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How Does the Stock Market Work?

Editorial Intern, TRANSFIN.
Nov 2, 2020 4:56 AM 5 min read
Editorial

News about the stock markets is everywhere. Most economic and political events in a country have a direct or indirect impact on the stock markets. Clearly, its importance cannot be downplayed.

Ever wondered how it works?

Let's get down to the basics...

 

What is the Stock Market?

Stocks, or shares, are financial instruments that can be purchased to acquire a percentage of ownership in a company. The one buying such shares is called the shareholder. The proportion of shares purchased would determine the extent of ownership as well as a dividend or capital gains received by the shareholder

Now, think of multiple companies who operate on a common platform to buy, sell or issue new shares – that’s what a stock market is. It is only when stocks are “listed” that the public can trade in them. 

Companies list their stocks initially in primary markets for public investors to purchase. These stocks are later bought and sold among investors and institutions in the secondary market. 

When you see headlines that the markets have “moved”, “gained” or “lost”, it usually refers to the collective movement of the stocks of all companies listed in a particular stock exchange. 

 

How are Stocks Traded in the Stock Exchange?

The stock markets can be compared to the traditional markets, where people buy and sell goods. Except these “goods” are financial instruments such as shares and other securities. Prices are set by computer algorithms that evaluate the demand and supply for a stock in the market. 

Those looking to purchase shares offer a price or “bid” that are then matched to the seller’s “ask” or offer price and processed as a successful trade. A stock exchange sees thousands of transactions taking place between traders, investors and companies on a daily basis that occur simultaneously. 

Stocks of a company are commonly classified based on the sector(s) in which the company operates. They are also classified on the basis of market capitalisation, which is a measure of the company’s market value. Based on what investors seek in their portfolio (collection of their financial investments), different stocks are picked from these classifications. 

Benchmarks serve as a standard to measure the performance of various financial securities. These are the closest possible representations of the overall market, as they are created across various asset classes. The most prominent benchmarks include the S&P 500 and the Dow Jones Industrial Average. In India, the important benchmarks are the Sensex and the Nifty 50. 

 

How does the Stock Market Support the Economy?

It has been said in the past that stock markets are a reflection of the economy… This is both true and false. To the extent of linking investor sentiment and trading activity, this certainly holds good. 

At a fundamental level, a company’s stock movements affect how much earnings can be made from investing in that company. A higher chance of earnings across stocks brings more investors willing to put money into the stock markets, causing stock prices to rise. This translates into confidence in the economy in what is usually called a wealth effect, wherein people spend more money as a result of their higher earnings. 

The vice versa is true as well.

When there is a downturn in the economy, investors are more sceptical about parking their money in the stock markets due to the bleak earnings from it. This, in turn, reflects in lower stock prices and an extended period of losses. This period sees weak consumer-spending and often needs governmental intervention to kickstart the economy. 

So, there is a cyclical relationship between stock movements, investor sentiments and economic activity. Social and political events that have economic ramifications also tend to influence the stock markets. 

 

Stock Markets 

 

Are there any Risks Involved in Investing in Stock Markets?

Stock markets are characterised by volatility. Since the share prices are influenced by factors beyond the control of companies or investors, there is a certain risk involved in making stock market investments which can lead to financial losses. In bearish markets, i.e. where stocks face prolonged periods of decline in prices, losses are prevalent, and investors are risk-averse. 

The up-side of high risk is the high return linked to stock market trades. In a bullish market, i.e. where stocks are tracking a positive trend over a prolonged period of time, the chances of profit are high. 

However, over time, investors become more wary of what stocks to invest in and how to minimise the risks associated with them. They not only learn to hedge against the losses but also know what strategies to apply when picking a stock to invest in. 

 

What is India’s Stock Market like?

India has two stock exchanges, namely the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). In terms of market capitalization, BSE is bigger than NSE. Even though NSE houses a fewer number of listed companies when compared to BSE, it trades at a higher value of transactions. 

An Indian company’s shares can be listed on either or both exchanges. If a certain company is listed on both exchanges, investors may choose to buy the company’s shares anywhere. A number of Indian stocks are listed on global exchanges like NASDAQ and New York Stock Exchange (NYSE) as well. 

The daily operations of India’s stock exchanges are regulated by the Securities and Exchange Board of India (SEBI). This body monitors financial transactions, conducts inspections and also manages administrative and regulatory tasks for the stock market. 

 

How Can You Invest in the Stock Market Today?

Those keen on investing in Indian stock markets need to create a Demat account and a trading account which will be linked to their portfolios. To carry out the trade, stockbrokers use web platforms and applications to access the markets. 

There is no minimum threshold for how much to invest, so investors are free to put in as much money as they wish to. 

Brokers or brokerage firms registered with stock exchanges can facilitate trading on behalf of individuals. When shares are bought, a purchase order is issued by the brokers which is matched with a sell order. The broker does the administrative spadework to process the trade at a given rate and monitors the portfolio thereafter. 

Stock markets can be a great source of alternate income for those with an eye for investing. The key is to strike a balance between the risks and returns over time and be vigilant of market movements. 

FIN.

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