What You Should Know About The Stock Market

Everyone’s heard of the stock market — but few know why it works. Were you aware that each stock has two prices? That you can’t buy and sell for the same amount? That a “stock market” works better and is more open than a “stock store”?

If you’re like most of us, probably not. Here’s why stock markets rock:

  • They match buyers and sellers efficiently
  • All prices are completely transparent and you see what other people have paid/sold for
  • You pick your own price and will get that amount if there’s a willing partner

Most explanations jump into the minor details — not here. Today we’ll see why the stock market works as it does.

iPods Ahoy!

I’m told iPods are popular with the 18-35 demographic. A market research firm asked me to find a good selling price, so I’ll pass the question onto you:

Me: You, the coveted 18-35 year old demographic, want an iPod. What’s it worth?

You: Dude, just get the price. Duh.

Ok hotshot, riddle me this: what is the price, exactly?

  • What you can buy it for? (Your best bid)
  • What you can sell it for? (What you’d ask for it)

So which price is the “real one”? Both.

You see, buyers and sellers each have prices in mind. When prices match, whablamo, there’s a transaction (no match, no whablamo).

The idea of two prices for every item is key to understanding any market, not just stocks. Everything has a bid and an ask, and each shopping model has a different way of handling them. This leads to different advantages for buyers and sellers.

Shopping Time

Suppose we want to buy an iPod from Amazon. You see the selling price of $200 (Amazon’s ask), and personally decide if it’s “worth it” (i.e. less than or equal to your bid):

In the store model, Amazon shows a public asking price ($200). Each buyer has a secret bidding price, some more than others. Buyers willing to bid $200 or more purchase the iPod; the rest hold off ($199 and below).

Amazon picks a price that attracts the most bidders yet still keeps a profit. In the store model:

  • Buyer pro: Buyers know the price and can pay less than their internal value
  • Buyer con: Buyers have to visit multiple stores to find the best price
  • Seller con: Sellers don’t know what each buyer is willing to pay; it’s difficult to set the pricing. Do low sales mean a bad price or a bad product?

Even though buyers are “in control”, they may have to search around to find a store that meets their bid (if any). That’s inefficient.

Onto eBay

Now suppose we want to sell our new, unopened gadget (you, the 18-35 demographic, are fickle like that; the survey said so). Sure, we could try to sell it on Amazon — now we’re our own store and need a price we think people will pay. We’re in the same boat as Amazon, and could set the price too low. That’s no fun.

Instead, we auction off the new iPod on eBay to maximize profits:

In the eBay model, buyers have public bids and compete for the product. The seller keeps their minimum price secret and hopes to make a profit by having someone “overpay”. In the auction model:

  • Seller pro: Sellers have a secret ask (reserve or minimum price) and can get paid above this.
  • Seller pro: Buyers’ demand is transparent. They can easily see if they are pricing too high.
  • Buyer con: Difficult to buy a product.

eBay is great for sellers — you have the chance of making extra profit. For buyers, it’s not so great: you can lose auctions by $1 (paying 201 when 202 was the highest bid), even though the seller would have been happy with 201. You could enter multiple auctions with $201 but risk getting two iPods.

Want Ads and Hagglers

There’s other trading approaches also:

  • Want ad: Publicly announce your desire for an iPod and let sellers fight it out.
  • Haggle: Find someone with an iPod, and without knowing a selling price, make an offer. You both haggle back and forth, trying to eke the other person out of a few bucks. If you’ve gone car shopping you know how fun this is.

In want ads, the asks are transparent while the bids (your value) are hidden. When haggling, both prices are hidden which can lead to a stressful situation.

It’s About Supply and Demand

Each model has similar concepts, namely:

  • Supply: sellers provide asks
  • Demand: buyers provide bids

The phrase liquidity refers to how effectively you can trade; how easily cash can flow. When buyers and sellers have to argue or haggle, trading freezes up. In particular, there’s a common problem in the market above:

  • There’s secret prices and a lack of transparency
  • There’s multiple vendors and a lack of consolidation

When buyers and sellers need to search to find each other, and haggle when they get there, trading slows down.

Enter the Market

But hope is not lost! Surprisingly, the very symbol of capitalism is an “open source” model:

  • All prices are transparent
  • Buyers write public bids (buying price)
  • Sellers write public asks (selling price)
  • There’s one location to get a particular stock; there’s no searching
  • Dealers/specialists help match buyers and sellers

And here’s what it looks like:

Every iPod seller lists their asking price (210, 205, 201, 200). Every iPod buyer lists their buying price (190, 195, 199, 200). When prices match, a transaction happens: the buyer who wants to pay 200 gets matched with the seller who wants 200. They’re happy.

Eventually the matches cease and we come to a standstill.

Drop and Spread ‘em.

Trades don’t last forever: there’s a standoff and an awkward pause. The lowest sellers want $201, and the highest bidder wants $199; this $2 gap is called the spread. The last price of a transaction was $200.

Now what happens? Buyers and sellers can do:

  • Limit order: put their bid/ask in the queue.
  • Market order: buy or sell immediately.

When you place a limit order (“Buy an iPod for 195″), your order gets added to the bid queue (similar for asks).

If you need to trade right now (“buy it now!” or “sell it now!”), then you use a market order. You’ll get the best price available:

  • Market order to sell: You can unload your iPod for $199 (the highest bid). The “last” price is now 199.
  • Market order to buy: You can buy for $201 (the lowest price). The “last” price is now 201.

Now this is interesting. Notice how market orders take items off the queue and change the last price. When people place market orders, the stock price fluctuates. Yes, it’s “just” supply and demand, but it’s pretty cool to know it’s happening real-time in the stock market.

If there’s a lot of buyers, they’ll “use up” the ask queue and the price will rise. If there’s a lot of sellers, they’ll “use up” the bid queue and the price will fall.

This explains why it’s hard to buy and sell for the same price. If you buy for 201, and no new bids come in, you’ll only be able to sell for 199.

In the real world, the list looks like this:


You see the bids, asks, quantities, and names. Here the bid is 204.91 (max someone will pay) and the ask is 204.92 (min someone will sell). When a buyer or seller gets restless, they may decide to immediately buy/sell, which moves the price. This detailed data is called a Level II quote.

So Who Runs This Popsicle Stand?

The NYSE and NASDAQ are the two major American exchanges. There are differences, but at the core they provide:

  • A single market to trade. All stocks for Microsoft (MSFT), are traded on the NASDAQ exchange. All stocks for Ford (F) are on the NYSE.
  • A market maker or “specialist” (not the kind that kills people). These people make the market liquid: they help collect and match bids and asks. The NYSE has one specialst per stock; NASDAQ has several market makers (dealers) who compete on price.

How Do They Make Money?

Well, often they don’t. In the NYSE, 88% of the trades happen between the public without needing the specialist (remember those guys waving papers and screaming at each other? I wouldn’t want to get involved with them either).

But sometimes they are needed. The market makers literally “create a market” by providing liquidity: you can buy and sell stocks to them at the bid and ask prices. Popular stocks have a small spread due to the demand and volume.

But how do market makers make money?

Well, it’s a bit like a currency exchange at a bank, where’s there’s a different rate for buying and selling. Let’s say Sue has an iPod to sell, and Bob wants to buy an iPod. It might go like this:

  • Hey Sue, I’ll take your iPod. Here’s 199.
  • Hi Bob, I’ll sell you an iPod. That’ll be 201.

See what happened? The market maker bought an iPod for 199 and sold it for 201: it pocketed the spread of $2. Dealers constantly change their prices based on the bids and asks; they can even lose money depending on the trades coming in. But usually it’s a pretty good gig.

You, the investor, can avoid paying “the spread” by placing limit orders to sell or buy at a certain price. But then you aren’t guaranteed to make a trade.

It’s All About Timing

Bill Gates has a lot of shares of Microsoft. People naively put this wealth as “shares times price”, but you know that doesn’t really work. If he tried to sell all his shares, he’d use up the bids.

Each block of shares would be sold for a lower and lower value — and potential buyers would panic and reduce their bids, thinking something was amiss. Sellers would fear the worst and lower their asks to compete. Pandemonium would ensue. So the actual liquidation value of his shares is really some fraction of the reported amount. But it’s still nothing to sneeze at.

Similarly, large institutions must spread their stock trades over time so they don’t disrupt the market (and evaporate their profits).

The market has built-in shock absorbers: as you sell more, the price you get is smaller and smaller, so you sell less. As you buy more, the price you pay gets higher and higher, so you buy less. So it makes sense to take things slow. Nifty.

There’s Much to Learn

I’ve simplified a lot of things and only scratched the glossed-over surface. Each market has its own rules to create a trading-friendly environment. Read more here:

  • Invest-faq on the NASDAQ and NYSE. The NYSE is an “auction market” where bids and asks are public (this is different from eBay auctions, where only bidders compete in a given auction). The NASDAQ is a “dealer market” where you buy/sell from a dealer’s personal inventory.
  • Investopedia on the difference between a market maker and specialist
  • See the current bid/ask for Microsoft or Google (and # of shares at that price)

But, my goal wasn’t to fill your head with details. I want to share insight:

  • Markets exist to match supply and demand
  • The stock market is fast, transparent, and efficient
  • Every stock has a bid and ask
  • Buying or selling changes the trading price in a direct, measurable way

Want a stock tip? Don’t listen to stock tips. (Stolen from a Charles Schwab ad). This article is about looking at a system as one way to solve a larger problem. Happy investing.

Other Posts In This Series

  1. The Rule of 72
  2. Understanding Accounting Basics (ALOE and Balance Sheets)
  3. Understanding Debt, Risk and Leverage
  4. What You Should Know About The Stock Market
  5. Understanding the Pareto Principle (The 80/20 Rule)
  6. Combining Simplicity and Complexity

Questions & Contributions


  1. One thing I’ve always wanted to know is what’s the incentive in buying stocks? What is the inherent value that I’m getting? Like with an iPod I’m getting a valuable item that can play my music but stocks seems like an abstract concept. I’m not getting anything other than a percentage of the company but not all companies pay their shareholders dividends.

  2. Hi dasickis, that’s a great question (could be a post on its own :) ). Basically, a share gives you a percent ownership of a company. If you own all the shares, then you own the entire company. So what can you do?

    1) If you’re a large organization, you can buy another company buy purchasing all its shares (or purchasing 51% so you have majority voting in all decisions). Some companies have precautions against this and have different “classes” of shares with different voting rights. They may never sell the shares with the most rights.

    2) You can earn a dividend, as you mention. Some companies are very stable and pay out dividends for shareholders each quarter. GE stock costs about $40 and pays out a $1.12 dividend each year (28 cents per quarter).

    3) You can invest for growth. This might be called “speculative” investing, but certain companies get more valuable over time. Google keeps coming up with new products. Facebook looks like it’s going to be large. Amazon expanded into new markets (Books -> Electronics -> Music).

    As companies grow, they become more valuable, so a given share becomes more valuable too. Like a comic book collector, you hope you can sell your share to another investor who thinks the price will go up even more.

    This is called “growth” vs “value” investing, but you hope to have a piece of a growing pie, and sell it off later. Of course growth stocks have inherent assets, but it’s not the primary reason you invest — it’s for the future potential. As time goes on, the growth company slows down and becomes a boring “value” company, where it returns profits to shareholders in the form of dividends. [The Board of Directors, elected by shareholders, can influence the direction of the company: does it reinvest profits into itself to grow faster, or hand out profits as dividends?].

    Hope this helps — great question! (There may be other reasons to invest as well; invest internationally to get a “share” of that country’s expanding economy if your own is stagnating).

  3. Hey Kalid,

    Thank you for the excellent answer. I understood the incentives in the first two reasons. I, however, am still having trouble figuring the incentive in the third reason. Now that I know that a company will grow in the future why does that make the stock more valuable? What tangible result will I achieve because CompanyX will grow?

    If CompanyX’s profits grow from $100 to $200 does that get split among all the owners (I thought those to be dividends)?

  4. Hi dasickis, no problem. This is a *great* question because “stocks are good” is something people often assume without thinking about it (myself included). I may turn this into an article after all :).

    To simplify things, imagine a company as a “machine” that makes money each year. Turn the crank, money comes out. [In some broken machines, turn the crank and it costs you money… but let’s ignore that :) ].

    Let’s say the machine spits out $1 million each year (after tax, expenses, polishing, etc.). How much would you be willing to pay to own this machine?

    Whatever price you pick, there’s a Price-to-Earnings ratio (called PE or P/E). This is the multiple of earnings you pay for an investment. So, while you could pay any amount, you’d likely pay around 10x, or 10 million dollars. That means you paid $10M to get $1M annually, which is a solid 10% investment. The owner may find that price fair, and you’re both happy.

    But $10M is a lot. If you can’t afford the entire machine, the owner could split it into a million pieces [shares]. In this case, you’d be willing to pay $10 per share, assuming all earnings are paid out as dividends [$1 per share]. But dividends are “boring”.

    Suppose the owner says this: I’ll sell half my machine for $5 million, and keep the other shares to myself. Using this money and the yearly earnings, I’ll do advanced research and development for improvements. By my estimates, in 3 years the improved machine will be spitting out $100 million per year, instead of $1 million.

    Wow! Now what would you pay? Probably a lot more than $10 [current value], since there’s the expectation the machine will be cranking out $100 per share in the future. You might pay $40, $100 or $500, depending on how likely you think the prediction is to happen.

    After 3 years, and $100M per year [no dividends have been paid yet — all income goes to research], the owner comes to you again. Hey, with even more improvements we can grow to $1 billion dollars per year. Yowza! What do you value it now? $1000 per share? $5000? $10,000?

    There’s two forces at play. First, there is the raw dividend: for growth companies a dividend is a bad sign. It means “Hey, I can’t improve the machine any more. Here’s your money.”.

    Second, there is the value other people will pay. Shares in a growth stock, to some extend, are only as valuable as what someone else will pay. It’s a little bit like an old comic book; if nobody cares about it, it’s not worth anything [Coconut-man]. But the first issue of Spider-man is quite valuable as a lot of people care.

    Shares of a value stock are inherently useful since they return a dividend. Shares of a growth stock depend, on some extent, to being able to sell to someone else down the road. [If it’s a poorly priced stock this is known as the “Greater Fool” theory. I may be a fool for buying at this price, but I can sell to an even Greater Fool later.]

    Now, the person you sell to down the road may in fact be a value investor. But if you bought a growth stock for $10, you get to sell it to the value investor for $1000, since the company machine is now churning out that much more money [and the board of directors has decided to start paying dividends].

    So, to answer your direct question: Value companies may pay out a large fraction of their earnings in dividends [but it’s unlikely for them to grow from $100 to $200 because they aren’t improving the machine]. For growth stocks, an improvement in profit would raise the stock price [“Yes, the machine is making more! It can sell for higher down the road!”] but not the dividend for the individual investor.

    Wow, hope that made sense :)

  5. Hi Kalid & Dasickis,

    thanks for posting your article, questions and answers, which I have found useful. Further to dasickis queries. I have another question, kinda related.

    Aren’t stocks and shares that most of us normal ppl will encounter. (home trading etc) Are in the secondary market.. where after the initial offering share price, the current price fluctuation is driven purely by speculation? i.e Google announces Android and they share prices hit the roof.. as everyone wants a piece of the action.

    So in reference of dasickis question “What tangible result will I achieve because CompanyX will grow?”. Thus if you hold google shares then you get the profit if you sold them now. I think alot of companies who issue shares that are traded in stock markets (secondary market) do not pay dividends and instead reinvest.. it depends on the company. So you are only buying those shares, in the view that the company will do things (launch new products, programs etc) that will effect it’s share price (in a postive way).

    Please correct me if I’m wrong :)

  6. Hey Alan and Kalid,

    Thank you both for your great responses. I’ve learned more about stocks and this issue has been pressing me for a while. I’m starting to see the incentive structure in growth stocks and when you relate it to comic books it makes a little more sense.

    Can you suggest some resources that helped you understand these concepts?

  7. Hi dasickis, you’re more than welcome. Yes, it takes a while, and to be honest, for many stocks the primary reason for investment is speculation (i.e. I think I can sell it to someone else) vs. intrinsic value.

    On recommendations, Warren Buffett is considered the best investor of all time, and his “strategy” was to find stocks that were undervalued and invest for the long term. So I’d recommend anything by him, or “The Intelligent Investor” by his mentor Ben Graham. Also, “A Random Walk Down Wall Street” is very good as well. This book is more about investing strategies (namely: don’t try to beat the market, buy a diverse “index fund” and hold for the long term).

    To be honest, I haven’t found a clear, simple explanation of the mechanics of the stock market — I’ve mostly pieced it together from various sources online (investopedia, wikipedia and others).

    @Alan: I think that’s basically right. For most companies you buy shares hoping the company will launch new products, grow into new markets, and become more valuable. Then you can sell your stake in the company for a higher amount (dividends are rarely a factor).

  8. Hi again – I am in the same situation as Kalid only read stuff from web and had things explained to me by friends! Hence I am not 100% sure. If you do find a good resource then please do share it!

  9. I used to know a guy who managed a team designing stock market software. When I asked him about it he told me,
    “The stock market was not designed for the common man”.

  10. @Alan: I’ll reply back here if I find anything :) (As always, if anyone finds a good resource feel free to share).

    @Nick: I think part of the mystique is that the stock market is a “rich man’s game” and most people don’t experiment with it until their first 401(k) or a few years of work.

    It takes money to make money… and the average joe may not have much. But, I have hope — I think investing in an index fund is a simple, effective strategy in the long run [and for those who don’t want to monkey around with individual trades].

  11. I’m a recovering stockbroker, having worked for UBS which is a very big Swiss bank that has a brokerage arm in the U.S. One of the many things I had to master in order to succeed was how the stock market works. People hand over their life savings to a stockbroker, and the SEC (securities and exchange commission) pays close attention to protecting the public from crooks and scam artists. So a broker has to know how the market works, and what all the rules are, in order to avoid running into trouble with the law, and also to avoid making a mistake that would cost his customer money.

    Your article about how the market works is very well written, and kind of elegant in it’s clarity and simplicity. What I would add is the world of investing can be a dangerous place for a novice investor who trusts that the system is fair and transparent. I know that sounds cynical, but bear in mind that we’re talking about the heart of our capitalist way of life, and the amounts of money being traded every day are so huge that there is a pretty big incentive to “cheat” by trying to gain an unfair advantage over other investors.

    I learned the hard way, just like all brokers, that the only way to survive and prosper in such a hyper-competitive environment is to question absolutely everything that you’re told- especially when it comes to listening to someone who is trying to get you to give them your money to invest for you. I was fortunate to have a mentor who looked after me and helped me dodge some big bullets along the way. He taught me to do my own research rather than rely on “street” research, which is usually biased. He also taught me to go against the crowd when it looked like the crowd was absolutely convinced that the market was going to go in a certain direction. The crowd is famously wrong most of the time.

    I also learned quite a lot about the tricks, traps, and outright lies that many brokers use in order to bring in more customers. You see, the problem with stockbrokers, or financial advisors, or whatever you want to call them, is that their incentives are all wrong. They are rewarded for gathering assets, and their pay is directly based on how much money they bring in the door. There is no reward for providing skillful and profitable advice to clients. A skilled and honest broker will keep his clients longer on average than an incompetent broker, but the incompetent or dishonest broker who happens to have great sales skills will out earn the good guy by a mile.

    I could go on for quite a while about this subject, because it’s always been my passion in life. Learning how the market works from the “inside” was a wonderful experience, and it has allowed me to see through the thick layers of b.s. that, unfortunately, are part of the investment landscape.

    Keep writing like you do, and I’m sure your success will continue to grow.

  12. To continue what Erik is talking about with cheating. I have learned from very reliable sources that work at large investment firms that insider trading happens all the time at major firms.

    Large firms have a private equity branch and hedge fund branch. Even though the two branches are barred from communicating according to SEC, information travels freely between the groups. My source told me that when the private equity branches are trying to buy a company they let their hedge fund branch buy it and then when the private equity branch announces to buy the company, the stock increases thus they get huge returns.

    That was just one example, there are supposedly many multi-billion dollar firms that engage in illegal activity to give them the edge.

    Now I have taken my source’s word with a grain of salt. I’m very skeptical because I would like to believe that the SEC observes these companies very closely (supposedly they don’t have enough power to stop these billion dollar deals). I just wanted to bring it out there. Please comment if anyone else has observed this behavior.

  13. Hi Kalid,

    The thing that attracted me to your site was the article on pythag. Maybe you can help me understand how to use it in my daily work. I designed a multi-factor model for stock investing that identifies the attributes of a stock- such as price/earnings ratio, price/book value, earnings growth, etc. and I subjectively assign weights to each of the factors based on experience and reasoning. If I understood the pythag article, there’s probably a way to write a formula that would tell me which factors are more important and which are less important when it comes to predicting how much the stock’s price is likely to rise in the future. Being thick-headed, I can’t seem to figure this out for myself. Can you shed some light on it for me?


  14. Hi Erik and Dasickis, thanks for the wonderful, insightful comments — it makes writing articles so much fun :).

    I’ve put together a sample spreadsheet that uses various factors to estimate how close a given stock is to an “ideal” stock:

    (download: http://betterexplained.com/wp-content/uploads/stock/StockValuationExample.xls)

    This computes the Pythagorean Distance via various metrics. However, the tricky part is appropriately weighing and scaling the factors, as all are not equally important. Still, it’s a starting point to develop your own model.

  15. Hi Dasickis, I’m more of an index fund investor — I generally have my savings in various asset classes (international, small cap, large cap, fixed income).

    I do have a few tech stocks but that’s mostly because I enjoy the industry and like to see some of this theory used in real life :).

  16. What do you use to create these graphics (in this post and in general) they are very well done and help a lot in understanding.

  17. Hi John, glad you liked it — I agree that diagrams help so much when explaining new ideas.

    I used PowerPoint 2007 to create the images — I drew boxes, lines, and colored them appropriately.

  18. excellent Mr. Azad!!! I really enjoyed reading this and all the comments after. Having felt your lead punches today all I can say is don’t get anymore insight into sparring or I will have to retire!!!

  19. Thanks Mr. Rose! Yeah, unfortunately for me sparring only seems to develop on the dojo floor and not on the web :)

  20. Wow Khalid. What a great teacher You are. Thanks much, I cleared with your help some basic trading terms that were long overdue in mind to get cleared. The best explanation I’ve found on the net! THANKS. Raph

  21. Incredibly useful. Most sites ramble but now i understand it, and that is a miracle.
    Pocket the pride from this knowledge transaction. Well done and thanks. (The pocketing is done through the knowledge market called the internet)

  22. I have a question for you that you may or may not know the answer to but here goes… who was the first business or businesses on the net to implement the use of a hidden floor or secret selling price?

  23. Hi Glen, that’s a good question, unfortunately I don’t know the answer offhand (I haven’t used that many auction sites). Yahoo answers may be a good way to find out.

  24. Hi,
    great article. I was looking for this explanation for a long time. The question I was looking for was why stock prices rise and fall – the mechanics(who puts up/down the price) and not the reasons(micro and macro economics).

    To go one further – the market is very dynamic – are there automatic “rules” that make the prices go up and down on stocks as well? Or is it purely individual buyers setting limits manually, stock by stock?

    For example – a stock is sold at $40, buyers start buying it, if the seller is smart, he would try and sell it for more – is this action automatic or manual?


  25. Hi Rodrigo, great question. As far as I know, all stock motion is the result of changes in bids and asks, just like changes in price on eBay is the result of incoming bids.

    *However*, there can certainly be (and most certainly are) automatic triggers that people set up — many firms let you do this. For example, if you own stock, you can set a trigger (limit order) to sell the stock when it reaches a certain price, such as $45. So, the impact of many limit orders may make the motion of stock look “automatic”, sort of like people automating auctions on eBay. But at the end of the day, it’s all bids and asks.


  26. Great article Kalid. However, I’ve been itching to find something out regarding the volume of trades. How exactly does this work? For instance, let’s say someone bids for an arbitrary number of shares, say 123 shares at a specific bid price. How is the transaction made if someone else has 150 shares they want to sell off at a price close to the bid? Does the transaction vary with the degree of volume? ie. 3 digit volume isn’t so much a factor as it would be for someone trading in volumes of 5 or 6 digits?

  27. Hi Kabir, great question. As far as I know, if you are trying to sell “odd lots” (non-round amounts of shares, like 123) then you need to find buyers who are willing to buy an arbitrary number. There are some postings like “fill or kill” where you try to complete the entire order, or none at all. So, it would depend on the availability of buyers and whether they had specified that they’d accept an odd number of shares. I think it may depend on the price of the share; Google shares are relatively expensive, so selling fewer or odd amount of shares is probably more common than Microsoft shares.

  28. Excellent. The idea of “using up” bids and asks was a huge ah-ha for me. I appreciate how concise your explanations are.

  29. @ishan: Great, glad you liked it.

    @Ticker Tape: Thanks for the comment! It’s really helpful to know what part made it click, so I get an idea of how to structure future posts.

  30. Thanx a lot! You’ve demystified a whole lot for me. Very easy to understand. (anyone who can’t explain something simply, doesn’t understand it well enough)

  31. I am always very skeptical when it comes to the stock market. After visiting your site, I fell though I can do it. Now, I understand the difference between BIDS and ASKS.
    What’s your recommendation for someone like me who wants to invest in the stock market?
    Where do you think I can find more information about the stock market?

  32. @Arry: I’m really not qualified for financial advice, but for books two ones I’ve seen recommended are “A random walk down wall street” (Malkiel) and “The intelligent investor” (Graham).

  33. Hey Kalid…..Great Articles….I like the way you explain stuff :-)…where do I find your complete profile ?

  34. Great well explained article. I’m always amazed by how little people actually know about the stock market and will have false impressions of it. Or how it is on the news every night, and people just seem to glaze over with dis-interest or just don’t understand even the basics of the market.

  35. @mike: Thanks — I didn’t realize how little I understood until I started asking myself if I really knew how it worked.

  36. Hi Kalid, I like your explanation very much, yet since there’s already so much praise about that I’ll just leave it here.

    I have a question though. According to your explanation of how the stock price changes, it seems the presence of limit order together with a market order is a premise for the price to change. What happens, I wonder, if say there are no limit orders being placed at all? If market orders on one side exhaust the those on the other side, would it lead to a change in price by itself?

    In your example above, if after all matching market orders have been cleared at 200
    there are still some selling market orders remaining, will they sit there to wait for the next bid at 200 or will the clearing price automatically goes down to try if it can be cleared at 199? I know in reality it is highly unlikely but I just want to point out that it seems puzzling how the market price can change without limit orders. Thanks.

  37. Hi Kalid, I read your replies to the questions and I think you are quite generous in giving answers to people. I have few questions as well, I hope you will give me simple answers:
    How do we know what will be the market tomorrow or how market will react tomorrow? It will go up or down? Are there any indicators that help us to determine the next day market movement? Some times market opens and straight away goes down but then later it goes up and closes up. Sometimes market opens with up signs but later on it goes down. How to determine that? Please don’t mind as purposely I am not typing my email address (later I will).
    Best regards

  38. Hi JM, how I wish I knew :). People use various “trend” signals (moving averages, trendlines, etc.) but it’s a black art.

  39. Excellent post and discussion Khalid. Lots of AHAs for me ….. Could you please tell me what software you used to produce the illustrations?

  40. Currently reading your calculus intuition… awesome. I think you should be charging more for it. Very few people intuitively understand calculus (so integral to most engineering, economics, financial aspects). Kudos for the altruistic dissemination of your hard earned ken.
    Might I suggest another topic… probability and random processes. Very important again for engineering and statistics. This too I feel falls under the less understood, and mostly crammed portion of ones study.

  41. Thanks, really appreciate it. I want it to be accessible to people but may have more complete editions down the line (with extra help and guidance). Probability is a great topic too, would definitely like to cover that as well :).

  42. Hi Khalid,

    The article is wonderful. Many thanks. I have some doubts regarding market orders.

    Sue wants to sell her iPod @ 201. Therefore Ask = $201
    Bob wants to buy an iPod @199. Therefore Bid = $199

    No matching of Bid and Ask. Therefore Market is at standstill.
    Now imagine:
    1) Sue places a market order to sell. It shall go to the highest bid i.e., 199 to Bob. (Bob gets an iPod at the price he wanted. Sue has to be content with a lower selling price than her expectation)
    2) Bob places a market order to buy. It shall go to the lowest Ask i.e., 201 to Sue. (Sue sells the iPod at the price she wanted. Bob has to shell out more than he wanted)

    Is this the way market order works?
    If yes, where does the market maker come into picture? (I couldn’t understand the “How market makers make money” section and the market orders in it)

    Please comment.

  43. @Anonymous: In the case where Sue and Bob are dealing with each other, the market maker isn’t needed.

    However, let’s say Bob wants to buy, but there is no Sue around? This is the role of the market maker: they have to offer a price Bob can buy at (From Wikipedia: The U.S. Securities and Exchange Commission defines a “market maker” as a firm that stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price.).

    Think of a market maker like a currency exchange booth at an airport. If you can find a guy on the street to match your needs, you can just trade currencies directly. But the booth is always there, advertising prices, and is required to buy/sell if you need. They can make money if there is a large line of people at the booth, some buying, some selling. They are essentially trading with the market maker, vs. trading with each other.

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