How the Stock Market Really Works

The stock market is the ultimate game. A game so mighty that the points you win are what everyone else works for. How do you win? Predict the future. Not just what happens in future, but what people will think in the future. Not just what people think in the future, but what people in the future think will happen in the future’s future. It’s a psychological mind-game of you vs. everyone else in the world. And points are money! 🥳

The nature of the stock market means that the very act of exercising an advantage, dilutes that advantage. If you know that the price of Google stock will rise tomorrow by 5%, simply by taking advantage of that today, you put the price there already and stop anyone else from taking the same advantage. Hence the market moves and evolves like a living being, always trying to get away from you.

Everyone who buys and sells on the stock market does so because they believe they know better than the person on the other side of the trade. Both of those people believe they are better off, by doing opposite things. And since every trade consists of exactly two people, one buyer and one seller, the market eternally stands on the knife’s edge at the center of all opinion.

Indeed, this is not the only way to play the stock market. You could say everyone has their own game. Some people use the stock market like a casino, making bets on equities they don’t understand. Others think of it as an investment for the long term. But all of these different models are still based on predicting the future. The gambler is predicting the future, but doesn’t realize its not just a game of chance. The passive investor eats from the same plate as everyone else but gets only the leftovers: a small premium for accepting risk on top of the returns that would be gained from an alternative less-risky investment, such as bonds. The dividend investor too is predicting that the future of her chosen investments continue to pay dividends, which is no certainty, and indeed dividend-paying stocks with low risk return the same as equally risky bonds.

The game is not won by taking risks; it’s won by betting on that which you believe to be a sure thing. And you better be right!

This article is about the equities and equity options markets. The equities market is where you buy and sell shares in public companies, e.g. Apple and Tesla. I don’t go into commodities or forex, although many of the same rules apply.

If you read about how to make money on the stock market, it doesn’t work

Why? Because other people read it too, and unless you’re the first person to do it whatever-it-is, which you’re not if you’re doing what someone else told you to do, the price has already moved to swallow up any profit that it would give. If I know that ABC will move from 100 to 101 tomorrow, then I will buy everything cheaper than 101 today, which makes the price 101 already.

This means you can only win by doing something unique that you invented. Why has no one told you this before? As the saying goes: those who can do, do; those who can’t, teach.

If you think you know how the stock market works, you don’t. Why? Because there isn’t a way that it works; it’s constantly changing and evolving. Everyone is using their own strategy, and the price of any stock rests at the point where half of people think it will go up and half think it will go down. Each of these thousands of people are personally adapting their strategy to try to predict the future price. Each stock then will move as if its a conscious and evolving lifeform, or AI. Why? Because the price is a feature of thousands of people (not to mention trading bots) that are strategizing against each other, and each of their orders moves the stock price, so it is as if each person is voting for where the stock should go. You can then consider that the stock itself is like a super-conscious entity as it has thousands of conscious components voting on what it should do, each trying to outsmart the others.

There is a massive industry that consists of teaching people how to trade and/or invest in stocks, which by the very nature of how the stock market moves, cannot work.

Any strategy that doesn’t work gives you exactly 50/50 wins and losses. Why? If it gave you more losses than wins you could just invert your method and buy when you’d sell, and sell when you’d buy — and then win! I’m not the first person to have thought of that, and since using a strategy makes the strategy stop working, you’ll find that any strategy you read about works exactly half the time. Winning half the time means you’ll lose money overall because of the spread between the buy and sell (bid and ask) prices, plus brokerage fees.

Indeed the whole thing is a massive scam. There are thousands of books and millions of web pages full of absolute bullsh*t. Worst of all are the investment managers. If they knew anything at all they wouldn’t be sitting in an office trying to convince you to give them your money, they’d be sitting on beach somewhere with a coconut and investing their own money.

How orders are made

The stock market itself is pretty much just a bunch of orders to buy and orders to sell, everything else is epiphenomena — it all happens naturally as a result of the game, not because it has to be that way. And yet buying and selling on the stock market is not like going into a shop and buying a Snickers bar, and yet that is how most people, even some experienced traders, think of it. If you want to win any game, you need to understand how the game works.

Neither is it about LIMIT, MARKET or STOP LOSS orders. Those are names given to some of the ordering strategies, and most explanations of the stock market present these to the reader as if they are a description of how it works. That’s like saying a car works by you putting your foot on the accelerator. These types of orders are fine, assuming you know how to use them, but to get ahead you need to understand exactly what is happening under the hood.

It’s simple. Let’s say there is a stock called ABC which Matthew wants to buy for $1. This gets added to a list at the stock exchange that essentially says:

Matthew will buy 1x ABC for $1

Mark want to sell but he wants $2 for it and won’t accept a penny less. The list now says:

Matthew will buy 1x ABC for $1
Mark will sell 1x ABC for $2

It’s important to note that Matthew and Mark can say anything they want. If Matthew wants to put in an order to buy ABC for minus ten trillions dollars, he can. No one will ever take the order, but he can make it.

Even though Matthew wants to buy and Mark wants to sell, there is no transaction because Matthew is only prepared to pay $1, whilst Mark wants at least $2.

The price of ABC stock in our example is $1.50, because that is the mid-point of $1 and $2. However, that does not mean that you can buy or sell the stock for $1.50. $1.50 is just the average between the highest offer to buy (called the ‘bid’) and the lowest offer to sell (called the ‘ask’). The difference between the bid and the ask is called the ‘spread’. There is ALWAYS a spread because anytime the bid and ask meet there is a transaction and these orders are taken off the list, hence the bid and ask can never meet and will always be at least $0.01 apart.

Luke wants to buy ABC too. He can see that the ask price is $2 by looking at the list. He has two choices, either take the $2 offer from Mark (this removes an order from the list, referred to as ‘removing liquidity’), or put in his own buy order at a price of his choosing (which adds an order, referred to as ‘adding liquidity’) and wait for someone else to take it.

All the different order types you’ve heard of are just different strategies around what I explained above. For example, a MARKET order instructs the brokerage to buy everything from the list until the intended number of shares are purchased. A LIMIT order instructs the brokerage to do the same thing up to a defined price, and then if the intended number of shares has not been obtained, to post an order on the list for the remainder.

You can instruct the brokerage to buy over time, or buy after the price has gone up or down, crossed a threshold, etc. Any number of different strategies are available with different names, and some brokerages even let you make up your own. But all of them are just fancy conditions for how and when to do one of the only two things you can do, which are:

1. Take an order from the list, or
2. Add a new order to the list.

What changes the price of a stock

The fact that the bid (highest price someone wants to buy) and the ask (lowest price someone wants to sell) can never meet is what causes the so-called ‘price’ of the stock, and its movement. The price of a stock is literally a stand-off between orders to buy and orders to sell.

Let’s take a new example list:

Carol will buy 10x ABC for $1.00
Mandy will buy 5x ABC for $1.01
Sarah will buy 1x ABC for $1.02
Adam will sell 6x ABC for $1.05
Carl will sell 9x ABC for $1.07
George will sell 1000x ABC for $2.50

According to this list the bid is $1.02, the ask is $1.05, so the price of the stock ABC is $1.035. As I said, the bid is always below the ask because if the bid and ask ever touch then a transaction occurs, the orders are filled and removed from the list.

Let’s say I want to buy 100 shares of ABC. If I instructed my broker to use a MARKET order then I’d be buying 85 of the 100 from George at $2.50. This is the reason why you should not use MARKET orders unless you know what you’re doing.

So instead I use a LIMIT order at the maximum price I’m prepared to pay, which lets say is $1.10. My brokerage will now take the 15 shares being sold by Adam and Carl for $1.05 and $1.07 respectively (too bad for Adam), and then create a new order for the remaining 85 at the price I specified. So the list now says:

Carol will buy 10x ABC for $1.00
Mandy will buy 5x ABC for $1.01
Sarah will buy 1x ABC for $1.02
I will buy 85x ABC for $1.10
George will sell 1000x ABC for $2.50

My action has changed the bid to $1.10, the ask to $2.50, and the price to $1.80. This gives me the illusion of having instantly made a profit, and it illustrates how meaningless the price of a stock is and why experienced traders always consider the bid and ask instead of the middle price. Even though the price of the stock is $1.80 with a bid and ask of $1.10 to $2.50, if I wanted to cash out, I could only do so at $1.02 or less, making a loss. Other people may consider their shares of ABC to be worth at least $1.10, but only because I am offering to pay $1.10 for them — I cannot buy from myself so it doesn’t apply to me.

My action may well also trigger actions from other people. For example, James may have been intending to sell his 200 shares at $1.07 the whole time, but he didn’t want me to know this. Instead of posting his intention to the list, he was waiting and watching for someone to post an order above $1.07 for him to accept. He sees my order to buy 85 shares at $1.10 and accepts this. Maybe then he adds the remainder of his own for sale at $1.10 in an attempt to attract buyers at what now looks like a reasonable price. So the list now says:

Carol will buy 10x ABC for $1.00
Mandy will buy 5x ABC for $1.01
Sarah will buy 1x ABC for $1.02
James will sell 115x ABC for $1.10
George will sell 1000x ABC for $2.50

The bid is now $1.02, the ask $1.10, and the price $1.06. I ended up paying $1.10 for most of my shares. To be exact I paid an average price of (6×1.05 + 9×1.07 + 85×1.10)/100 = $1.0943. Truth is that I would have paid $1.07 if I’d have entered that price instead. Why? Because James would have taken that order from me at $1.07 instead of $1.10, but I never know this because he sneakily waited for me to add my order to the list instead of adding his own. It now appears that my shares are worth $1.06 down from $1.80, but the reality is that I could only have sold my shares $1.02 or less before and that’s still true now.

James’ action of adding his sell order for 115 shares is not a transaction, but still causes the price of the ABC to change from $1.80 to $1.06. The price of a stock can change just based on what people say they will pay, without any transaction occurring.

The other important factor is the size of the bid or ask. That’s the number of shares that are being currently offered at this price. The sizes are given in hundreds, so a size of 5 means 500 shares. In the previous example the bid size is tiny and the ask size is fairly large. This means a lot of shares are for sale and few people are trying to buy. That implies the price is going to fall. Why? I’ll show you with a new example.

Joe will buy 2000x ABC for $0.88
Jack will buy 300x ABC for $1.00
Jane will buy 200x ABC for $1.00
Jill will sell 1,000x ABC for $1.10
Janet will sell 1,200x ABC for $1.10
Janet will sell 1,200x ABC for $1.20

In the above list the bid is $1.00 with size 5, and the ask is $1.10 with size 22. If a new someone comes along and buys 500 shares at market price, the ask is still $1.10 and nothing has changed. But if someone sells 500 shares at market price then the bid changes to $0.88. In short, it’s easier for the price to move in the direction with the smaller size.

For popular stocks the bid and ask are very close together. At the time of writing APPL (Apple Inc.) has a bid of 115.05 (with size 900) and an ask of 115.09 (with size 1000). The sizes tend to be of similar quantity on popular stocks, which is more than likely because there are people monitoring any discrepancy in the bid and ask size and automatically buying or selling based on this. Their doing that gives them a profit and it also stabilizes the prices, so it’s technically positive for most people.

For most people then, who are just buying and selling a thousand dollars here or there of popular stocks, they almost don’t need to know everything I’ve just explained. For them the bid and ask are always close together, and the sizes are larger than any of their own transactions. I said almost don’t need to know, because if they ever get into stock options, less mainstream stocks, or actually make a decent amount of money, they need to know these basic rules for how the game works.

How does the success of the company affect the price of its stock

Most people assume the price of the stock reflects the successes of the company, and that is true, but it’s true only because most people believe it, not because it’s true.

The price of a stock has no direct connection at all to the performance of the company, with two exceptions. A company can distribute profits (profit is not revenue) to its shareholders by:

1. Paying a dividend, or
2. Buying its own shares (called a ‘buy-back’)

A buy-back increases the price of the stock because the company buys millions of dollars of its own stock, pushing the price up. They say this is good for the shareholders, and I guess it is to some extent it is, but not anymore than anyone else buying the shares and then holding them. There isn’t necessarily any particular reason why, let’s say Google, has to use its profits to buy its own shares instead of the shares of Microsoft. Indeed one could argue that any company with a buy-back policy and a no dividend policy (most tech & Internet companies) is doing nothing but investing in itself and is giving NOTHING to its shareholders.

To say that again, if a company is not paying a dividend, you could make a reasonable argument that there is no value at all in holding the stock, except for selling it to someone else for more than you bought it for. But since they would be buying it for the same reason… it has no inherent value at all and never did. It doesn’t matter if the company makes a trillion dollars per second or nothing, because none of it is going to you. EXCEPT that everyone else thinks it matters… so it does. It’s essentially a legalized Ponzi scheme. 🤦🏽‍♀️

The whole game is only pretending to be economic, and it is in truth entirely psychological.

The real winners are the people who owned those companies when they went public, because they got billions of dollars for nothing. They can continue to pay themselves massive salaries and bonuses out of the profits AND sell their shares which in many cases do nothing and are worth nothing.

That might make you think that you’d better invest only in dividend-paying companies, but it really makes no difference because the price of all the stocks continue to track the companies they’re named after, due to belief, despite there being no direct technical reason why they should. Dividend paying stocks are not a better option. For a start you usually end up paying more tax on dividends. Then the dividend payout reduces the value of the stock by the same amount, so its not different from just selling some of the stock, except with higher taxes. And generally speaking, companies only pay a dividend when they have nothing better to do with it (i.e. reinvesting in growth) which implies their growth has slowed and they’re at the end of their life-cycle.

On that: companies have life-cycles much like people. When they’re children they need a lot of support, they grow quickly and are all over the place. Finally they find their niche and establish their reputation within it, maturing and settling down. Finally they become holding companies, i.e. grandparents, and quietly oversee a large family of little ones.

The metaphor has more truth in it than you may think. For example, those companies that survive over multiple generations tend not to be the original company, but one of the children or grandchildren with the same name. Apple Inc. for example had a younger brother called NeXT Inc. (both founded by Steve Jobs.) Eventually they merged, but I think it’s reasonable of me to say that while the brand remained Apple, the company that we today call ‘Apple’ is in spirit the adult form of NeXT Inc.

To answer the original question of how the success of a company affects the price of its stock: it does so only to the extent that everyone believes that it does.

If it makes you uneasy that the connection of a stock to its company is only arbitrary and the strength of the connection is mostly due to belief, consider that too applies to cash and gold. Cash has no inherent value except maybe to make a fire, and gold some manufacturing use, otherwise both are accepted by others because of shared belief in their value.

Once you get the hang of understanding how value works, it makes it easier to predict how it will change.

Game theory

So far I’ve explained that:

• Everything you read about how to trade stocks is a lie
• Stocks are bought and sold by accepting an order from a list or adding an order to the list and waiting for someone else to accept it
• The price of a stock is a standoff between buy and sell orders
• Shares are not really connected to the company’s performance, except by belief
• It’s all just a massive psychological game of predicting what everyone else will do next

To clarify: you are buying and selling symbols, with no inherent value, on a free platform. This is as close to a game with no rules as you can get. The rules that do exist are:

• Each transaction is an exchange to or from USD and another symbol
• All transactions must be agreed on by both parties

The goal is to amass the highest quantity of USD. Other than that it’s a free for all.

There is no end to the game. This makes it what’s called in game theory an infinite game. An infinite game, as opposed to a finite game, has particular strategies that work.

Throughout this article I’ve been using the language of ‘winning’ because it’s easy to understand and grabs attention. Really though, you can’t win. But you can lose. Warren Buffet put this perfectly when he said his #1 rule “don’t lose money”. Most people overlook this phrase, they think he is joking because it’s synonymous with “make money”. It’s not the same and it’s not a joke. It’s a secret hidden in plain sight.

The surest way to lose an infinite game is to treat it as you would a finite game. A race is a finite game. In a race you run as fast as you can and it doesn’t matter what happens after the finish line. You can step over the finish line and die, and you’d still be considered the winner. But what if the race never ended? What if you were in a race that went on forever?

If the race never ends, the way you play is completely different. Being #1 is not the goal anymore than it would be the goal in a 200m sprint to be #1 at the half way point. In an infinite game the goal is to survive.

A race that never ends cannot be won. But it can be lost. You can drop out of the race, give up, lose the ability to play, or die.

The stock market is exactly like this. You have to pay to play, and it never ends. So how to win? Don’t lose. Every 7 seconds a new person enters the race with their hard earned life-savings, thinking themselves clever, seduced by greed and lies, and off they sprint. One big mistake and they’re out, and their money stays behind.

Do you remember the story of the hare and the tortoise? Slow and steady wins the race. Or as Albert Einstein put it:

Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.

Do what is obvious to you

One of the best lessons I’ve learned in life is that what is obvious to me is not obvious to everyone else. Play to your strengths and do what is obvious. It’s obvious to me right now that Intel is undervalued and its main competitor AMD overvalued, but it must not be obvious to everyone else because if it were that’d change.

Millennial traders are doing well at the moment, not because they understand how to play the game, but because they don’t.

Traditionally most of the money on the market were handled by investment firms, which have a particular way of doing things. They care about serious business, like how much money a company makes, and the previous accomplishments of the executives, etc.

Millennial traders want to trade on their own and they are doing the super obvious… they’re buying stocks in companies they personally like. Tesla is cool, as is Apple, and Amazon, so that’s what they buy. This is a very superficial way to invest and it’s also an excellent strategy. They’re not doing it because they’re clever, they’re just more switched on to the modern world and how it works. They’re intuitively understanding something about the future that the suits in their corporate towers have lost touch with. Every 7 year old knew that TikTok was the next big thing about 3 years before the suits had even heard of it.

I like to consider the company’s popularity, it’s financials, and on top of this whether it makes sense from a business perspective. Does it even seem like a viable business? Would this still be relevant in 5 years? Could Google or Amazon decide to give the same product for free tomorrow?

The traditional method of pouring over charts only works when everyone else is not doing that. And when everyone is pouring over charts there’s nothing more to be squeezed out of that, and the best bet is to buy what you and your friends think is a great company. As I explained earlier, the market evolves to always be one step ahead.

Want to know about dark pools, shorting and market makers? See my next article: How the Stock Market Really Works, Part II

When I’m not making money, I’m writing about philosophy and spirituality. For more of my articles go to alasdair.com