Practice: How Markets Work
Fourteen scored problems on where money goes when shares are sold, what the bid-ask spread costs, who handles and oversees your order, and how an index is built.
What you'll do
This set works through the second module. You'll follow the money in an IPO and in ordinary trading, calculate a spread and the cost of trading through it, put the journey of an order in sequence, match the organizations that oversee the markets to what they do, and work out how the same price move changes two differently built indexes. Each answer comes with the working, and your score appears as you go. Nothing is recorded outside this browser.
This draws on
Work through the problems in order and check each answer once you've committed to it. The score counts your first try. The companies and numbers are fictional.
Where the money goes
1. A company sells 4 million new shares to the public at $15 each in its IPO. How much does the company raise, before fees? Answer in millions.
4 million × $15 = $60 million. This is the primary market: the shares are new, and the money goes to the company. Review: What a Financial Market Is.
2. A year later, the same shares trade at $40 on the stock market. How much more cash has the company received because of the rise from $15?
In the secondary market, investors buy from and sell to each other. A higher price changes what shareholders own. It doesn't change what the company has in the bank. Review: What a Financial Market Is.
3. Which market is each of these?
- Maria buys 50 shares through her broker from an investor who's selling
- A company sells shares to the public for the first time
- A fund sells its holding in a company on the stock exchange
- A government sells newly issued bonds to investors
If the security is new and the issuer receives the money, it's the primary market. If an existing security passes from one investor to another, it's the secondary market, which is what people usually mean by "the stock market". Review: What a Financial Market Is.
The cost of trading
4. A stock is quoted with a bid of $24.90 and an ask of $25.10. What's the spread, in cents?
$25.10 − $24.90 = $0.20, or 20 cents. The bid is the most any buyer will pay right now, and the ask is the least any seller will accept. Review: Bid, Ask, and the Spread.
5. What's that spread as a percentage of a $25 share price?
$0.20 ÷ $25 = 0.8%. Comparing spreads as percentages lets you compare stocks at different prices. A 20-cent spread is small on a $500 share and large on a $5 one.
6. You buy 200 shares at the ask and sell them straight away at the bid. The quotes haven't moved. How much have you lost?
200 × $0.20 = $40. You paid $5,020 and received $4,980. The spread is a cost you pay on every round trip, even with no commission and no change in price. Review: Bid, Ask, and the Spread.
7. Two stocks both trade around $20. One has a spread of 1 cent and the other a spread of 40 cents. What's the most likely difference between them?
Spreads mostly reflect how actively a stock is traded. With many buyers and sellers competing, the bid and ask are pushed together. With few, the gap widens, and getting in and out costs more. Review: Bid, Ask, and the Spread.
Who handles and oversees your order
8. Put the journey of an order in sequence.
- Your order is matched with a seller
- The trade settles: shares and cash officially change hands
- You place an order in your broker's app
- You receive a confirmation with the price, shares, and time
- Your broker decides where to send the order
You place the order, your broker routes it to an exchange, a market maker, or another venue, it's matched with a seller, you get a confirmation, and the trade settles. The matching is usually over in a fraction of a second. Settlement comes later. Review: Exchanges, Buyers, and Sellers.
9. Who does each of these?
- Stands ready to buy or sell a stock at publicly quoted prices
- Buys and sells on your behalf, and decides where your order goes
- Runs a regulated marketplace that matches buy and sell orders
- Owes you a duty to seek the most favorable terms reasonably available
Your broker acts for you and chooses where to send the order, with a duty of best execution. Exchanges match orders. Market makers quote prices at which they'll trade, and earn the difference between what they buy and sell at. Review: Exchanges, Buyers, and Sellers.
10. Which organization does each of these?
- Requires companies that sell securities to the public to disclose information
- Runs BrokerCheck, where you can look up a broker's record
- Steps in if a member brokerage firm fails and customers' assets are missing
- Insures deposits at member banks
- Oversees brokerage firms and registers the people who work at them
The SEC oversees the securities markets and requires disclosure. FINRA oversees brokerage firms and runs BrokerCheck. SIPC protects customers of a failed brokerage firm up to set limits, and the FDIC insures bank deposits up to a legal limit. None of them protects you against an investment falling in value. Review: Who Regulates the Markets.
11. An advert describes an investment as "approved by the SEC". What should you make of that?
The SEC reviews filings for whether they meet disclosure rules. It doesn't judge whether an investment is a good one and never approves an offering, so a claim that it has is false. Review: Who Regulates the Markets.
Prices and indexes
12. Investors expected a company to report profit of $1.50 a share. It reports $1.60 and lowers its forecast for next year. The share price falls. Why?
A share's price reflects what the business is expected to earn in the future. This quarter was better than expected, and the outlook is now worse, and the outlook counts for more. Good news and a rising price aren't the same thing. Review: Why Prices Move.
13. An index holds two stocks. Alder trades at $200 and Birch at $50. The index is price-weighted: it's the average of the two share prices. Alder rises 10% and Birch doesn't move. By what percentage does the index rise?
The index starts at ($200 + $50) ÷ 2 = $125. Alder rises to $220, so the index becomes ($220 + $50) ÷ 2 = $135. $10 ÷ $125 = 8%. Alder dominates because its share price is high. Review: Market Indexes: What "The Market" Means.
14. Now weight the same index by market value. Alder is worth $2 billion in total and Birch $18 billion. Alder again rises 10%. By what percentage does the index rise?
The two companies are worth $20 billion together. Alder's 10% rise adds $0.2 billion, and $0.2 billion ÷ $20 billion = 1%. The same price move that lifted the price-weighted index 8% lifts this one 1%, because Alder is a small company with a high share price. When someone says "the market" rose, it matters which index they mean.
Look one up
15. Pick a company you know and look up its quote during market hours. Write down the bid, the ask, the spread in cents, and the spread as a percentage of the price. Then do the same for a much smaller company. This isn't scored.
What to notice
Expect the large, heavily traded company to show a very narrow spread, a tiny fraction of a percent, and the smaller one to be wider. That difference is the cost of trading it, and it's one reason Order Types: Market, Limit, and Stop matters more for thinly traded stocks.