One of the most accessible trading platforms in North America is the stock market. An estimated 58% of adults in the U.S have money in the stock market. There are three significant ways to make money in the stock market.
The first and common strategy is selling shares for a profit. The other options are short-selling and collecting dividends. However, your profitability depends on the changes in the stock prices. This article uncovers the secrets behind the stock market and explains why stock prices change.
What is the Stock Market?
To understand the stock market, you must first learn what makes a stock. Stocks are equities of a publicly traded company. When you buy stocks, you become part-owner of that company. The stock market refers to marketplaces where investors trade shares of listed companies. Usually, the stock market consists of several different stock exchanges.
The most popular stock exchanges in the U.S include the New York Stock Exchange (NYSE), Chicago Board Options Exchange, and Nasdaq. Collectively, these platforms form the stock market. Although the stock markets are most known for trading stocks, it covers other securities such as bonds and currencies.
Stock exchanges are formal institutions with regulations. In the U.S, the Securities Exchange Commission (SEC) regulates trading activities in the stock market. They ensure that investors can trade in stocks with minimal risks. They achieve this by providing transparency, fair dealings, and price discovery. Company financials are public information and give potential investors a better idea of performance. In addition, the law of supply and demand generally rules stock markets. At the end of any given day, you can tell how many shares changed hands by looking at the trade volume. The higher the value, the more popular the stock.
Supply and Demand
Stock traders rely on various indicators and complicated metrics to analyze the market. However, the real driving force behind stock prices is supply and demand. The stock market is not that complicated, and it operates like an auction. The sellers represent the supply side while the buyers are the demand.
Sellers have two options when they want to dispose of their stocks: setting an asking price and accepting bids. When dealing with asking price, the seller sets an asking price for the stock which a buyer matches, then the exchange executes the trade, and finally the stocks change hands. The second option a seller has is by accepting bids. As more potential buyers join the bid, the demand goes up then so does the price. However, if everyone is trying to sell, the market floods stocks. Sellers begin to accept lower prices to limit their losses. As a result, the stock price falls.
Companies have various mechanisms for stabilizing their stock prices. When the supply is greater than the demand, the stock prices can hit rock-bottom. To prevent this, the company buys back some of its shares at the market price. The goal is to limit supply in a process known as delisting. Conversely, excess demand requires issuing new shares to the public through IPOs or spinoffs.
What Causes Traders to Buy or Sell Stocks?
Understanding supply and demand is one thing. However, you need to know what causes the supply and demand to change in the first place. This way, you are not caught by surprise. Traders usually buy or sell their stocks based on specific information. Here are some of the factors that cause traders to buy or sell stocks.
News and Earnings
Earnings are a company’s revenue after subtracting costs. It is also referred to as profits or net income. In the U.S, the law requires publicly traded companies to publish their earnings quarterly. This information is widely available in news outlets and publications during the earning season. Most companies report their earnings based on the year calendar. Usually, the reports come out in March, June, September, and December.
However, not all companies follow the calendar year. Some have a fiscal year that starts in the middle of the year. Whatever the date, the investors follow earnings closely. The earnings are an indication of the company’s financial health. As a result, high earnings lead to increased stock prices, while low earnings negatively affect the stock prices. Earnings per share (EPS) is a more accurate metric to compare different companies.
Businesses don’t operate in a vacuum; prevailing economic conditions have an impact. A collection of these statistics is what makes up financial data. Investors use the information to predict future market conditions. Here are the major economic data investors to look at.
- Gross Domestic Product: The GDP is the value of everything produced in a country. The Department of Commerce releases this data quarterly. Typically, the GDP needs to grow above 3% to create jobs. A high GDP provides a positive outlook for the economy and boosts stock prices. A low GDP has the opposite effect.
- Unemployment: A high unemployment rate means people are looking for work but can’t find it. It is usually an indication that something is wrong. The stock prices typically take a hit when the unemployment rate is higher than expected.
- Inflation and Deflation: Inflation refers to the decrease in purchasing power of the local currency. Most investors hoard their money during inflation which reduces stock prices. However, a certain level of inflation is desirable in the stock market. Deflation is also seen as a red flag for the economy.
- Interest rates: Stock prices are directly affected by interest rates. A high interest rate makes borrowing expensive. Businesses incur an extra cost that eats into their profits. Low profitability causes the shares to plummet. The Federal Reserve uses interest cuts to boost the economy.
Analysts and economists use data provided by the company and the Federal reserve to make calculations. This information helps in predicting future stock market trends. It also allows investors to identify securities worth investing in. Professionals mostly do stock market analyses. They use data available in the financial statements to calculate competitive advantage and financial health.
Information such as price-to-earnings ratio, return on equity, and earnings per share determine the attractiveness of an asset. The analysis also looks at past stock prices and attempts to assess future costs. This type of analysis is what experts refer to as technical research. Fortunately, modern investors don’t have to rely on professional analysts. You can do all this with the help of analysis tools such as average directional index, on-balance volume, and the stochastic oscillator.
Experts divide the stock market into different industrial sectors. This designation helps investors diversify or target a specific sector. The common sectors in the stock market include energy, healthcare, financials, communications, and real estate. As a result of the interconnection, sectors often follow the same trading pattern on any given day. This phenomenon is what experts refer to as sector sympathy.
Sector sympathy trading is a strategy where an investor looks at the performance of the hot stock in the same sector. A bad earning report of one major player in an industry often affects other stocks in the same sector. For instance, if you invest in airline stock. Low earnings by Delta may mean other stocks in the airline sector will suffer the same fate.
This correlation provides an opportunity for investors to capitalize on the trend. As soon as a player releases their financials, you can expect the same from all the rest. The investor can either buy in anticipation or sell if one player in the stock has taken a hit. The key to pulling this is identifying sectors susceptible to sympathy. Airlines, retail, biotech, and cybersecurity are good places to start.
Compared to other securities, stock markets are one of the safest investments. This is because stocks are less volatile compared to other markets. However, this doesn’t mean stock prices don’t change. The only difference is that the change is more gradual. Profiting from the stock market requires the ability to predict market trends. We hope this article helps you understand how the stock market works.