How the stock market conjures up money out of thin air

Since I had to explain it anyway, I can put just as well write it down here in my blog. The question, I was asked was, how the stock market can magically generate money out of thin air and the short answer is: It cannot, but psychology can be used as a means to redistribute existing wealth.
There is no such thing as an intrinsic value. The value of any object depends on it's scarcity and our desire to own it. By manipulating desire for and the availability of an object, it's value can either be increased or decreased.

Take a grain of sand for example. Sand is available in abundance and most people don't want it (unless of course, they are in the construction or semiconductor industry). This is what makes silicone dioxide literally dirt cheap. Diamonds on the other hand are rare crystals. They are as pretty as hard to come by, making them valued possessions.

The stock market takes this concept to a more abstract level. It allows people to own shares (parts) of companies. The value of such a share largely depends on the amount of shares available on the market and how well the company in question is doing, or rather how well people think it is doing.
In that respect, the stock market is a large gamble. People try to buy when stock prices are low and sell again, when they are high, making a profit from the difference in buy- and sell price.

This simple financial version of the queen of spades game is certainly easy enough to understand, but won't make a lot of money on it's own. Stock prices rarely explode in a way, that results in a huge difference between buy- and sell price. With normal fluctuation of market prices, there usually is only a few cents to be made from buying cheap and selling expensive, so it must be done in large volumes in order to gain a reasonable amount of money in a short time.
This however is a problem, as can be shown by a simple example. Suppose there is a company, whose shares are worth $100 on Monday and $101 on Friday. Buying one share at the start of the week and selling again at the end of it will result in a profit of $1 (assuming, there are no trading fees or taxes to pay). Of course, trading just a single share would hardly be lucrative, but what if there were 10,000 shares available?
Obviously, 10,000 shares would turn into a net profit of $10,000 on Friday, if an upfront investment of one million dollars can be made on Monday. One million dollars however, is not the kind of cash, most people have in their banking account and this is where the financial trickery of conjuring up money starts.

Meet the concept known as a "margin buy". Assume having some insider knowledge concerning the scenario above and being convinced, that the stock price of the company will indeed rise from $100 on Monday to $101 on Friday. Not having the money to buy the desired 10,000 shares is not really a problem. Money can be borrowed and in fact, lending money with interest is what banks do for a living, so the course of action is quite trivial:

1. On Monday, borrow one million dollars and use it to buy those 10,000 shares on margin.
2. Wait till Friday for the stock price to rise and once it does, sell the 10,000 shares again.
3. Return the one million dollars plus interest to the bank.

If all goes well, the profit of the whole transaction will be $10,000 minus the interest on the borrowed money. Of course, there are two risks in this gamble. The first being, that trading fees, interest and taxes will eat up the entire profit, the second is, that the stock market does not behave as expected and the share price will drop. Both results in a loosing bargain.

Margin buying is still easy enough to understand. It's again just buying low and selling high, only with other people's money and the hope of being able to return the borrowed funds in time, before having to pay a large amount of interest on it. The real magic starts by gambling on falling instead of rising market prices. This so called "short selling" is what most people have difficulties with understanding. How can someone make money out of a dropping market value?
The answer is quite simple and pretty much works like a reversed margin buy. However, instead of borrowing money from a bank to buy stock, a broker borrows stock in order to sell it for money. This somewhat counter intuitive concept is probably best be explained by an example.
Assume the afore mentioned company again. Only this time, it starts with a share value of $100 per piece on Monday, which drops to $99 on Friday. Now the course of action would be as follows:

1. Borrow 10,000 shares on Monday and immediately sell them for a total of one million dollars.
2. Wait for Friday and as soon as the share price drops to $99, buy the 10,000 shares back for a total of $990,000.
3. Return the shares back to the bank and pay the lending fee.

Again, as with the margin buy, the short sell harvests $10,000 minus fees. Short selling comes with the same risk as margin buying of engaging in a loosing bargain, if the stock price behaves differently than predicted. It furthermore bears the risk of producing a land slide effect. A large short sell can easily result in the stock price to drop in the first place, in case it is unsuspicious enough to make other brokers join the bandwagon. It may also backfire and result in a regression, where the broker is forced to sell more and more shares of his own portfolio at lower and lower prices in order to free enough cash to buy back the borrowed stock.