Everybody would have heard how investors invest in the stock market. But how does the stock market really work? Who controls it?
In this article, we will try to explain to you how all of this really works!
In India, there are two primary stock exchanges:
- The Bombay Stock Exchange (BSE) – Sensex is its index.
- The National Stock Exchange (NSE) – Nifty is its index.
How does stock market work?
Participants of stock market
There are 4 participants to facilitate the trading of shares in Indian stock market.
- Securities and Exchange Board of India (SEBI),
- Stock exchanges,
- Stock brokers, and
- Traders or investors.
The stock exchange act as a platform for trading in financial products.
The companies (issuing/issued shares), stock brokers, traders and investors must register with SEBI and the stock exchanges (BSE, NSE, or regional exchanges) before trading.
Primary stock market
The primary stock market provides the channel for sale of new shares by a company to get listed in a stock exchange.
The primary stock market provides an opportunity to issuers of stocks, especially corporates, to raise resources to meet their requirements of investment and/or discharge some obligation and liabilities.
In the Indian stock market, 1000’s of corporates are listed on the stock exchange.
They are then called public companies because they have given out their shares to the common public.
For this, companies need to pay a fee to the stock exchanges. Also, a promise to provide all important details of the company’s financial information such as Quarterly/Annual reports, Balance sheets, Income statements, along with information of new projects or future objectives etc. to the stock markets.
The process of becoming a public company is called an Initial Public Offering (IPO), i.e. it is the first time a company’s share is appearing on the stock exchange.
Secondary stock market
The secondary stock market refers to a market where shares of a company are traded after being initially offered to the public in the primary market and/or listed on the stock exchange.
Majority of the trading in stock markets is carried out in the secondary market.
It is a market where buyers and sellers meet directly and the issuer (company) does not meet the investor/traders as it is the listed stock that is bought and sold. The company may not have anything to do with most sales and purchases.
Trading in the stock market
Once listed to the stock exchanges in the primary market, the stocks issued by companies can be traded by the investors/traders in the secondary market to make profits or cut losses.
Stock brokers and brokerage firms, act as a mediator between you, as an investor, and the stock exchange.
Your broker passes on your buy order for shares to the stock exchange. The stock exchange searches for a sell order for the same share.
Once a seller and a buyer are found and fixed, a price is agreed to finalize the transaction. Post that the stock exchange communicates to your broker that your order has been confirmed.
This message is then passed on to you by the broker.
Meanwhile, the stock exchange also confirms the details of the buyers and the sellers of shares to ensure the parties don’t default.
It then facilitates the actual transfer of ownership of shares from sellers to buyers. This process is called the settlement cycle.
Earlier, it used to take weeks to settle stock trades. But now, this has been brought down to T+2 days.
If you conducted a stock trade today, you will get your shares deposited in your demat/trading account by the day after tomorrow (i.e. within two working day).
Along with all these, the stock exchange also ensures that the trade of stocks is honored during the settlement.
If a settlement cycle is not upheld, the sanctity of the stock market is lost, because it means trades may not be upheld.
Stock brokers identify their clients by a unique code assigned to an investor.
After the transaction is done by an investor, the stock broker issues him/her a contract note which provides details of the transaction such as time and date of the stock trade.
Apart from the purchase price of stock, an investor is also supposed to pay brokerage fee, stamp duty and securities transaction tax.
In case of a sale transaction, these costs are reduced from the sale proceeds and then the remaining amount is paid to the investor.
At the broker and stock exchange levels, there are multiple entities/parties involved in the communication chain like brokerage order department, exchange floor traders etc.
But the stock trading process has become electronic today. So, the process of matching buyers and sellers is done through computers online.
As a result of that, the complete trading process can be finished within minutes.
Pricing of shares in stock market
The key to making money in the stock market is to learn how to properly value a company and its share price in the context of the Indian economy and the firms operating sector.
There is a bit of homework you need to do which takes less time and effort than most people spend on fantasy sports leagues, and it is not any rocket science that our financial industry wants you to believe.
Let me explain you the how stocks are priced through a simple example.
Let’s say you bought a notebook for ₹100. Next day, a friend of yours offered you to sell it for ₹150 to him.
So, What’s the price of the notebook then?
It is ₹150. You can encash ₹150 by selling the notebook to him.
But you choose to reject his offer hoping that may your other friends may bid more than ₹150.
The very next day 3 of your other friends offered you ₹200, ₹250 and ₹300 for it respectively.
Now what’s the price of notebook?
Yes, its ₹300 as the highest bidder urge to pay ₹300 for the notebook.
Now again you rejected the offers hoping that tomorrow its price may hike more.
And exactly what you have thought, happened. You and your notebook become popular in the school and the highest amount offered is ₹500.
Let’s say you expect the price to rise even further. You do not sell.
But this time, luck was not on your side. A fellow student of yours bought a more unique notebook.
This affects the price of your notebook a lot.
Most of your friends are attracted by fellow students’ notebook. Your notebook loses 90% of its value. Now, only a bunch of your friends are ready to pay you – that too an amount of ₹50 only.
This is exactly how demand and supply affect the price of a share in the stock market.
When the students were optimistic and ready to pay higher cash than its current price, the price appreciated. When a less number of students wanted your notebook, the price fell down.
Just keep this small concept in your mind:
- When the demand for shares is more than supply, price rises.
- When the demand for shares is less than supply, price falls.
The Indian stock exchanges, BSE and NSE, have computers which determine the price of stocks on the basis of volume traded.
Lakhs of investors/traders and crores of shares are traded every day in the Indian stock market.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.