The Motley Fool

How Do Share Markets Work?

Your stockbroker buys and sells shares in the market, but how does the market work?

More specifically, how does the action of fulfilling an order take place, and does it matter to the ordinary private investor? To answer the second question first, it is important to know a little about how the market actually works, because there are one or two questions that every new investor will ponder which can’t really be otherwise answered.

So today, I’m going to look at how a traditional market works, using traditional market makers — there are new-fangled electronic trading systems around these days that carry out the functions of a market, and the largest companies in the FTSE are traded using them, but to understand those the traditional nature of the market still needs to be understood. And a number of smaller companies, notably those trading on the Alternative Investment Market (AIM), don’t rely on the same electronic systems.

Where do shares come from?

If you want to buy things like bananas or shoes, you get them from the makers or growers (via the retail chain), and they make or grow enough to satisfy demand. But when you want to buy some shares, the company itself doesn’t issue new ones for you — the number of shares in any company at any one time is pretty much fixed.

What you have to do is get the shares from an existing shareholder, and those include individual private shareholders, investment funds, other companies, company pension funds, and all manner of professional and institutional investors. And the only way to get some shares off them is to offer them enough to be willing to sell.

So you might think that your broker will go off to the market, armed with your order to but some shares, and ask around the other brokers, “Do any of you have any customers trying to sell shares in this company?”

Some trading systems do work like that, but for the most part it would be a very ineffective system, and lots of orders would simply fail because there didn’t happen to be someone available at the time wanting to take the other side of it — in fact, with quite a lot of shares, you can go hours, days, or even longer without anyone wanting to buy or sell any.

Market makers

And that’s where market makers come in (I slipped the term in earlier without defining it). A market maker is a party (usually a brokerage company, but it could be an individual) who has a contract with the stock exchange giving them the right to act as a kind of share wholesaler, keeping their own supply of shares of whichever companies they make a market in.

With that right comes an obligation, and a market maker must quote what is known as an “ask” or “offer” price, and always be ready to sell shares on demand at that price. Similarly, a market maker must quote a “bid” price, and always be willing to buy shares from you at that price. The difference between the ask and bid prices is known as the “spread”, and that represents the market maker’s profit.

The price you will usually see quoted when you look up a share on a web site is what is known as the “mid” price, and is usually somewhere between the ask and the bid (although many systems show the price of the last transaction, which will either be at the ask or the bid).

Setting the price

So it is the market makers who actually set the current share price, and they decide the level to set it at by balancing buyers and sellers. If the demand for a share increases (say because of good news just released), the market makers need to get hold of more in order to satisfy the demand, and so they will raise their prices to encourage more people to sell (and, at the same time, discourage some of the buyers). Similarly, if there is an increase in people trying to sell, the market makers will drop their prices in order to encourage more investors to buy (and to discourage some of the sellers).

If you take a look at some bid and ask prices, you’ll probably notice two things. Firstly, with large well-traded companies, you’ll see a very small spread, while with smaller companies, you’ll see a wider spread.

The other thing you might notice is that spreads are sometimes wider towards the start and end of trading than in the middle of the day. That’s because news (results, profit warnings, etc) tends to be announced after the market has closed or before it opens, and so market makers will set a wider spread to protect themselves from any resulting sudden moves.

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