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How Does the Stock Market Works?

In the simplest terms, the Stock Market Works where companies can raise capital by offering investors a piece of ownership in the company. This can be done through shares of stock, also known as equities.

What is a Stock Market?

The term stock market works refers to several exchanges in which shares of publicly held companies are bought and sold. Such financial activities are conducted through formal exchanges and via over-the-counter (OTC) marketplaces that operate under a defined set of regulations. 

Both ‘stock market’ and ‘stock exchange’ are often used interchangeably. Traders in the stock market buy or sell shares on one or more of the stock exchanges that are part of the overall stock market.

The leading U.S. stock exchanges include the New York Stock Exchange (NYSE) and the Nasdaq.

Stock Market Indexes

Indices represent aggregated prices of several different stocks, and the movement of an index is the net effect of the movements of each component. Major stock market indexes include theDow Jones Industrial Average (DJIA) and the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and the fact that it only consists of 30 stocks (when there are many thousands to choose from), it is not a good indicator of how the stock market is doing. The S&P 500 is a market-cap-weighted index of the 500 largest companies in the U.S. and is a much more valid indicator.

Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market sector. Investors can trade indices indirectly via futures markets, or via exchange-traded funds (ETFs), which act just like stocks on stock exchanges.

A market index is a popular measure of stock market performance. Most market indices are market-cap weighted, which means that the weight of each index constituent is proportional to its market capitalisation. Keep in mind, though, that a few of them are price-weighted, such as the DJIA. In addition to the DJIA, other widely watched indices in the U.S. and internationally include the:

  • S&P 500
  • Nasdaq Composite
  • Russell Indices (Russell 1000, Russell 2000)
  • TSX Composite (Canada)
  • FTSE Index (UK)
  • Nikkei 225 (Japan)
  • Dax Index (Germany)
  • CAC 40 Index (France)
  • CSI 300 Index (China)
  • Sensex (India)

Why Companies Issue Shares

To make the transition from an idea germinating in an entrepreneur’s brain to an operating company, they need to lease an office or factory, hire employees, buy equipment and raw materials, and put in place a sales and distribution network, among other things. These resources require significant amounts of capital, depending on the scale and scope of the business.

Raising Capital

Many corporate giants started as small private entities launched by visionary founders like Jack Ma of Alibaba (BABA) or Mark Zuckerberg of Meta.

A startup can raise capital either by selling shares through equity financing or borrowing money through debt financing. Debt financing can be a problem for a startup because it may have few assets to pledge for a loan.

Equity financing is the preferred route for most startups that need capital. The entrepreneur may initially source funds from personal savings, as well as friends and family, to get the business off the ground. As the business expands and its capital requirements become more substantial, the entrepreneur may turn to angel investors and venture capital firms.

Listing Shares

Companies can access larger amounts of capital than they can get from ongoing operations or a traditional bank loan by selling shares to the public through an initial public offering (IPO). 

This changes the status of the company from a private firm whose shares are held by a few shareholders to a publicly-traded company whose shares will be held by numerous members of the general public. The IPO also offers early investors in the company an opportunity to cash out part of their stake, often reaping very handsome rewards in the process.

Once the company’s shares are listed on a stock exchange and trading on the market, the price of these shares fluctuates as investors and traders assess and reassess their intrinsic value. There are many different ratios and metrics that can be used to value stocks, of which the single-most popular measure is probably the price-to-earnings (PE) ratio. Stock analysis tends to fall into one of two camps—fundamental analysis, or technical analysis.

How the Stock Market Works

Stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence, with zero to low operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and secondary markets.

As a primary market, the stock market allows companies to issue and sell their shares to the public for the first time through the process of an initial public offering (IPO). This activity helps companies raise necessary capital from investors.

A company divides itself into several shares and sells some of those shares to the public at a price per share.

 To facilitate this process, a company needs a marketplace where these shares can be sold and this is achieved by the stock market. A listed company may also offer new, additional shares through other offerings at a later stage, such as through rights issues or follow-on offerings. They may even buy back or delist their shares.

Investors will own company shares in the expectation that share value will rise or that they will receive dividend payments or both. The stock exchange acts as a facilitator for this capital-raising process and receives a fee for its services from the company and its financial partners.

Using the stock exchanges, investors can also buy and sell securities they already own in what is called the secondary market.

The stock market or exchange maintains various market-level and sector-specific indicators, like the S&P (Standard & Poor’s) 500 index and the Nasdaq 100 index, which provide a measure to track the movement of the overall market.

What Are the Functions of a Stock Market?

The stock market ensures price transparency, liquidity, price discovery, and fair dealings in trading activities.

The stock market guarantees all interested market participants have access to data for all buy and sell orders, thereby helping in the fair and transparent pricing of securities. The market also ensures efficient matching of appropriate buy and sell orders.

Stock markets need to support price discovery where the price of any stock is determined collectively by all of its buyers and sellers. Those qualified and willing to trade should get instant access to place orders and the market ensures that the orders are executed at a fair price.

Traders on the stock market include market makers, investors, traders, speculators, and hedgers. An investor may buy stocks and hold them for the long term, while a trader may enter and exit a position within seconds. A market maker provides necessary liquidity in the market, while a hedger may trade in derivatives.

What is the Significance of the Stock Market?

The stock market is a component of a free-market economy. It allows companies to raise money by offering stock shares and corporate bonds and allows investors to participate in the financial achievements of the companies, make profits through capital gains, and earn income through dividends. The stock market works as a platform through which savings and investments of individuals are efficiently channeled into productive investment opportunities and add to the capital formation and economic growth of the country.

How Does Inflation Affect the Stock Market?

Inflation refers to an increase in consumer prices, either due to an oversupply of money or a shortage of consumer goods. The effects of inflation on the stock market are unpredictable: in some cases, it can lead to higher share prices, due to more money entering the market and increased job growth. However, higher input prices can also restrict corporate earnings, causing profits to fall. Overall, value stocks tend to perform better than growth stocks in times of high inflation.

How Much Does the Stock Market Grow Every Year?

The S&P 500 has grown about 10.5% per year since it was established in the 1920s. Using this as a barometer for market growth, one can estimate that the stock market grows in value by about the same amount each year. However, there is an element of probability: in some years the stock market sees greater growth, and in some years it grows less. In addition, some stocks grow faster than others.

How Do People Lose Money in the Stock Market?

Most people who lose money in the stock market do so through reckless investments in high-risk securities. Although these can score high returns if they are successful, they are just as likely to lose money. There is also an element of psychology: an investor who sells during a crash will lock in their losses, while those who hold their stock have a chance of seeing their patience rewarded. Finally, margin trading can make the stock market even riskier, by magnifying one’s potential gains or losses.

Types of Stock

Stock, a key instrument in the world of investments, is broadly categorised into two main types: common shares and preferred shares, each with distinct features and benefits.

Common Shares:

Common shares represent ownership in a company and grant shareholders ownership rights, such as voting in corporate meetings and elections. Shareholders have a say in the company’s decisions and policies. Common shares generally form the majority of a company’s equity and are more actively traded in the stock market due to their large market value and trading volumes.

  • Voting Rights: Common shareholders have voting rights that allow them to influence the company’s decisions during corporate meetings and elections.
  • Priority: Common shareholders have a lower priority compared to preferred shareholders in terms of dividend payments and assets during liquidation.

Preferred Shares:

Preferred shares, on the other hand, do not typically carry voting rights, meaning shareholders don’t participate in the company’s decision-making processes. However, preferred shareholders have priority over common shareholders concerning dividends and assets in case of a company liquidation.

  • Voting Rights: Preferred shareholders generally lack voting rights in the company’s affairs.
  • Priority: Preferred shareholders are prioritised over common shareholders in receiving dividends and assets during liquidation.

Both types of shares serve distinct purposes and appeal to different investors based on their risk tolerance, investment goals, and preferences. Common shares offer an active role in the company’s governance, while preferred shares provide a sense of security through priority in dividends and assets. Understanding these types of stock is essential for anyone involved in the stock market and investment decision-making.

What is a Stock Exchange?

A stock exchange serves as a pivotal platform within the financial realm where various financial instruments like stocks, bonds, and commodities are actively traded. In the Indian context, this market provides a space for buyers and sellers to convene and engage in trading these financial tools during specific hours on any business day, adhering meticulously to SEBI’s well-defined guidelines.

However, an essential condition is that only companies listed on a stock exchange are permitted to partake in the trading activities within it. For stocks not listed on reputable stock exchanges, there is an alternative: the ‘Over The Counter Market’. However, shares traded here may not be held in the same esteem as those within the stock exchange market.

Typically, stock exchanges in India operate independently, devoid of ‘market makers’ or ‘specialists.’ The trading process in Indian stock exchanges is order-driven and conducted over an electronic limit order book, where trading computers automatically match orders. This system efficiently pairs investors’ market orders with the most fitting limit orders.

One significant advantage of this order-driven market is the transparency it brings to transactions by publicly displaying all market orders. Brokers play a crucial role in this trading system, acting as intermediaries through whom all orders are placed. Both institutional investors and retail customers can utilise the benefits of direct market access (DMA) by using trading terminals provided by brokers associated with the stock exchange market. This direct access allows investors to place their orders directly into the trading system, streamlining the trading process.

How Share Prices Are Set

Share prices in the stock market are determined through various methods, the most common being an auction process where buyers and sellers place bids and offers to buy or sell shares. Let’s explore the dynamics of share pricing and how it unfolds in the stock market.

Auction Process: Bids and Offers

In the stock market, buyers and sellers engage in an auction-like process. A bid is the price at which a buyer wishes to purchase shares, while an offer or ask is the price at which a seller wishes to sell. When a bid matches an ask, a trade is executed.

Stock Market: Supply and Demand

The laws of supply and demand play a fundamental role in determining share prices. For every stock transaction, there must be both a buyer and a seller. If there are more buyers for a specific stock than sellers, the stock price tends to rise. Conversely, if sellers outnumber buyers, the price tends to decline.

Bid-Ask Spread

The bid-ask spread is the difference between the highest bid price and the lowest ask price. It represents the range between what a buyer is willing to pay and what a seller is willing to accept. A narrower spread indicates higher liquidity in the stock.

Matching Buyers to Sellers

Stock markets often employ professionals like specialists or market makers to ensure continuous bids and offers. A two-sided market comprises the bid and offer prices. The spread (difference between them) and the size of bids and offers influence stock liquidity. A narrower spread and substantial bids/offers indicate better market depth.

Evolution of Trading Systems

The evolution of trading systems is remarkable. Initially, manual trading involved an open outcry system where traders used verbal and hand signals to trade on the exchange floor. However, this method has been largely replaced by electronic trading systems, significantly improving trade efficiency and reducing costs.

Modern electronic systems swiftly match buyers and sellers, enhancing trade execution speed and overall market efficiency. These advancements have revolutionised the way share prices are set, making markets more accessible and efficient for all participants.

Advantages of Stock Exchange Listing

Listing a company on a stock exchange comes with a host of advantages that can significantly impact the company’s growth, visibility, and operational capacity.

Enhanced Liquidity

An exchange listing translates to readily available liquidity for the shares held by the company’s shareholders. Investors can easily buy or sell shares in the secondary market, promoting market activity and allowing shareholders to quickly access their investment.

Capital Expansion

One of the primary benefits of stock exchange listing is the ability to raise additional funds by issuing more shares. This infusion of capital enables the company to fund expansion initiatives, invest in research and development, or pursue strategic opportunities.

Employee Attraction and Retention

Publicly tradable shares facilitate the establishment of stock options plans, serving as a valuable tool to attract and retain top talent. Stock options provide employees with an incentive to work towards the company’s success, aligning their interests with that of the shareholders.

Enhanced Visibility and Credibility

Listed companies enjoy greater visibility and credibility in the marketplace. Analyst coverage and demand from institutional investors often increase, which can drive up the share price. A higher share price and increased visibility can attract more investors and potential stakeholders.

Strategic Acquisitions

Having listed shares provides the company with the advantage of using its shares as currency for acquisitions. This means the company can use its own stock to partially or wholly pay for acquisitions. This approach can be strategic and financially efficient, aiding in growth and diversification.

Disadvantages of Stock Exchange Listing

While there are numerous advantages to listing a company on a stock exchange, there are also drawbacks that need to be carefully considered. These disadvantages can range from financial implications to restrictions on business strategies and operations.

Financial Costs

One of the most significant disadvantages of stock exchange listing is the substantial financial costs involved. These costs encompass listing fees, compliance charges, and higher expenses associated with regulatory reporting. For smaller companies, these financial commitments can pose a considerable burden.

Compliance and Regulatory Burden

Being listed on an exchange demands strict compliance with regulations and reporting requirements. The regulatory framework often includes extensive financial disclosures and governance standards. Meeting these obligations can be complex, time-consuming, and costly, diverting valuable resources from core business activities.

Restrictive Regulations

The stringent regulations imposed on listed companies can be constricting. These regulations are designed to protect investors and ensure market transparency, but they may limit a company’s flexibility in executing its business strategies. The necessity to adhere to specific rules and guidelines can impede agility and innovation.

Short-Term Investor Focus

Stock exchange listing exposes a company to a diverse array of investors, many of whom have a short-term investment horizon. This short-term focus can exert pressure on the company to prioritise meeting quarterly earnings estimates rather than pursuing a long-term strategic vision. It may discourage long-term investments and sustainable growth strategies.

Investing in Stocks

Investing in stocks is a fundamental avenue for wealth creation and financial growth. Over extended periods, stocks have demonstrated their potential to yield superior returns compared to other asset classes. These returns primarily emanate from two sources: capital gains and dividends.

Capital Gains

A capital gain materialises when an investor sells a stock at a higher price than the purchase price. This increase in value can result from various factors, such as company performance, market conditions, or investor sentiment. Capital gains are a crucial part of the overall return on investment from stocks.

Dividends

A dividend represents the portion of a company’s profits distributed to its shareholders. Dividends are a consistent and vital component of stock returns. Remarkably, dividends have contributed nearly one-third of the total equity return since 1956, underscoring their significance. They provide a regular stream of income to investors and reflect a company’s financial strength and stability.

Diverse Investment Strategies

Investors employ various strategies based on their risk tolerance and financial objectives. Some seek substantial returns by focusing on capital gains, often associated with higher-risk investments. This strategy requires an appetite for market volatility and a willingness to stay invested for the long term.

Conversely, conservative investors, particularly those reliant on steady income from their portfolios, may opt for stocks known for a consistent history of paying substantial dividends. Such stocks provide a reliable income stream, aiding in meeting regular financial needs.

The Reality of Stock Investing

While investing in stocks offers the allure of substantial returns, achieving exceptional gains akin to the success stories of prominent companies like Meta, Apple, Amazon, Netflix, and Alphabet is relatively rare. These success stories are exceptions rather than the norm in the stock market.

Conclusion

Understanding how the stock market works involves grasping concepts such as supply and demand, market trends, and investor sentiment. It is influenced by various factors, including economic conditions, company performance, and geopolitical events. While the stock market can present opportunities for wealth creation, it also carries inherent risks. Therefore, it is essential for individuals to conduct thorough research, diversify their portfolios, and seek professional advice to make informed investment decisions. Overall, the stock market plays a pivotal role in the global economy, shaping financial landscapes and providing avenues for individuals and businesses to grow and prosper.

FAQs

How do you make money from stocks?

Holding for the Long Term. Long-term investors often advise, 'Spending time in the market is better than trying to time it right.' Favoring Funds Instead of Single Stocks. Reinvesting Dividends. Selecting the Appropriate Investment Account.

Can I invest ₹ 100 in the share market?

Initiating investment with just ₹ 100 in the stock market is feasible. Thanks to the emergence of digital platforms and fractional investing, it's possible to commence stock market investment with as little as ₹ 100.

What is the risk of stocks?

Buying stocks comes with no assurances of profits, rendering it one of the riskiest investment choices. In cases where a company underperforms or loses investor favor, its stock value can plummet, potentially resulting in financial losses for investors.

Which share is best to buy today?

IFB Industries (₹892.60) Bank of India (₹89.69) Graphite India (₹463.65) IIFL Finance (₹539.80) Rashtriya Chemicals & Fertilizers (₹116.25) Bank of Baroda (₹202.35)

What is the Stock Market and How Does It Operate?

The stock market is a platform where shares of public companies are bought and sold. It operates through a network of buyers, sellers, and exchanges. Investors can purchase shares, hoping for price appreciation or dividends.

What Are the Basic Functions of the Stock Market?

The stock market facilitates capital raising for companies, offers liquidity to investors, and enables price discovery. It allows companies to issue shares and the public to buy and sell them.

How Can I Get Started in the Stock Market?

To start, educate yourself about stocks and market dynamics. Open a brokerage account, conduct research, choose stocks wisely, and consider consulting a financial advisor for guidance.

Is the Stock Market Easy for Beginners to Understand?

While initially complex, understanding the stock market is feasible with education and practice. Begin with learning stock basics, market terminologies, and gradually progress to trading strategies and analysis.

What Strategies Can Help Me Earn ₹500 Per Day in the Share Market?

Aim for consistent gains through short-term trading, considering price trends and market sentiment. Opt for strategies like intraday trading, momentum trading, or swing trading for potential daily profits.

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