How the Stock Market Works

The stock market is where investors can trade in different financial instruments, such as shares, bonds and derivatives. The stock exchange is a mediator that allows buying/selling of shares.

In India, the two primary stock exchanges are the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Further, there is a primary market where companies list their shares for the first time. Thereafter the shares  are further traded in the secondary market.

Working of the Stock Market

Participants:
The stock exchange provides a platform for trading in financial products. The companies (listing their shares), brokers, traders, and investors must register with SEBI and the exchange (BSE, NSE, or regional exchanges) before trading.

Securities and Exchange Board of India (SEBI):SEBI is the market regulator whose primary job is to ensure the Indian stock market functions smoothly with transparency, so that general investors can invest without worries. Exchanges, companies, brokerages, and other participants are all needed to abide by the guidelines laid down by SEBI.

Stockbrokers: Stockbrokers are the members of exchanges. They are the intermediaries who execute the buy and sell instructions from investors in exchange for fees.  In the Indian setup, investors need to trade through broking houses/brokers, who act as facilitators.

Investors and traders: There are two types of players in the market – investors and traders. Investors buy company shares to hold them for the long-run and generate a source of income from it. Traders are the opposite of investors and get involved in buying and selling of equities.   

Investors are motivated by company performance, long-term growth opportunities, dividend payouts, and other such factors. Traders, in contrast, are influenced by price movement and demand and supply factors.

Now, let’s talk about the two types of markets we have mentioned above. 

Trading in the stock market is a process of matching the buyer to the seller. Your broker passes on your buying request to the stock exchange, which then compares it with a seller. Once the trade is fixed and the price agreed, the exchange informs your broker about it, and the transaction takes place. Meanwhile, the bourse confirms information regarding the buyer and the seller so that parties don’t default. The actual transfer of stocks then takes place to complete trading.

Earlier, the process took days, but digitisation helped reduce the time to T+2, that is, within two days of the transaction and the process of bringing it down to T+1 is underway.

Understanding the pricing mechanism in the stock market

The price of stocks in the market is driven by demand and supply factors. Company’s share price depends partially on its market capitalisation value, which is the total of a company’s stock price multiplied by the number of outstanding stocks.  The last selling price becomes the new asking price in the market. Say you want to buy 100 shares of company XYZ, and the previous closing price was Rs 40. The fair value of the share is Rs (40*100) or Rs 4,000. 

There is another way to calculate the fair price using the discounted cash flow method. The theory suggests that the fair price is equivalent to the total of all future dividend payments, discounted at present value.  

Stock market works through a network of exchanges, broking houses, and brokers, and they function as mediators between companies and investors. Companies get listed in the exchange through initial public offerings or IPO before investors can purchase their shares. IPO helps to establish the market -cap of a company, and the stock exchanges have separate lists for large-cap, middle-cap, and small-cap companies from which investors can pick up shares to buy.

Apart from that, stock exchanges also have indices. Indian exchanges NSE and BSE have separate indices called Nifty and Sensex. These indices comprise shares of the top large-cap companies based on their market volume and popularity of shares. General investors follow these indices to understand the market direction. 

Another important concept to learn while on the topic of how the stock market works is the bid-ask spread. ‘Bid’ refers to the price that buyers are willing to pay for an underlying, which is often less than the ‘ask’ price of the seller. The difference between the two prices is called the bid-ask spread. The buyer needs to increase the bid price and the seller needs to reduce the ask price for a trade to happen. 

Steps to Invest in the Indian Stock Market

The companies file a draft offer document with the SEBI that comprises information about the company. On approval, the company offers its shares to investors through an IPO on the primary market. The Company issues and allots shares to some or all investors who bid during the IPO. The shares are then listed on the stock market (secondary market) to enable trading. On receiving instructions from the clients, the brokers place their orders on the market. On matching a buyer and seller, the trade is successfully executed. 

Types of stockbrokers in India

India has mainly two major types of stockbrokers– Full-service brokers and Discount brokers.

Full-service brokers are the traditional brokers who provide a wide variety of services ranging from buying and selling of shares, investment advice, financial planning, portfolio updates, share market research and analysis, retirement and tax planning, and more. These brokers will offer you personalised investment services with individualised recommendations to suit your needs and financial goals. 

Discount brokers are online brokers who offer no-frill stockbroking accounts. They are known for providing the necessary trading facility at the least possible cost but no personalised services. 

Important concepts to know

(i) Moving averages – Derived from stock history, they show the general trajectory of a stock and where it is likely to be headed.

(ii)  Business cycle – This cycle follows an emotional cycle wherein market fear follows market greed followed by fear again. The best time to buy stocks is when fear is at its peak which is when the economy is in a recession and it is possible to avail of stocks at low prices. Conversely, when the economy booms, the prices of stocks soar and allow traders to cash in, realising gains should they sell their shares.

(iii)Diversification – Investing in a wide variety of stocks spread over diverse sectors, is ideal as it cushions traders against inevitable market setbacks and reduces volatility. 

(iv) Price of a stock Stocks shouldn’t be viewed and bought based on their price alone. Consider whether it is overpriced or underpriced as well as other issues such as the condition of the economy or the sector.

(v) Traders must know the sort of buy or sell order they enter into which can be restricted by price or time frames –  Limit orders are those orders which are only carried out by stockbrokers provided the price matches what the trader wishes them to be. Stop-loss orders are given to stockbrokers by traders to prevent a big drop in the value of their stocks. 

A few more things to know before investing:

Budgeting

The first step in your financial planning is budgeting – a process for tracking, planning, and controlling the inflow and outflow of your income. It entails identifying all the sources of income and taking into account all current and future expenses, intending to meet your financial goals. 

Inflation effects on Investment

As the prices of goods and services increase, the value of the rupee goes down. Real return is the difference between nominal return and inflation. 

Risk and Return

Usually higher the risk, higher the maximum returns and vice versa. Risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment. Learn how to analyze risk and returns while investing here.

Power of Compounding

Compounding is the ability of an asset to generate earnings, which are then reinvested or remain invested to generate their earnings. In other words, compounding refers to generating earnings from previous earnings. 

Myths about stock market

Myth 1: Trading in stock market = Gambling

The generic sentiment of people about trading is that it’s a gamble, either you win or lose.   

Myth Busted

Investing is more like science where you need to do proper research about the fundamentals and technicals of the securities, current market trends, and growth prospects of the company. 

Myth 2: Past performance guarantees future returns

While making an investment decision, investors consider ratings or past performance of the stock. 

Myth Busted

Investing decisions are based on the future of the company and not just the historical trends. Interest rate, GDP, exchange rate, etc. are some of the major macroeconomic variables that affect the performance of the stock. Investors must also consider quarterly earnings, level of competition, cost of production, new product launch, change in top management, etc. 

Myth 3: Stock that comes down, will go up eventually or vice versa

Most people believe that a falling stock will eventually go up. Similarly, they also resist buying stocks that are on their all-time high, assuming that they will fall down in near future. 

Myth Busted

When a stock falls, investors need to research the reasons for the fall. Is the decline only due to market sentiment, which may reverse; or is the fall due to some significant event that may hurt the financials of the company? Also, just because a stock has seen a sharp rally, does not mean it cannot appreciate further. 

Myth 4: You need to invest a lot of money to make money

Myth Busted

The truth is that the investors need simply to be disciplined and well-researched. Regular investing of smaller sums over a long period can unleash the power of compounding and make millionaires out of ordinary investors. 

Myth 5: You need to do frequent trades to be profitable

Another thing that holds prospective investors from investing is that they think they will have to frequently trade to earn good returns.

Myth Busted

The truth is quality trades are better than quantity trades. You can do a number of trades without proper research and not earn desired returns. On the other hand, if you invest after thorough research and do quality trades, you might earn good returns. 

Myth 6: Trading stock with low P/E (Price-to-Earning) ratios is good and safe

The price-to-earnings ratio (P/E) helps to determine whether the stock is overvalued or undervalued. Conventional wisdom indicates that the lower the price compared to earnings (P/E ratio), the better the deal. 

Myth Busted

There may be a good reason why the stock is trading cheap. So, you must consider the growth prospects of the company, operational revenue, product launch (if any), debt structure, peer comparison, management, etc. 

Stock market bubbles

Some indicators can help to check if the market is overvalued:

Prices are high relative to fundamental valuation | Peak Valuations: During a stock market bubble, the prices are just pushed up by the sentiment of the market and the herd mentality. Simply put, the fundamentals of a company are not increasing at the same pace as its stock price.

High leverage – Speculators may borrow money from the brokerages firm (on margin) or NBFCs to keep on the bull rally. The debt cycle keeps increasing, and when stocks drop, the investor wealth can be completely wiped out due to the high margin.

Government measures such as low-interest rates– Lowering the interest rates encourage people to borrow and invest. It also encourages foreign influx in the form of FDI or FPI. It is inversely related to the stock market. Lowering interest rates, the market goes higher.

Popularisation of a trend | Behavioural Finance– Sometimes narratives of bull markets overpopularise themselves. The hype around some stocks causes the prices to rise up exponentially, which leads to a bubble. 

A lot of IPOs with oversubscription– Looking at the current scenario, the past two years saw many IPOs, out of which 90% were oversubscribed, which shows the market’s bullish sentiment.

Market CAP to GDP Ratio – This indicator suggests the valuation of the stock market compared to the GDP of a country. In India the market cap to GDP ratio is around 75%. This means that the Indian stock market valuation is 75% of the GDP. However, in recent months the market cap to GDP ratio has touched 100%.

PE Ratio – To understand whether the stock markets or company is overvalued, a good indicator is the PE ratio. 

PE ratio = price per share / earnings per share

Historically the Nifty PE ratio ranges between 15-25. In the event that the PE ratio falls below 20, you can say that the market is undervalued. PE ratio between 20-25 indicates that the market is fairly valued. If the PE ratio crosses 25, then the conclusion is that the stocks are overvalued. To understand this a bit better, let’s look at an example.

Besides this, several more indicators such as the Buffet Indicator, SmallCap Index, and the Sensitivity Index help identify a stock market bubble.  However, these indicators are not always accurate in predicting the bubble.

Factors That Trigger A Stock Market correction

Any development that forces investors to start selling stocks in large numbers will trigger a correction like global economic changes, rising inflation, slow-down in economic growth, or even fear or panic selling. When a critical mass of investors has sold off, it creates a spiralling effect, and more investors get into sell-off mode.