Stock Markets: A Deeper insight
Any person who has little or no knowledge on the stock market may tend to think of it as online gambling. Unfortunately, many new investors think of it as a short term investment alternative that can provide either huge monetary profits or leave with depressing losses.
However, it is not a blind game. The more it is understood, the better a decision one can make. Thus, we will try to find answers to the most fundamental questions and take a deeper plunge in the stock market.
Why is there, a need of a Stock Market?
Suppose you want to launch a business and you need to find investors for it. You could give a print ad or an online ad or contact already known people. Now, if your investors want to disengage from your business, they need to find other investors who would be willing to invest in your business which is obviously difficult. Thus, a stock market solves this problem. Stocks in publicly traded companies are bought and sold in a stock market (also known as a stock exchange). It can be thought of as a space where anyone who wants to buy and sell shares of stocks can go to buy and sell. It also facilitates in determining the prices of stocks and the overall economic health.
What is a Stock Exchange?
Technically, a stock market refers to an individual stock exchange. Stock market is a general term for all stock exchanges in a country. A stock exchange facilitates trading of stocks and securities such as shares of a company, derivatives, equities, bonds, etc by stock brokers. The first stock exchange was in Amsterdam, Netherlands when Dutch East India Company issued its shares on Amsterdam Stock Exchange. Today, there are many stock exchanges such as NYSE and NASDAQ in USA, BSE and NSE in India, and many stock exchanges in Europe such as Deutsche Boerse in Germany, London stock exchange in London, Borsa Italiana in Italy etc.
Who issues Stocks and who buys them?
The first step for a business to sell its shares of stock is to become a corporation and the legal process involved is called incorporation. Small ventures may be owned and managed by a single individual. These are called sole proprietorships. Several people may also enter into a Partnership. A corporation may all be held by a small group of investors and shares may not be traded publicly, thus, the firm being closely held. Companies choose to issue stock to the public to raise a large quantity of investment capital quickly through an initial public offering (IPO) and become public. Although a corporation is owned by its stockholders, it is legally distinct from them. For many legal purposes, the corporation is considered as a resident of its state. As a legal “person,” it can borrow or lend money, and it can sue or be sued. It pays its own taxes.
A publicly held company is owned by thousands of people (who are called as shareholders) who trade their shares on a stock exchange. The shareholders are the owners of the company, since each share of stock entitles the owner to have a say in the corporation. Although the stockholders own the corporation, they do not manage it. Instead, they vote to elect a board of directors and are not generally employed by the corporation. The board of directors represents the shareholders. It appoints top management and is supposed to ensure that managers act in the shareholders’ best interests.
How does Stock Exchange Work?
The buying and selling of different stocks is done in an area called the floor. The floor is divided into a number of locations called posts. Each post is assigned a number of stocks which are traded from that post. If a broker wishes to buy certain shares, they go to the designated post where that stock is traded. If the price of the stock at that moment is what they are authorized to pay, the broker completes the transaction themselves, otherwise a certain professional called the specialist receives that order. The role of the specialist is to enter the information from the broker into a book that records orders to be executed. If and when the stock reaches the quoted price, the specialist buys the stock as per the orders by the broker. The transaction is reported to the investor.
As soon as the transaction occurs, the broker makes a memorandum and reports it to the brokerage office. An employee of the exchange present at that post records the details of the transaction such as the number of shares, its price, stock symbol, etc on an optical card. The card is then fed into the optical reader which transmits the information of the stock to the market. Thus, the information of this single transaction is added to the stock market. The information display shows the details of the last trade of the stock. This entire process is traditional way of trading and so is also called floor trading. With the advancement in technology, most of the trading these days is electronic trading, but the basic concepts remain the same!
What role does stock market play in an Economy?
It has an array of important functions that make it vital to an economy. A few of the major roles can be listed as below:
- Facilitation of transactions associated with the buying and selling
- Tracking of the price changes of securities
- Creation of investment opportunities for small investors
- Assisting company growth and sharing of profits.
- Capital raising for development projects and/or businesses
- Reflection of economic health of the country
Thus, we see that Stock Market forms a very important economic platform for robust functioning of businesses and financial systems. Now that we are equipped with the basic knowledge about the stock market, we will try to understand the various factors that influence the stock prices and their trends in the next article.
So, friends, till now we learnt a few fundamental terms and concepts about stock market.
What is a Trend?
Sudden rise or drop in the prices of stocks are called spikes and are extremely hard to predict. A trend is the direction in which the price is moving and will either be an uptrend, a downtrend or a sideways trend.
The main point of looking at market trends is to buy into an upward trending market rather than a downward trending market. Checking on the trend of the market gives a better chance of making a gain rather than a loss.
What factors make the prices to rise or fall?
Inflation: It is the rate at which the price of goods and services increases. It is a result of factors such as rise in cost of manufacturing, transportation and selling goods. A certain level of inflation is acceptable and somewhat necessary as it means that the economy is robust and consumers are spending money. However, high rates of inflation may lead to an opinion that companies may cut spending. This causes a drop in the revenue and coupled with the higher cost of goods, investors lose confidence in the company and sell the stock. As the demand for stock decreases, the price of the stock decreases. When the same trend is observed for a number of companies, the stock market observes a downward trend.
Interest Rates: Interest rates are also an effective means for the Reserve Bank of India to have an influence on the economy and the stock market. Cash Reserve Ratio (CRR), Repo Rate and Reverse Repo Rate are the major tools for the RBI. Higher interest rate mean that money becomes more expensive to borrow as banks must pay up higher interest rates. Hence, they raise their own interest rates on loans and credit card accounts. This causes businesses to borrow less money and businesses have to cut their own spending resulting in laying off workers or no bonuses, leading to slower growth and consumers to purchase less leading to lower profits to companies. Thus, with revenues and profits falling, the market value of the companies’ stocks decreases as well.
International and Domestic Issues: Economy is adversely affected by wars and so are the markets. Similarly, cases of crime and fraud, domestic or political unrest evoke an unsettling emotion and people withdraw their money from the markets. Consumers worry for their money when CEOs steal money. The sense of fear and insecurity makes investors dump their stocks, causing a fall in the market.
Earnings: Due to an array of management decisions or a string of other factors, when a company reports lower profits, the investors lose interest as everyone wants a growing and profitable firm. Lower profits means that a company is not doing good enough as it did before, thus investors lose confidence and sell their share of stock of the company which decreases the value of the stock.
Oil Prices: Oil for commercial energy or domestic energy is nearly indispensable, for years yet to come. When oil prices are touching the sky, people move to alternate transport options or buy fewer goods also leading to decrease in the profits for the company. Raise in oil prices is not welcomed by the market and tends to react negatively to high oil prices.
Foreign Markets: Economic trends in important foreign markets can have adverse effect on the Indian stock market as well. When the Indian companies cannot sell as many goods to companies in these economies, as they used to, there is a slide in the revenues and profits of the company in the home stock markets as well. Also, if foreign stock exchanges experience sharp declines, then Indian investors may think of a ripple effect, resulting to a drop in the Indian stock exchanges.
How to identify long-term trends?
Bull and Bear Markets are the names used to describe general stock market conditions. A bull Market is a trend of rising prices and increased investment where as a Bear market is a time period of decline in the stock market. Bull and Bear markets are characterized by general investor sentiment as well. Regardless of actual market conditions, bull and bear markets go in cycles.
Bull Markets are characterized by optimism, investor confidence and expectations that strong results will continue. The basic feature of a bull market is that economy remains strong while unemployment levels are the lowest. Consumers spend money on goods and services, generating profits for corporations. When revenue increases, people want to buy those stocks. The share prices, thus, increase, as the demand is more than the supply of those shares. Riskier investments are also made based on the good sentiment in the market.
In a Bear Market, there is a massive change of sentiments from optimism to widespread pessimism and even fear. The economy seems to be weak while the unemployment rates increase. A cut in spending habits of consumers results in lower profits and growth. This devalues stocks and, hence, investors sell their stock as they anticipate the stock to fall further. Riskier investments are done away with due to an environment of pessimism and low confidence in the market.
The basic principle for making money from trading is to buy low and sell high. Thus, recognizing bull and bear markets forms a very important way to make money on stock trading. However, identifying the trends in market is very tough. A major difficulty in doing so stems from the fact that speculation and psychological effects play a large role in the markets just as in inflation. If a considerable proportion of investors is fearful and low on market confidence, they contribute to further declines by “panic selling”. On the other hand, optimism and increased trading boosts investor confidence. The most effective method to make money is to create a varied portfolio of carefully deliberated stocks and maintain appropriate liquidity get through tough times.
About the author: The author Digvijay Sisodia has keen interest in stock markets. He regularly writes articles explaining various stock market terms.
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