How the stock market works

Chapters of the article

• What is a share
• Types of shares
• What is the stock market
• Share price development
• What does a stock fall mean
• How to buy and sell stocks
• What to look out for when choosing a broker

What is a share

A share means an ownership interest in a company. When you own shares in a company, you are a shareholder and are entitled to a share of the company’s assets and profits. In many cases, shareholders also have the right to vote at company meetings. The number of votes you have is usually based on the number of shares you hold. This right gives you influence over the composition of the board of directors and the direction of the company. Some companies also distribute part of their profits to shareholders in the form of dividends. The amount of dividends you receive is proportional to the number of shares you own. Dividends are usually paid at regular intervals, usually once a year.

Types of shares

There are several types of shares, each with its own set of characteristics and rights, but the most common types are common and preferred shares.

Ordinary shares

Ordinary shares are the most typical type of share. Holders of common stock have voting rights, which means they can vote on important corporate matters such as the election of the board of directors and major business decisions (such as acquisitions or major transactions). Shareholders are also entitled to a share of the company’s profits, usually in the form of dividends. In the event of a company’s liquidation or bankruptcy, shareholders have a claim on the company’s assets after all debts and liabilities have been paid.

Priority shares

Preferred stock is a type of stock that has certain rights in preference to common stock. Preferred shareholders usually have a fixed dividend rate, which means they receive dividends at a set rate before any dividends are paid to common shareholders. In the event of liquidation or bankruptcy of the company, preferred shareholders have a greater claim on the company’s assets than common shareholders.

What is the stock market

The stock market is a financial market where buyers and sellers trade ownership stakes in companies (shares). The stock market is an important part of the global financial system and performs several important functions:

• Capital allocation: It helps companies raise capital by selling shares to the public through initial public offerings (IPOs) or follow-on offerings. This capital can be used for a variety of purposes such as expansion, research and development or debt reduction.
• Investing: Investors, including individuals, institutional investors and various funds, buy and sell shares as a means of investing their money. Shares represent ownership in a company and investors hope to benefit from the company’s success through share price appreciation and dividends.
• Liquidity: The stock market provides liquidity and allows investors to buy and sell shares easily. This liquidity is crucial for investors who need to convert their investments into cash when needed.
• Price discovery: Share prices are determined by the dynamics of supply and demand in the market. The stock market acts as a price discovery platform that reflects investors’ perceptions of a company’s value and future prospects.
• Risk management: investors use the stock market to manage their investment portfolios, diversifying across different stocks and sectors to spread risk.
• Economic indicator: stock market performance is considered a reliable economic indicator. A rising market is considered a sign of confidence in the economy, while a falling market indicates economic concerns. In today’s world, however, it is more relative.

There are various stock exchanges around the world, the most famous of which are the New York Stock Exchange (NYSE) and Nasdaq in the United States, the London Stock Exchange (LSE) in the United Kingdom and the Tokyo Stock Exchange in Japan. In the Czech Republic, the most important is the Prague Stock Exchange.

Share price development

The rise or fall of a stock is influenced by many factors and can occur for a variety of reasons. It is important to understand that stock market movements are inherently volatile and subject to a wide range of influences:

• Economic conditions: economic indicators such as GDP growth, employment rates, inflation and consumer sentiment have a significant impact on stock markets. Positive economic changes lead to growth, while negative changes cause declines.
• Corporate profits: the financial performance of companies is a major driver of stock prices. When companies do well, it leads to an increase in stock prices, while failure causes a decline.
• Interest Rates: Central bank monetary policy (and in particular changes in interest rates) influence the direction of stock markets. Lower interest rates encourage investment in equities because fixed income investments are less attractive in comparison.
• Geopolitical events: political instability, trade tensions, conflicts and other geopolitical events cause overall uncertainty and can therefore affect equity markets. Improvements in relations between countries may strengthen the stock market, while the emergence or escalation of problems between countries may lead to a decline.
• Market Sentiment: Investor sentiment and psychology also play a key role in market movements. Fear and greed can drive investors to buy or sell stocks, leading to fluctuations.
• Company-specific news: News about specific companies, such as product launches, mergers and acquisitions, legal issues or management changes, can significantly affect their stock prices and thus affect the entire stock market.
• External shocks: Unexpected events such as natural disasters, terrorist attacks or health crises (e.g. the COVID-19 pandemic) have sudden and significant impacts on stock markets.
• Market speculation: Speculative trading, driven by rumours or short-term trends, can lead to rapid price movements. However, this is usually only a temporary situation and does not last long.
• Government Policy: Fiscal and monetary policy, including tax changes, government spending and regulatory decisions, affect the overall economy and, in turn, the stock market.

In addition, it should be remembered that stock markets are forward looking. That is, they respond to expectations about the future, not just to current conditions. As a result, market movements can sometimes seem disconnected from immediate economic or corporate realities.

What does a stock crash mean

This is a situation where the price of a particular stock or the entire stock market experiences a significant decline in value over a relatively short period of time. Stock declines can be triggered by a number of factors, such as geopolitical changes, the bursting of a financial bubble or the spread of negative news about a particular company. Sometimes a single event or news item can lead to a sharp decline in a stock’s price. Yet we have seen stock price crashes several times before.

The most famous example is the New York Stock Exchange crash of 1929, which marked the beginning of the Great Depression. The crash was triggered by a combination of factors, including excessive speculation in the stock market, unsustainable levels of margin trading and economic fears.

A more recent example is the Great Recession of 2008. This was triggered by the collapse of the US mortgage market, which was fuelled by the issuance of mortgage-backed securities. When house prices started to fall and borrowers stopped paying their mortgages, a domino effect occurred, leading to massive losses in the banking and financial sector. Large financial institutions faced insolvency or were on the verge of collapse and the contagion quickly spread to global financial markets.

How to buy and sell shares

We have already discussedhow to start investing in stocks from a more theoretical point of view in our earlier article, so here we will look at how to do it from a practical point of view.

To buy shares, you will need a broker or stockbroker who offers access to the Czech stock market or international exchanges. You can choose between:

• Online brokers: you can open an online account with a reputable international brokerage firm that offers access to both Czech and international stock exchanges. Popular international brokerage platforms include Interactive Brokers, eToro, Saxo Bank and DEGIRO.
• There are also several localbrokerage firms in the Czech Republic that provide access to both Czech and international markets. These firms often offer personalized service and support to local investors. These include Patria Finance, J&T Banka and Česká spořitelna.
• Some large banks, such as the aforementioned Česká spořitelna or Komerční banka, offer brokerageservices to their clients.
• Online trading platforms: Some financial institutions and online trading platforms offer easy access to the stock market. But make sure you choose a platform that provides access to the stocks you want to invest in.

When choosing where to buy stocks, consider factors such as fees, range of available investments, ease of use of the platform, research tools and customer support. It is also essential to do your research and have a clear investment strategy before buying stocks.

What to look out for when choosing a broker

Choosing the best broker for your needs involves weighing various factors to ensure that it aligns with your financial goals, trading style and preferences. Here is a detailed guide on how to choose the best broker for you:

1. Define your goals and needs

• Define your investment goals. Do you want to invest for retirement, do you want short-term gains, or something else?
• Consider your risk tolerance. To what extent are you willing to expose your money to market fluctuations and potential losses?

2. Safety

• Make sure the broker is registered as a securities dealer or investment intermediary with the Czech National Bank.
• Check whether the broker offers investor insurance or other protection schemes.

3. Fees and commissions

• Compare the fees and commissions charged by different brokers. Look for cheap options, especially if you plan to make frequent trades.
• Consider account maintenance fees, inactivity fees and other hidden fees.

4. Available assets and markets

• Make sure the broker provides access to the specific markets and stocks you want to trade. Not all brokers offer the same range of securities.
• If you want to trade international stocks, check if the broker offers access to international markets.

5. Account types and minimum deposits

• Make sure the broker has account types that match your investment size and goals.
• Check the minimum deposit requirements for each account type.

6. Read user reviews and ratings

• Search for online reviews and ratings from other users to get an idea of the broker’s reputation and customer experience.
• If possible, open a demo account with the broker first and test its platform and services without risking your real money.

Although investing in stocks offers value for your money, it also comes with some risk. It is therefore important to have clearly defined goals, a tolerance for risk and a well thought out investment strategy.