuous clash of supply and demand: when more people want to buy than sell, the price rises, and vice versa. That is why the price moves throughout the trading day. Outside trading hours, however, there is no trading - when a company releases important news in the evening or over the weekend, the market absorbs it all at once and the stock opens the next day with a jump (a gap) above or below the previous close.
At any moment there is a highest price buyers are willing to pay (the bid) and a lowest price sellers are willing to accept (the ask). The difference between them is called the bid/ask spread. For large, heavily traded companies the spread is minimal - such stocks are called liquid: you can buy and sell them quickly and without moving the price much. A stock's liquidity describes how easy it is to trade, not the company's financial health.
You place orders in two basic ways. A market order executes immediately at the current market price - you are certain of execution, not of the price. A limit order executes only at the price you set or better - you are certain of the price, not of execution. A third common type is the stop-loss: a sell instruction that triggers once the price falls to a level you set in advance - it serves to cap a loss without you having to watch the market constantly.
How much the price swings over time is measured by volatility. High volatility means large swings, not automatically a bad company - and a calm price is no guarantee of quality either. A prolonged rise of the whole market is called a bull market, a persistent decline a bear market - commonly declared after a drop of more than 20% from the peak. The price is simply what the market pays at a given moment: in the short run it is moved by sentiment and news, but over the long run it is pulled by the company's business results - the trajectory of revenue and expected profits. What the company is actually worth is a different question - and it is exactly the one the Fair Price Index answers.
Company size and company type
A company's size on the exchange is measured by market cap (market capitalization): share price times the number of shares. A company with 100 million shares at $50 has a market cap of $5 billion. The price of a single share alone says nothing about size - a $10 stock can belong to a bigger company than a $1,000 stock.
By market cap, companies divide into large caps (big, established) and small caps (smaller, often riskier). Large, stable companies with a long history are called blue chips.
A division by their relationship to profit is useful too: dividend stocks pay out part of their profit to shareholders, while growth stocks preferentially reinvest profit into further growth - which is why they often pay no dividend at all. Neither type guarantees a higher total return. A stock's total return always consists of two components: the price change plus the dividends paid - judging the price move alone means overlooking part of the return on dividend stocks.
ETFs, indices and fractional shares
A stock index, such as the S&P 500, measures the combined performance of a selected group of stocks. You cannot invest in an index directly - it is a yardstick, not a product. But you can invest in an ETF, an exchange-traded fund that tracks the index: with a single purchase you get a share in a basket of hundreds of companies. What you gain is diversification, not a guarantee - an ETF's value falls when the market falls. Most large indices weight their members by market capitalization: the biggest companies therefore move the index the most, while a small member barely affects it. Running an ETF is not free either - its ongoing cost is expressed by the TER (total expense ratio), an annual fee deducted gradually straight from the fund's assets, typically hundredths to tenths of a percent for large index ETFs.
If the price of a single share or ETF is high, fractional shares let you invest a chosen amount - you can buy, say, a tenth of a share. That makes it possible to invest even small amounts regularly.
When buying foreign stocks or ETFs, also account for currency risk: a Czech investor's return on a dollar asset depends on the exchange rate too. If the koruna strengthens against the dollar, the return in koruna terms falls even though the stock itself made money in dollars - and conversely, a weaker koruna improves the koruna return.
Test yourself
Market basics are one of the six areas of the Stock Analyst certification exam. If you have mastered the chapters above, you are on the right track - Bulios Black members can verify their knowledge in the Bulios certification and earn a certificate right on their profile.