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How does a stock market work?

Written by - Akshatha Sajumon

February 18, 2021 11 minutes

Investing in stocks is one of the means to create wealth as the stock market has the potential to yield attractive returns. When investors invest in the stock of a company, they not only become a part-owner of the company but also participate in the profits earned by the company. Stock investing could give them regular returns in the form of dividends, as well as the benefit of capital appreciation when the value of their investment rises. Investing in the stock market is, therefore, quite beneficial.

That being said, one cannot ignore the market risks associated with stock trading. While investors can make profits in a rising market, they can also suffer losses when the markets fall. Stock trading is, therefore, risky. Investors need to understand how the stock market works so that they can use stock market investments to their benefit. So, let’s understand the concept of the stock market and how it works.

What is the stock market?

A stock market is a platform where stocks and other securities like bonds, currencies, commodities, and derivatives are bought or sold. The stock market gives the companies a platform to list their stocks for sale to raise capital. It also gives investors the platform to trade in listed stocks to generate returns.

What is a stock?

Stock is a type of instrument that is offered by companies as a means to raise capital. Stock, which is also called share, denotes per unit ownership in a company. If a company issues 10,000 units of stocks, and an investor invests in 1000 such units, the investor is said to have become a 10% owner of the company. Stocks give investors the right to earn dividends on their investments. Moreover, investors could make a profit, if their investment in the share rises. 

A stock market is, therefore, a marketplace where stocks of listed companies are bought and sold. 

Participants of the stock market

The stock market is composed of different participants. Each participant plays a different role in the stock market. Here’s a look at the different participants of the stock market –

  • The regulator

The role of the regulator is to frame rules and regulations that determine the working of the stock market. The regulator governs the stock market, ensures that the participants adhere to trading laws, and also regulates the market on the whole. The Securities and Exchange Board of India (SEBI) is the regulator that regulates the stock markets in India. 

  • Companies

Companies participating in the stock market offer their stocks for sale. Companies need to list themselves on the stock market to offer their stock for trade.

  • Stock exchange

The stock exchange is where the stocks are listed. These listed stocks, bonds, and derivatives are then traded by investors. In India, there are two primary stock exchanges – the National Stock Exchange (NSE) & the Bombay Stock Exchange.  Nifty is the benchmark market index of 50 most traded companies on NSE and  Sensex is the benchmark index of 30 most traded companies on BSE.

  • Intermediaries or stockbrokers

Intermediaries or stockbrokers are middlemen, either individuals or firms, through which trading in stock and other instruments can be done. As per SEBI norms, investors can buy and sell shares only through authorized stock brokers. Brokers or intermediaries charge a fee or brokerage on the transactions done through them.

  • Investors and traders

Investors are those who invest in the securities on the stock market, and traders are those who buy and sell stocks and other securities on the stock market. Investors and traders can be domestic retail investors, institutional investors, Asset Management Companies, foreign institutional investors, Non-Resident Indians, and OCIs. 

  • Depository and Depository Participants

Trading in stock requires investors to have a Demat account. This Demat account is offered by Depositories. National Securities Depository Limited (NSDL) and Central Depository Services Limited (CDSL) are two depositories in India. Depositories, however, do not offer Demat account facilities directly to investors. Investors have to open the Demat account through a Depository Participant (DP) that acts as an agent of the depository. 

  •  Clearing Corporation 

Clearing corporations settle stock trading between traders. When a stock is traded between investors, one investor sells the stock while another buys it. Clearing corporations locate the buyer and seller of a particular stock and settle the trade between them. They debit the buyer’s account and credit the amount to the seller’s account. In India, there are different clearing corporations, like India International Clearing Corporation (IFSC) Limited, Indian Clearing Corporation Limited, etc.

Types of stock markets

There are two main types of stock markets. They are as follows –

  • Primary market

The primary market is the main market, where companies list their stocks for sale for the first time. This listing is done through an Initial Public Offering (IPO). IPO is, therefore, the first public offering of stock by a company. IPOs allow companies to list their stock on the market to raise funds. This listing is fresh, and it is open for a specified time.

Investors can bid for the stocks and then buy the stock at the issue price as specified by the company issuing the stock. After the end of the subscription period, the shares are allotted to bidders who bid at the highest prices. Companies that issue their stock through IPOs have to pay a fee to the stock exchange for listing their stock. Moreover, they are required to disclose their financial statements and give details of their future projects and growth.

  • Secondary market

Once the stock is offered to the public through an IPO in the primary market, it can be traded in the secondary market. The secondary market is the place where listed stock and other securities are bought and sold by traders continuously. Trading happens between investors and traders. The company whose stock is being traded is not involved in such trading.

How does the stock market work?

The working of the stock market can be defined through chronological steps. Here is a look into the steps that show how the stock market works-

  • Step 1 – Stock listing through IPO

Firstly, companies offer their fresh stock to the public for sale through an Initial Public Offering (IPO). This IPO is done per the rules and regulations laid down by the regulator and after being approved.

  • Step 2 – IPO subscription

Investors subscribe to the IPOs through their brokers.

  • Step 3 – Allocation of stock

After the IPO closes, the stock is sold to successful bidders at an issue price fixed by the company.

  • Step 4- Stock listing on the secondary market and trading

After the IPO, the stock gets listed on the secondary market. Such stocks can then be bought and sold among investors looking to make profits or cut losses.

How can you trade in the stock market?

If you are looking to trade on the stock market, you need the following –

  • A Demat account
  • A trading account
  • A bank account
  • A broker

You will have to open a Demat & Trading account with any  SEBI authorised brokers. Thereafter, you can pick a stock to buy. You will have to communicate your desire to buy a particular stock to the broker. The broker places your purchase request on the stock exchange and the exchange searches for a seller. Once a seller is found, the price for the transaction is fixed. The exchange also authenticates the identities of the buyer and the seller to ensure that no fraudulent trade takes place and that the parties don’t default on their intentions to buy and sell.

Once the price is fixed, the trade is settled between the buyer and the seller. The seller’s Demat account is debited by the number of shares sold, and the buyer’s Demat account is credited with such shares. Moreover, the seller’s bank account is credited with the transaction amount, and the buyer’s bank account is debited. Settlement of the shares bought and sold is done within T+2 days, i.e., within 2 days from the transaction date.

Buyers also pay brokerage on the cost of the shares, while for sellers, the sale price is reduced by the brokerage cost.

Pricing of shares in the stock market

The price of a stock is the perceived worth of the company in the eyes of the investors in absolute terms. The price shows the amount buyers are willing to pay to buy one unit of the stock at current market dynamics. When an IPO is launched, the company fixes the issue price of the stock that it offers for sale. However, once the stock is listed in the secondary markets, its price can move up and down. The pricing of shares depends on the law of supply and demand. 

Here’s how the law applies to share pricing –

For every trade, a buyer and a seller are needed. Thus, there is a need for demand and supply. If there are more buyers than sellers, the demand for the stock increases. It makes the stock attractive to the buyers. This pushes the price of the stock upwards. However, if there are more sellers than buyers, the supply increases, which reduces the perceived value of the stock. As such, the prices are pushed down. 

There is also a concept of the bid-offer spread. This is the difference between the bid price and the ask price. The bid price is the maximum amount that a buyer is willing to pay for the stock, while the offer price is the lowest price at which the seller is selling the stock. If the buyer accepts the ask price, or if the seller accepts the bid price, the stock is traded. 

If buyers are more than sellers, the bid prices will increase, and sellers would also increase their ask price. This, therefore, increases the price of the stock. On the other hand, when sellers are more than buyers, buyers would reduce their bid price, and sellers might also reduce their ask price. This would, therefore, reduce the price of the stock.

High-quality stocks of established companies have low bid-offer spread and are liquid.

Bull and bear market

The terms ‘bull’ and ‘bear’ are used to describe the sentiments of the stock market. When the economy is strong, and prices of securities listed on the market rise consistently for some time, it is called a bull market. During this time, the value of stocks increase, and investors earn attractive returns. Investors can also book their profits by selling their stockholding if their goal of investing is achieved. 

On the contrary, if the stock prices start declining consistently over a sustained time, it can be called a bear market, the market sentiments are low and stock prices decline. This could be a good time to pick up some stocks which have good fundamentals. 

Difference between stock market correction and stock market crash

Other common terms associated with the stock market are ‘correction’ and ‘crash’. These terms are different from one another. A stock market correction is said to happen if the prices in the stock market decline by 10% or less. A stock market crash, on the other hand, occurs when the stock prices fall by 10% or more in one single day. 

Stock market investing tips

Investors looking to invest in the stock market should keep the following tips in mind –

  • Understand the working of the stock market to understand how your investment would work.
  • Choose a suitable broker to trade in the stock market.
  • Pick the right stocks for your portfolio and aim to diversify your stockholding. Consult your broker/investment advisor for expert advice on the right stocks to pick.
  • The stock market is volatile. Do not panic if the value of your stock falls. Assess the profitability of the company. If the company fundamentals are strong, the value of your stock will increase when market sentiments become positive.
  • Have a long-term horizon. The stock market has been proven to offer good returns to investors who had the patience and a long-term investment perspective.

The stock market is a roller-coaster ride that is prone to its ups and downs. Understand how the market works, and then invest. Start small and then you can increase your investments gradually as you learn the ropes of stock market investing. 

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