What is a Stock Exchange, how does it work and how to start investing

what is stock exchange

As a new investor, you'll discover that many of your stock trades are going to be placed on one of a handful of stock exchanges. What is a stock exchange? How many major stock exchanges are there in the world? Those are great questions. Let's take a look, so you understand what is a Stock Exchange, how it works, and how to start investing.

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What Is a Stock Exchange?

First, what is a stock exchange? Put simply, a stock exchange is an institution, organization, or association which hosts a market where stocks, bonds, funds, futures, and commodities are traded. Buyers and sellers come together to trade during specific hours on business days. Stock Exchanges impose rules and regulations on the firms and brokers that are involved with them. If a particular company is traded on a stock exchange, it is referred to as "listed."

Securities that are not listed on a stock exchange are sold OTC, which stands for Over-The-Counter. Companies that have shares traded OTC are usually smaller and riskier because they do not meet the requirements to be listed on a stock exchange. Many giant blue-chip stocks, such as Berkshire Hathaway, at one time traded on the over-the-counter market before migrating to the so-called "Big Board," or New York Stock Exchange.

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What Is the Purpose of a Stock Exchange?

When a business raises capital by issuing shares, the owners of those new shares are likely going to want to sell their stake someday. Maybe they have a child going to college and need to cover the tuition bill. Perhaps they pass away, and their estate is subject to some hefty estate taxes. They may even leave it to their grandchildren, who get to enjoy the stepped-up basis loophole, but the heirs want to liquidate to buy a house. Whatever is driving their decision, they aren't likely to tie up their funds unless they know somehow, someway, at some point in the future, they'll be able to find a buyer for their holdings without too much trouble in what is known as "the secondary market."

Without a stock exchange, these owners would have to go around to friends, family members, and community members, hoping to find someone to whom they could sell their shares. (Technically, you can do this. You don't have to sell your shares on a stock exchange. You can take physical possession of your stocks in certificate form, endorse them, and sign them over to someone in exchange for payment in your lawyer's office, or at your dining room table if you are so inclined. When the stock exchange was closed during World War I, many people did just that, creating a secondary shadow market.

The downside is that there is no transparency. Nobody knows what the best price is for a given stock at any given moment in time. You could be selling your shares for $50 while the guy two towns over is getting $70.) With a stock exchange, you will never know the person on the other end of the trade. He, she, or it could be halfway around the world. It could be a retired teacher. It could be a multi-billion dollar insurance group. It could be a publicly-traded mutual fund or hedge fund.

The need for convenience is what led to the establishment of the biggest stock exchange in the world. In the United States, a group of stockbrokers met under a buttonwood tree in New York City. On May 17th, 1792, twenty-four of these stockbrokers got together outside of 68 Wall Street to sign the now-famous Buttonwood Agreement, which effectively created the New York Stock & Exchange Board. Almost three-quarters of a century later, in 1863, it was officially renamed the New York Stock Exchange. These days, most people refer to it as the NYSE.

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How the Stock Exchange Works?

Wholesale market stock exchange

The best way to compare a stock exchange with a wholesale market. Just as on the stock exchange, the actual end consumers and sellers rarely meet directly. Producers sell their goods to wholesalers, where vegetable traders procure their goods. Consumers in turn buy vegetables from traders.

The exchange itself does not trade, nor does the operator of a wholesale market have a stand there. It organizes the market, takes care of the rules, provides the infrastructure such as the trading system but also the house, takes care of the supervision, advertises the market place.

For trading itself, the exchange relies on the help of securities trading banks, the market participants in the narrower sense. In a broader sense, the term 'market participant' also includes investors, analysts, journalists, etc.. The producers on the stock exchange are the issuers of the securities, shares, and bonds are companies, derivatives are banks.

In the meantime, the transactions are predominantly carried out fully electronically. Stock exchange traders are no longer in direct contact with each other, but a computer system compares the buying and selling wishes.

Market participants: traders, investors, and companies

Players on the marketplace are investors (in our wholesale market comparison the end consumers, issuers (the producers), and the traders).

The group of traders includes the specialists on the exchange floor who, like stand operators in the wholesale market, combine the buying and selling orders and thus make the prices

In stock exchange trading, bank traders take on this task, who - like a flying vegetable seller - place orders from customers in the electronic trading system. Whether for their own account, for customers, or on behalf of issuers, in order to increase the tradability of security.

Investors and traders

End users are a very heterogeneous group. There are large institutional investors, such as municipal treasurers or insurance companies, mutual funds and asset managers. But there are also private investors with very long-term asset targets and few stocks in their portfolio, equity savers, as well as very active traders with speculative strategies.

Investors have no direct access to the trading system. At a Stock Exchange, access to the trading floor and thus to direct trading has always only been possible for participants with admission to trading. Today, there is no longer any floor trading on the spot anyway. Investors place their orders via a custodian bank or, in the case of some professional investors, via the trading desk of their institution. However, online brokers, for example, offer order placement on the Internet via order masks, which are so fast that it hardly differs from direct access to the trading system.

Companies

Just like investors, companies are not to be found on the floor. There "only" the shares of the companies are traded. Nevertheless, for many issuers, the listing on the Stock Exchange is an unforgettable highlight in the company's history. The stock exchange atmosphere at the first price-fixing in broker-supported floor trading is unique. This experience can be followed live on the Internet during an IPO on the electronic trading platform.

An IPO opens up many opportunities for companies seeking capital. As a rule, listed companies not only grow faster, they also react more stably to economic fluctuations. In general, an IPO makes sense when it comes to placing companies on a broader equity base.

Unlike debt capital, equity capital is available for an unlimited period of time and increases a company's flexibility. In the long term, it can be used for strategic projects, for example, to position the company in international competition, to consistently pursue growth strategies, to increase awareness in the market and among investors, and to promote its attractiveness as an employer.

Company succession can also be regulated through an IPO: The conversion into a stock corporation and a subsequent IPO make the enterprise value transparent and facilitate the separation of ownership and management. An IPO on the Stock Exchange keeps all these opportunities open for companies.

Whether an IPO is successful depends not only on the company itself but also on the market environment. What is the current valuation on the stock market, i.e. where are the prices? Which sectors are receiving particular attention? There are also certain fashions on the stock market. If everyone is still talking about solar energy today, nanotechnology could be the darling of the season tomorrow. How high is the investors' liquidity? The IPO industry calls this an open 'window of opportunity' for an IPO.

Corporate Governance – good behavior of listed companies

Investments require trust – in business models, products, markets, and above all in the management of a company. The major global fraud cases in the history of financial markets have made many private investors suspicious and damaged their interest in equity investments. This is one reason for the demand for clear rules of corporate etiquette. The increasingly international orientation of corporations and their investors is another factor. Globalization requires uniform rules so that companies and their markets can be better compared.

The term corporate governance, which can be translated as corporate management, describes a regulatory framework for the management and supervision of companies. It is above all a question of the legal and actual distribution of tasks between the supervisory board, management board, and owners, as well as the remuneration and incentive systems of these bodies.

With the increasing importance of sustainability criteria in investment decisions, governance is once again moving more into the focus of investors. Corporate good conduct is one of the three pillars - in addition to the environment and social responsibility - of sustainable management.

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What Are the Major Stock Exchanges in the World?

At one time, the United States had thriving regional stock exchanges that were major hubs for their particular part of the country. In San Francisco, for example, the Pacific Stock Exchange had an open outcry system where brokers would handle buy and sell orders for local investors who wanted to purchase or liquidate their ownership stakes. Most of these were shut down, purchased, absorbed, or merged following the rise of the microchip, which made electronic networks much more efficient for finding liquidity so that an investor in California could just as easily sell his or her shares to someone in Zurich.

According to Wikipedia's List of Stock-Exchanges, the 20 biggest stock exchanges in the world by market capitalization (USD bn) of listed securities are:

  • New York Stock Exchange (30,923)
  • NASDAQ (10,857)
  • Japan Exchange Group (5,679)
  • Shanghai Stock Exchange (4,026)
  • Hong Kong Stock Exchange (3,936)
  • Euronext (3,927)
  • London Stock Exchange Group (3,927)
  • Shenzhen Stock Exchange (2,504)
  • TMX Group (2,095)
  • Bombay Stock Exchange (2,056)
  • National Stock Exchange (2,030)
  • Deutsche Börse (1,864)
  • SIX Swiss Exchange (1,523)
  • Korea Exchange (1,463)
  • Nasdaq Nordic Exchanges (1,372)
  • Australian Securities Exchange (1,326)
  • Taiwan Stock Exchange (966)
  • B3 (938)
  • JSE Limited (894)
  • Bolsas y Mercados Españoles (764)

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How to Invest on a Stock Exchange 

Let's start with this basic truth: At its core, investing on a stock exchange is about laying out money today with the expectation of getting more money back in the future — which, accounting for time, adjusting for risk, and factoring in inflation, results in a satisfactory compound annual growth rate, particularly as compared to standards considered a "good" investment.

That's really it; the heart of the matter. You lay out cash or assets now, in the hope of more cash or assets returning to you tomorrow, or next year, or next decade.

Most of the time, this is best achieved through the acquisition of productive assets.

Productive assets are investments that internally throw off surplus money from some sort of activity. For example, if you buy a painting, it isn't a productive asset. One hundred years from now, you'll still only own the painting, which may or may not be worth more or less money. (You might, however, be able to convert it into a quasi-productive asset by opening a museum and charging admission to see it.) On the other hand, if you buy an apartment building, you'll not only have the building but all of the cash it produces from rent and service income over that century. Even if the building were destroyed after a decade, you still have the cash flow from ten years of operation — which you could have used to support your lifestyle, given to charity, or reinvested into other opportunities.

Each type of productive asset has its own pros and cons, unique quirks, legal traditions, tax rules, and other relevant details. Broadly speaking, investments in productive assets can be divided into a handful of major categories. Let's walk through the three most common kinds of investments: Stocks, bonds, and real estate.

Investing in Stocks

When people talk about investing in stocks, they usually mean investing in common stock, which is another way to describe business ownership or business equity. When you own equity in a business, you are entitled to a share of the profit or losses generated by that company's operating activity. On an aggregate basis, equities have historically been the most rewarding asset class for investors seeking to build wealth over time without using large amounts of leverage.

At the risk of oversimplifying, I like to think of business equity investments as coming in one of two flavors — privately held and publicly traded.

  • Investing in Privately Held Businesses: These are businesses that have no public market for their shares.
     

When started from scratch, they can be a high-risk, high-reward proposition for the entrepreneur. You come up with an idea, you establish a business, you run that business so your expenses are less than your revenues, and you grow it over time, making sure you are not only being well-compensated for your time but that your capital, too, is being fairly treated by enjoying a good return in excess of what you could earn from a passive investment. Though entrepreneurship is not easy, owning a good business can put food on your table, send your children to college, pay for your medical expenses, and allow you to retire in comfort.

  • Investing in Publicly Traded Businesses: Private businesses sometimes sell part of themselves to outside investors, in a process known as an Initial Public Offering, or IPO. When this happens, anyone can buy shares and become an owner.
     

The types of publicly traded stocks you own may differ based on a number of factors. For example, if you are the type of person that likes companies that are stable and gush cash flow for owners, you are probably going to be drawn to blue-chip stocks, and may even have an affinity for dividend investing, dividend growth investing, and value investing.

On the other hand, if you prefer a more aggressive portfolio allocation methodology, you might be drawn to investing in the stock of bad companies, because even a small increase in profitability could lead to a disproportionately large jump in the market price of the stock.

>> Start Investing in Stocks

Investing in Stock Market Indices

In addition to individual stocks, many investors are concerned with stock indices (also called indexes). Indices represent aggregated prices of a number of different stocks, and the movement of an index is the net effect of the movements of each individual component. When people talk about the stock market, they often are actually referring to one of the major indices such as the Dow Jones Industrial Average (DJIA) or the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and that it only consists of 30 stocks—when there are many thousands to choose from—it is not really a good indicator of how the stock market is doing. The S&P 500 is a market-cap-weighted index of the 500 largest companies in the U.S., and is a much more valid indicator. Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market sector. Investors can trade indices indirectly via futures markets, or via exchange-traded funds (ETFs), which trade like stocks on stock exchanges.

A market index is a popular measure of stock market performance. Most market indices are market-cap weighted—which means that the weight of each index constituent is proportional to its market capitalization—although a few like the Dow Jones Industrial Average (DJIA) are price-weighted. In addition to the DJIA, other widely watched indices in the U.S. and internationally include:

  • S&P 500
  • Nasdaq Composite
  • Russell Indices (Russell 1000, Russell 2000)
  • TSX Composite (Canada)
  • FTSE Index (UK)
  • Nikkei 225 (Japan)
  • Dax Index (Germany)
  • CAC 40 Index (France)
  • CSI 300 Index (China)
  • Sensex (India)


>> Start Investing in Stock Indices

Investing in Exchange-Traded-Funds (ETFs)

Exchange-Traded-Funds or ETFs give you a way to buy and sell a basket of assets without having to buy all the components individually. The ETF provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don’t own the underlying assets in the fund. Even so, investors in an ETF that tracks a stock index get lump dividend payments, or reinvestments, for the stocks that make up the index. (Related: Learn how to invest in index funds.)

While ETFs are designed to track the value of an underlying asset — be it a commodity like gold or a basket of stocks such as the S&P 500 — they trade at market-determined prices that usually differ from that asset. What’s more, because of things like expenses, longer-term returns for an ETF will vary from those of its underlying asset.

>> Start Investing in ETFs

Investing in Fixed-Income Securities (Bonds)

When you buy fixed-income security, you are really lending money to the bond issuer in exchange for interest income. There is a myriad of ways you can do it, from buying certificates of deposit and money markets to investing in corporate bonds, tax-free municipal bonds, and U.S. savings bonds.

As with stocks, many fixed-income securities are purchased through a brokerage account. Selecting your stockbroker will require you to choose between either a discount or a full-service model. When opening a new brokerage account, the minimum investment can vary, usually ranging from $500 to $1,000. Alternatively, you can work with a registered investment advisor or asset management company that operates on a fiduciary basis.

Investing in Real Estate

Real estate investing is nearly as old as mankind itself. There are several ways to make money investing in real estate, but it typically comes down to either developing something and selling it for a profit, or owning something and letting others use it in exchange for rent or lease payments. For a lot of investors, real estate has been a path to wealth because it more easily lends itself to using leverage. This can be bad if the investment turns out to be a poor one, but, applied to the right investment, at the right price, and on the right terms, it can allow someone without a lot of net worth to rapidly accumulate resources, controlling a far larger asset base than he or she could otherwise afford.

Something that might be confusing for new investors is that real estate can also be traded like a stock. Usually, this happens through a corporation that qualifies as a real estate investment trust or REIT. For example, you can invest in hotel REITs and collect your share of the revenue from guests checking into the hotels and resorts that make up the company's portfolio. There are many different kinds of REITs; apartment complex REITs, office building REITs, storage unit REITs, REITs that specialize in senior housing, and even parking garage REITs.

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Pros and cons of stock exchanges

Stock exchanges have a range of pros and cons for both the companies that are listed on them and for the individuals seeking to trade on them.

Pros of stock exchanges

  • For a company, being listed on a stock exchange comes with a certain level of prestige. This is particularly true for older exchanges, such as Amsterdam, London, and New York. Being listed on an exchange also means investors can buy shares in the company, which helps the company expand by raising funds.
  • By investing on a stock exchange, it is likely traders will be at less risk of counterparty default. This is due to the high levels of regulation on stock exchanges, which is something that OTC methods of trading lack.
  • Additionally, online brokerage firms have made it even easier for traders to access stock exchanges and gain the opportunity to profit from any short-term market movements.


Cons of stock exchanges

  • For a company, listing on a stock exchange can be time consuming and expensive. And once the company has listed, it will have to consider its responsibility to shareholders, who now have a stake in the company.
  • Investing on a stock exchange does not guarantee stability. The stock market is susceptible to market volatility, which means that there can be dramatic swings in the price of a stock, usually in response to political and economic events around the world.
  • Stock exchanges can also experience crashes. Although they are rare, stock market crashes can significantly reduce the value of stocks and lead to economic depressions that last for years.


Traders and investors can manage their exposure to stock market volatility by implementing a risk management strategy.

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Getting Started with $50 Welcome Bonus

Once you've settled on the asset class you want to own, your next step is to decide how you are going to own it. To better understand this point, open an investing account with virtual money (stock market simulator) and build a portfolio composed of stocks, indexes, and ETFs.

Understanding what is a Stock Exchange is important, but if you need some help MetaTrader 5 AM Broker provides access to the largest Stock Exchanges in the world through one single account accessible from any device and operating system.

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