How the Stock Market Works

Yeah, this really isn't a good article.

I think the writer has confused themselves while attempting to simplify some of these concepts. Instead they should have accepted the financial market is complicated and cannot be condensed into a single blog post.

For anyone who is really looking to understand how the stock market works, I would recommend picking up a copy of "Trading and Exchanges: Market Microstructure for Practitioners" by Larry Harris.

Bond market is off too - bond writers don't set the rate, they just describe the payment schedule and auction it off. Market determines a price, which implicitly sets the rate.

It seems like an earnest effort by the author. I'd encourage them to find a pro to run this piece by as a further learning experience. When you stop getting edits, you are ready to teach a simplified version to others!

The very first line:

> This is Part 1 of a series. I am not claiming to be an expert by any means, this is just an effort for me to internalize things I’ve learnt.

Derivatives is a difficult to asses market, in terms of size. For example, the largest derivatives markets out there - interest rate swaps - trade contracts that usually have ~zero net value at the beginning of their lives, when the sides open the contract. Derivatives typically start small and sometimes end up huge.

The investable universe looks something like that:

https://imgur.com/a/68U3LsZ

I think the writer was trying to write something cute and smart there with that connection, if only it was actually correct.

Yeah, I don't think it is true - as a secondary function, shares can occasionally give dividends.

No, it’s idiotic. Companies in in aggregate enjoy earnings growth. Ergo why what you buy today is worth more tomorrow.

Even for options it doesn't have to be zero sum.

E.g. you could give someone insurance on their stock position if you can take the risk. This allows them to participate in the game so you both benefit.

Another is that you might be able to lend more cheaply than the other can loan but they want to leverage up their portfolio. With options you can effectively make a cheaper loan to them to purchase a specific product. They lend more cheaply, you make part of the spread.

It’s not true in absolute terms: for example during a bubble or an upward trend everyone wins. However, if you only consider excess returns (return - some average return), or look at certain derivatives then there are situations where some winning positions require equivalent losing positions.

The economy is not a zero-sum game and that's something I wish more people understood. Real GDP per capita grows. The average US citizen has access to more intrinsic values that aristocrats had just a few centuries ago.

However, he may be talking about pure trading, a.k.a speculation, which is very close to a zero-sum game. If you are not in for the dividends, yes, that's close to a casino where the banks who charge for transactions are the inevitable winners.

I wish we followed Warren Buffet's advice and forbid to sell a stock less than 6 month after buying it. I also don't see any interest in making the stock prices change every nano second. A quote a day can be enough if you are an investor, not a speculator.

all the people who labor and can't afford stock lose to inflation in this paradigm

There is a zero-sum game in the some sense if you focus on potential buyers. If you buy out all the onions in a grocery store (and continue to do so once they restock), eventually the grocery store is going to start raising onion prices. Thus anyone purchasing onions after you will suffer a slightly higher price. In theory, the long term price of a stock should be the sum of its discounted future cash flows. If you bid up a stock through purchases, anyone who wanted to purchase the stock after you (assuming your decision to purchase did not affect their decision) will suffer a slightly higher purchase price, most likely leading to reduced future gains. Liquidity is gained for any sellers.

No, it is not true. It is not true for options either. The zero-sum trading game fallacy is a common misperception.

For any kind of asset, the ability to transfer it has value. When someone needs to buy a new car, they often sell their old car to a dealer at a price that is lower than what they could get if they sold it to another individual. They do it because it is more convenient and/or they can't wait around for the right buyer to come along. A dealer has a better idea of the car's value and is willing to put it into inventory until someone buys it at a higher price. He takes a risk he might have to wait longer than expected to sell it again (which incurs more inventory cost), but he trades a lot of cars, so on average, his relative risk is lower than yours would be. He essentially charges you a fair price for this service. Even though technically you might say you lost on the deal, both sides are winners if the price was reasonable.

In a similar way, a stock trade can be a win-win situation. One trader may be willing to do the transaction at a discount because they have a better way to use the money or because they need to reduce their risk. Another trader may know more about the stock and/or have a different risk profile, so he is willing to take the risk of holding the asset until a profitable transaction is possible. This provides a win-win for both sides if the charge for the service is reasonable.

Of course, there are traders who are detrimental to a market and provide no value, just as there are crooked car dealers. That doesn't invalidate the value of good trading just as it doesn't invalidate the value of good car dealing.

This is definitely not true. In a zero-sum game, every bit of profit one person makes comes from the pocket of the counterparty. A stock option is a zero-sum proposition: at the expiration of the option, one party ends up “in the money”, the other party is “out of the money” by the same amount.

Stocks are not a zero-sum game. They have sustained value, so when I sell you a share of stock, you get the share, and I get money equal to the value of the stock.

One might argue that day trading is roughly a zero-sum game, if we make the simplifying but inaccurate assumption that the values of stocks don’t change across a trading session, and assuming that everyone goes home each night with all positions closed out.

If the stock market appreciates 7% per year on average, then it appreciates by 0.02% per day and you're effectively making $0.20 per $1000 per day with massive volatility. $0.20 is so miniscule, it's not even large enough for a restaurant tip. It's not that uncommon to see large swings in either direction; The market went -4.85% just this week. The stock market is not a zero sum game over the long term (10+ years), but on a day-to-day basis, the market is effectively a zero sum game. If you manage to make more than the market's return, it's because some poor guy or gall out there made less than the market's return.

Fun fact: over 60% of the trade volume on the stock markets comes from bots. If you have enough of a superiority illusion to think your daytrading game these days can outplay the MIT PH.D Quant traders that wrote HFT bots for hedge funds, then you're in for a surprise.

I don't have the exact Peter Lynch quote but he said something to the effect that any period of less than two years in the stock market and you're basically entering a casino. Any period of greater than 2 years and you're investing.

Some other investor said that you should give a company enough time to use and generate a return from the money it received from selling it's stock before you fundamentally expect to see the returns.

You are partially right. What you miss is that there are the so called market makers - exchanges that ensure liquidity. They buy from you and sell to you while managing order books. These are simply trades records that have a key role in determining the price pressures for it go up or down.

In the US, the government makes sure the answer to that question is “yes”.

Regulation NMS

"Market makers" ensure that at any time, there are standing orders to buy/sell that are close to the current market price (the difference is called the spread). If you buy/sell at market price, you are taking an existing offer at their price.

You could also do what they do. Instead of buying immediately at market price, you could enter a lower price and create a standing order to buy at that price. However, if the price goes up, you might miss out on buying the stock at all.

Similarly for selling. You can enter a higher price, but it won't sell if the market price doesn't go up.

Conceptually this isn't so different from what a grocery store does. They offer something for sale and wait for a buyer willing to pay that price. However, margins are much lower and prices change much quicker for stocks.

(Note: I'm not recommending messing with any of this.)

The market price is (basically) the highest price that someone else is bidding to buy at, so your offer to sell at that price guarantees there is a buyer because the buyer's bid for stock at that price is already there when you place your offer to sell.

It can get a little more complicated than that though -- you might be trying to sell 1000 shares and the highest bid might only be for a quantity of 500 so the "market" price for your first 500 shares will be different than the next 500 (unless there are other bids at that same price, which there often are but there's no guarantee on the volume you'll be able to sell at that price).

And that's why they call it a stock exchange... it's just a bunch of people (and companies) making bids and offers to "exchange" stocks at difference prices. When a buyer and a sell agree on a price, you have a transaction (trade). Your offer to sell at market price is just an agreement between you and someone else willing to buy at that price.

There is pretty much always someone willing to buy or sell a stock at some price. The best way to think of the exchanges are as a perpetual auction. There is a line of buyers willing to buy shares at all different prices, and similarly there is a line of sellers willing to sell at various prices. Anyone can 'join the line' by entering a limit order at some price.

Buying at market price simply means you immediately buy from the seller offering the lowest price.

It's very rare for an order book to be empty for a particular stock, but you typically do see the bid/ask spread increase as a stock loses popularity.

Mortgages have the advantage that you can't get margin called at an inopportune moment.

And it's also worth remembering that the stock market has increased in value (inflation adjusted) for decades. So whilst yes, it's true there are winners and losers, most of the time the winners outnumber the losers.

I think you mean, a personal channel by a former McKinsey consultant.

Depends. You can invest low risk (yielding say only 5% yearly profit). If a big company which is supposedly stable falls (such as Morgan Stanley) you may get lose a little but since you spread enough not so much.

You get income than the interest from your bank this way. While in EU you get guaranteed 100.000 EUR when a bank collapses, but if shit really hits the fan (crisis, many companies collapsing, EUR or USD losing a lot of value) you are toasted regardless.

Except I think the only way to make any serious money in the market is to bet against it when things are over/under valued, and of course.. be right.

What does that mean... don't try to buy individual stocks, just buy the index?

It's less about being "smarter," it's really about identifying your advantage and understanding whether you can exploit it. This could be something as obvious as an information advantage (insider trading) to simply having more time/patience. If you can buy and hold for decades, you can wait out the bumps, the people who are forced to sell, and for more money to enter the market.