To understand the stock market or share market, first we need to know what are shares.
What are shares?
Shares are small parts of a company to which its shareholders are entitled.
Suppose three friends Rahul, Rohan and Rohit open a company ABC which requires Rs. 9,000 to start its business and they decide to put equal amount of money. They’d each be putting Rs. 3,000 and each of them will be entitled to 33.33 % of the company.
In this case, the total market capitalization of the company ABC is Rs. 9,000 and Rahul, Rohan and Rohit are the promoters of the company.
If the company wants to raise another Rs. 11,000 for its business expansion. It can either take a loan of Rs. 11,000 from a bank or raise money through equity route. Here, we’ll talk about the latter.
To raise money through equity route it will first file a DRHP (Draft Red Herring Prospectus) and complete all the necessary formalities to issue an IPO (Initial Public Offering). Suppose the company fixes a price of share at Rs. 1,000 per share, it’ll issue 11 shares in the IPO. During the IPO people will subscribe to shares of the company ABC.
Total market capitalization of this company would be Rs. 9,000 (Initial funding by company promoters) [plus] Rs. 11,000 (Raised in IPO) = Rs. 20,000. If, at the end of the IPO 11 people bought one share each, combined they posses 55%(11,000/20,000) of the company while, combined promoter share holding of the company would now be 15% each, i.e. 45% (9,000/20,000).
Now that we know about shares, we can understand about the stock market or share market more easily.
What is a stock market?
The stock market or share market or equity market is a place where shares of different companies are traded. Companies need funds to grow and there are two types of financing available.
- Debt financing – Where company takes a loan from a bank for certain period of time which it has to return with interest.
- Equity financing – Company raises capital by issuing its shares to the general public. Here the company does not have to return the capital raised.
The history of stock exchange dates back to 1602 AD. Amsterdam Stock exchange was the first formal stock exchange.
Two of the largest stock exchanges in India are NSE and BSE. Stock exchanges are secondary markets.
Functions of an exchange
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When a company wants to raise capital from the public though equity financing, it has to perform an IPO (Initial Public offering) where it offers its shares for sale at fixed price or sets a price band. This is called the primary market. The primary market enables companies to raise capital by issuing its shares to the public. After this, the shares are listed on an exchange for the public to trade. This is called the secondary market. People who buy shares from the primary market have to wait for the company to get listed on a stock exchange before selling their shares. But there are black markets where these shares can be sold prior to their listing on an exchange.
The share price of a company is determined by the last price for which the share(s) of the company was bought or sold in the exchange. Capital raised by the company remains unaffected regardless of its share price. Market capitalization of a company is the total number of outstanding shares (floating [plus] restricted) multiplied by the price of one share. Floating shares are those that are held by public & institutional investors and restricted shares are those that are held by the promoters of the company. Outstanding shares do not include treasury shares which are held by the company itself. The share price only affects the market capitalization of the company. Share price and market capitalization of a company denote the investor sentiment regarding its future growth, as such, share price of a company can become cheap or dear depending on investor sentiment and market conditions.
Usually trading in a stock market takes place as a continuous auction of shares of listed companies. Some traders ‘bid’ to buy a security while others ‘offer’ to sell a security. It’s obvious for buyers to bid a lower price and sellers to offer a higher price. A trade is completed when the price converges to the point where a bid meets an offer, or an offer meets a bid. The New York stock exchange (NYSE) works on this model.
Apart from auction method where market converges naturally to execute a trade, there’s another method called dealer method. Here the market makers are dealers who hold huge sums of cash as well as shares. They sell their shares at a higher price than they buy it for, hence creating a spread in prices. This spread is their commission. Usually the spread increases if there are more sellers than buyers or vice-versa. NASDAQ works on this model.
Since a listed company raises capital from the public it must disclose its financial data to the public periodically. This helps the public in making a sound investment decision. Stock exchanges ensure that the listed companies follow this protocol and disclose the said data at set intervals. Exchanges can also sought clarification on other serious matters to which the company has to respond.
Apart from that, the stock exchanges are also required to ensure compliance of certain terms and condition laid by a separate regulatory body to protect investor’s interest and promote fairness in the securities markets. In India we have SEBI (Securities and Exchange Board of India); in the USA they have SEC (Securities and Exchange Commission).
Non compliance by any listed company might get them unlisted from the exchange.
Different types of trading in stock market
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There are two main types of trading in the stock market.
- Intraday trading – In this method of trading participants can buy and sell stocks freely, but they have to square off their position by the end of the trading session (in India that is 3:30 PM).
g. When we buy X numbers of Stock A, we have an open position in Stock A. We can close the position by selling X number of shares of Stock A.
Intraday trading is beneficial to both Brokers and Traders. Traders don’t have to stay in the market for long. They can go in and out in seconds. They get leverage from the broker in the form of margin for both buying and selling of stocks. Brokers on the other hand earn money through commissions. They don’t care if a trade is profitable or not they get the commissions, and leverage means they can get more commission as more shares are traded.
E.g. suppose broker A offers me 10 x margin on the shares of Reliance Industries which is trading at a price of 1,000 rupees. It means that I can buy 100 shares of Reliance for just Rs. 10,000. Here, 10,000 is my capital and the rest 90,000 is covered by the broker as margin.
Apart from that, they also allow short-selling of shares. Short-selling is a form of trading where you sell the shares which you don’t own. This strategy is used by traders to make money when they expect the prices of shares to fall.
E.g. a share of Reliance Industries is trading at Rs. 1,200. Although you don’t own any of its shares your broker allows you to sell it. So, expecting the prices to fall, you decide to sell 100 shares of Reliance Industries. You’re now short by 100 Reliance shares. This is also called an open position. Shortly after, the price of Reliance share comes down to Rs. 1,000. You buy 100 shares at Rs. 1,000 per share. Now, you’ve closed your position and you’re no longer short by any amount of Reliance shares. You sold at Rs. 1,200 and bought at Rs. 1,000, your profit per share is Rs. 200. Multiplying it by no. Of shares we get Rs. 20,000. So, you earn a profit of Rs. 20,000 [minus] Brokerage.
- Delivery based trading – In this method you get delivery of the shares which you have bought, to your demat account. Similarly, if you sell some shares it will be debited from your demat account.
Demat account is an account which stores the data of your shares in electronic format. Earlier, in pre-digital world, people used to get certificate of ownership of the shares after buying shares of a company. This certificate of ownership is called material form. Dematerialised form on the other hand, is the data of ownership of shares which is held electronically by depositories. These depositories are like banks but instead of Currency they deal with the transaction of shares. We have the option to convert our demat shares to material and vice-versa, at will.
Unlike Intraday trading, you cannot short-sell in delivery based trade because shares are credited to your demat account 2 -3 days after you’ve bought them.
Other than those two types of stock trading there are also derivatives trading. Derivatives are financial contracts which derive their price from the underlying stock or commodity. They help in hedging the risks associated with fluctuating prices of a stock or commodity. Two main types of derivatives contract are:
- Futures contract – As the name suggests, these are contracts to buy/sell a share at a future date at a specified price.
E.g. suppose market price of a share of Reliance industries is Rs. 1,000 and I expect the price to increase, I will buy a future contract to purchase x number of shares of Reliance Industries for Rs. 1,000 each on DD-MM-YYYY. If few days later the price of Reliance Industries increases to Rs. 1,200, I can still buy x number of shares of Reliance Industries at Rs. 1000 and sell the same on the open market to earn a profit of Rs. 200 per share.
- Options contract – This contract is like an insurance against price fluctuations. You get paid depending on the market price movement of a stock or commodity. The current market price of a stock or commodity is known as spot price. The price beyond which the insurance pays you is called strike price. There are two options, call and put. In call option you protect yourself from price rise, i.e. you get paid for the amount of price rise from the strike price. And in put option you protect yourself from price decline, i.e. you get paid for the amount of price decline from the strike price.
E.g. suppose a Reliance Industries share is trading for Rs. 1,002. This price is called the spot price. You feel that the shares might decline in the near future so you buy a put option with strike price of Rs. 1,000. If you had to pay Rs. 2 per share and you bought one lot of 1000 shares, you had to pay Rs. 2,000 as premium. If ten days later a share of Reliance Industries is trading at Rs. 980 you can exercise your put option and earn Rs. 20 per share (strike price of Rs. 1,000 [minus] current market price of Rs. 980). Since you had bought 1 lot of 1000 shares your total profit would be Rs. 20*1000 shares = Rs. 20,000. You had to pay a premium of Rs. 2,000 so, your net profit would be Rs 20,000 [minus] Rs 2,000 = Rs. 18,000.
Both, futures and options contract have an expiry date beyond which the contracts become worthless. In case of futures you can buy the security for specified price in cash on the expiry date, but in options your contract becomes worthless if the options contract terms are not met.
E.g. if the current price of a stock is higher than the strike price of the put contract on expiry date, you lose the whole premium amount paid.
Some stock market terms worth noting for newbies:
Arbitrage – Simultaneous buying and selling of shares of a company on different exchanges to earn a profit from price gap between the exchanges.
E.g. suppose Reliance Industries is trading for Rs. 1,000 on NSE and Rs. 1,003 on BSE. To do an arbitrage trading one has to buy on NSE and sell on BSE until the prices on both exchanges are same or arbitrage is no longer profitable due to brokerage.
Bull market – Common term to describe rising prices of the overall market.
Bear market – Common term to describe falling prices of the overall market.
Compound annual growth rate (CAGR) – Representative returns of a fluctuating asset class over a specified period of time more than one year.
We recommend watching these videos to get better insight about the stock market.
We recommend these books from amazon.
The Intelligent Investor (English) Paperback – 2013 – by Benjamin Graham (Warren Buffet was inspired by him)
Security Analysis: Sixth Edition, Foreword by Warren Buffett – by Benjamin Graham
Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics) – by Philip A. Fisher (Warren Buffet’s investment style is inspired 85% by Benjamin Graham and 15% by Philip A. Fisher)