How Does the Stock Market Actually Work?

1. What a stock actually is

2. What happens after you click buy

3. Market makers and price discovery

diagram

note

Market makers do three jobs

They quote prices.

They provide liquidity.

They absorb temporary order imbalance.

Why spreads exist

The spread pays for inventory risk, adverse selection, and trading costs. If a market maker buys shares from you right before bad news hits, the inventory can lose value fast.

Real-world intuition

A very liquid mega-cap stock may trade with a one-cent spread. A thinly traded stock can show a spread of 20 cents, 50 cents, or more. Wider spreads mean higher trading costs for ordinary investors.

illustration

equation

$$\text{Mid price} = \frac{\text{Best bid} + \text{Best ask}}{2}$$

note

The mid price is not always the trade price

The midpoint is a reference point. Your actual fill depends on the order you send and the liquidity available when it reaches the market.

4. Why stock prices move

5. How most people should invest

Transcript

Welcome to Slate. Today we're looking at How Does the Stock Market Actually Work?. We'll cover How stock exchanges match buyers and sellers, Market makers, bid-ask spreads, and price discovery, Why stock prices move: earnings, sentiment, and momentum, and Index funds, ETFs, and how most people should invest. Let's get into it.

A stock is a tiny ownership claim on a company. If a company has 1 billion shares and you own 1 share, you own one-billionth of the company. That claim usually comes with voting rights and a share of any future profits, if the board pays dividends. Here’s the key idea: the stock market is not the company’s cash register. When you buy shares on the New York Stock Exchange or Nasdaq, the company usually does not get your money. You are buying from another investor, through an exchange. Think of it like a giant used-book market. The publisher is the company. The book changes hands many times after the first sale, but the publisher is not in the middle of each trade. The first sale is different. That is an initial public offering, or I-P-O. In 2021, U.S. companies raised about 142 billion dollars in I-P-Os, according to S&P Global, because new shares were sold to the public. After that, most trading is in the secondary market. That secondary market matters because it sets the price everyone watches. A company’s stock price is not a direct measure of its current size. It is the market’s estimate of what one share is worth right now, based on future profits, interest rates, and risk. A stock trading at 20 dollars is not automatically cheap, and one at 500 dollars is not automatically expensive. You have to look at the number of shares and the company’s earnings, which is why market value equals share price times shares outstanding.

When you click buy, your broker does not usually shout into a trading pit. It sends an electronic order to a venue, often through a market center that can route the order to an exchange or to a wholesaler. The order includes the symbol, the number of shares, and the order type. A market order says, fill me now at the best available price. A limit order says, fill me only at this price or better. The order book is the queue of standing buy and sell orders. On one side are bids, which are prices buyers are willing to pay. On the other side are asks, which are prices sellers are willing to accept. The difference is the bid-ask spread. If the best bid is 99.98 dollars and the best ask is 100.00 dollars, the spread is 2 cents. That spread is the market’s friction. It compensates the people willing to provide liquidity. Here is the important part. A market order crosses the spread. If you buy 100 shares with a market order, you may get filled at several prices if the available shares at the best ask are not enough. That is called slippage. In a liquid stock like Apple, the spread is often just one cent during regular trading hours. In a thinly traded small-cap stock, the spread can be much wider. The whole process can take milliseconds. On the New York Stock Exchange, trades are electronic and extremely fast. Human floor brokers still exist, but the matching is mostly automated.

A market maker stands ready to buy and sell, even when other traders are stepping back. That is why the market keeps functioning when urgency shows up. Think of a market maker like a bookstore owner who is always willing to buy used copies and sell them again. The owner earns the spread, but takes the risk that prices move before the books can be resold. In U.S. equities, market makers and other liquidity providers quote bids and asks all day. They help create price discovery, which is the process of turning scattered opinions into one live price. The price is not chosen by a committee. It emerges from competition among orders. If buyers become more aggressive, bids rise. If sellers rush in, asks fall. A simple way to see this is through a supply-and-demand curve. When more people want to buy now, the price climbs until enough sellers appear. When bad news hits, sellers may accept lower prices to get out first. That does not mean the market is irrational. It means the market is incorporating new information. Algorithms now dominate much of this process. A 2023 report from the Securities and Exchange Commission noted that U.S. equity markets are heavily electronic, with high-speed routing and automated execution. Human judgment still matters, but the machine layer is what makes modern price discovery so fast. Market makers do not set fair value by themselves. They help the market keep moving so fair value can be found.

Stock prices move because people update their expectations. Earnings are the cleanest reason. If a company reports revenue of 10 billion dollars when analysts expected 9.4 billion, the stock can jump because future cash flow looks stronger. But the market does not react only to the headline number. It reacts to guidance, margins, and whether the company sounds confident about the next quarter. Rates matter too. When interest rates rise, future profits are worth less in today’s dollars. That is why growth stocks often get hit harder when Treasury yields rise. The math behind that is discounting, and it is one reason the same earnings stream can justify very different prices in different rate environments. Sentiment matters because humans are social. If investors expect a stock to rise, they buy early, and the buying itself pushes the price up. That can create momentum, where winners keep winning for a while. Academic research has documented momentum in stock returns, including a famous 1993 paper by Narasimhan Jegadeesh and Sheridan Titman. News, index rebalancing, and passive fund flows also move prices. When a company is added to the S&P 500, demand from index funds can lift the stock because those funds must buy it. In 2020, Tesla joined the S&P 500 and its share price moved sharply around the inclusion date, partly because passive funds had to rebalance. The daily price is a short story. The long-term value is the company’s ability to generate cash.

For most people, the point is not to outsmart the tape. It is to own broad market growth at low cost. That is why index funds and exchange-traded funds, or E-T-Fs, are so powerful. An index fund tries to match a market index like the S&P 500. An E-T-F is a fund that trades on an exchange like a stock, so you can buy or sell it during the day. The big advantage is diversification. If you buy one company, one bad earnings report can hurt you badly. If you own 500 large U.S. companies through an S&P 500 fund, one company matters much less. The second advantage is cost. Many broad index funds charge expense ratios below 0.10 percent per year. Vanguard’s S&P 500 index fund, for example, has long been known for very low costs. Here is the practical lesson. For a long-term investor, the exact millisecond of execution matters less than the habit of buying consistently. A limit order can help in thinly traded stocks, but for highly liquid E-T-Fs and large-cap stocks, the spread is usually tiny. What matters more is staying invested, keeping fees low, and not turning every headline into a trade. If you want one sentence to remember, it is this: the stock market is a matching engine for human expectations, and index funds let you own that engine instead of trying to predict every move it makes.