Stock Market basics & how it works (for beginners)

What is the stock market?

The stock market is an assemblage of stock exchanges, retail and institutional investors, stockbrokers, companies and regulators. The stock market usually refers to a secondary market where stocks which include shares, derivatives, commodities are bought and sold among investors themselves and regulated by a government authority like SEC in the USA.

Who are the key participants of the stock market?

There are varying market participants involved in the stock market. Few participants are very common across the globe. Some key participants are as follows:

  • Retail Investors: Individual people are retail investors. They generally invest their own money and trade small amounts.
  • Institutional Investors: Banks and Hedge funds are good examples of Institutional Investors. They manage money for others through wealth management services. Pension funds are often managed by Institutional Investors.
  • Stock Exchange: They provide the platform to buy and sell securities/shares of companies. The stock exchange lists all tradable shares of a company and enables trading between investors. The stock exchange typically charges a small commission for buying and/or selling shares through their platform. New York Stock Exchange (NYSE) is the world’s largest stock exchange. Stockholm Stock Exchange, Xetra, NASDAQ are a few examples of a stock exchange.
  • Stockbrokers: We need brokers to access the Stock Exchange platforms. These stockbrokers are registered entities who execute your buy and sell stocks order on your behalf. Ameritrade and Fidelity are well-known brokers in the US. Nowadays, we have a plethora of online platforms which charge a fixed fee like Robinhood where an individual can easily buy and sell stocks or apply for IPO without paying any commission.
  • Depositories/Custodians: Depositories/Custodians are services providers which hold your securities on your behalf like banks hold your money. Often the broker offers the service to open a depositories account.
  • Regulators: Regulators are the government authorities who make rules and laws to ensure the smooth functioning of stock markets. Regulators are also enforcers to address any frauds or complaints that are raised by investors. SEC is a regulatory body for the Stock market in the USA.
  • Clearinghouse: Clearinghouses help prevent defaults by ensuring that buyers have the necessary funds to pay for their trades and that sellers are in possession of the assets they intend to sell.

Transfers Agents, Underwriters, Merchant Bankers are a few more key players and generally, they are involved in the issuance of new securities like IPO.

What are the types of Stock Market and their services?

The stock market is generally categorized into two parts

  • Primary Market: The primary market is where the company offers the shares to the public at large for the very first time, that’s why they are also called a new issue market in some jurisdictions. The primary market has no physical presence and the shares are purchased/subscribed directly from the company. Some examples of the primary market offering are IPO, Offer for Sale, Private placement.
  • Secondary Market: The secondary market is where the previously issued securities in the primary market are traded. It is a highly regulated market and companies have no role in these. In the secondary market, the securities are traded through the stock exchange among investors themselves.

Apart from the stock exchange, another platform is OTC market. In OTC (Over The Counter) market, participants engage in transactions among themselves and there is no or minimum regulatory oversight. These markets have the least liquidity.

Is the stock market investing risky or gambling?

The stock market is often perceived as gambling or pure luck. It is not true in every sense. In the short term, the stock market can be volatile but in the long run, stock market investing is as risky as any other investment platform.

Volatility is not risk, risk is when you put your money into a stock without knowing underlying business fundamentals. If you intend to make quick money or get rich overnight without knowing the fundamentals of the underlying then that is gambling, you may lose a lot of money in that way.

Short term trading stocks can be gambling too unless the trader has developed extensive technical analysis skills. There is a difference between trading and investment. In trading, one often looks at charts and price movements to take positions, which bears the same risk as gambling. The basic premise behind chart indicators is that historical trends will repeat themselves which might not be true and hence it is often advised to stay away from trading.

We want you to become investors and become financially independent. Educate yourself with the basics of the stocks market and the risks associated with it. Invest for the long term in fundamentally strong businesses then you can reap the benefits of your investment. Focus on your long-term investing goals, not get rich overnight.

What is the stock market index?

The stock market index is a basket of stocks that are chosen based on their market cap, revenue, etc and acts as an indicator to determine the market movements and performance of the stock market. So, any changes in the price of the chosen stocks result in fluctuation in the index and reflect the general mood and sentiment that is being present in the market at that moment.

There is a general index like Dow Jones and then their sectorial index which tracks the performance of the stock in a particular sector like IT, Banks, etc. For example, S&P 500 is a popular stock index in the US that tracks the performance of 500 large companies in the US.

Stock Market Index is an indicator that reflects the movement of the stock market. There are thousands of stocks that are being traded in a stock market and it is difficult to monitor the movement of all the stocks. So, a few stocks are selected from the pool of stocks based on company size, the number of shareholders, etc. and, a basket of such stocks are created known as an index.

This index moves based on the change in share prices of stock present in them. It helps in getting a general understanding of the sentiment of the market. Though, indeed, the stock market index doesn’t reflect the value of all the stocks. It could be the case that the Stock market is negative but your stock could be rallying.

What types of assets can you buy at Stock Market?

There are various assets classes that you can buy at the stock market. Stock exchanges across geographies offer varying assets through their platform. Some common assets one can buy are –

  1. Equities – Shares of a company is equity. For example, if you buy shares of Apple then you become an equity investor of Apple.
  2. Commodities – Gold, Silver, Crude Oil, etc. are commodities. You can invest in commodities via the futures market and/or buy stocks of the companies that produce the commodities
  3. Derivatives – Futures contracts, forward contracts, options, swaps, and warrants are commonly used derivatives.
  4. ETF – Exchange Traded Funds are a type of funds that is generally comprised of stocks of the sector or index which it tracks. For example, S&P 500 ETF tracks the S&P index. ETFs can include either stock, bonds, commodities, etc.
  5. Bonds – Bonds are a form of fixed income investment. Bonds are debt financing for a company or government. The bond issuer promises to pay back the investment, with interest, over a certain period of time.

How does the stock market determine the stock price?

The price of the stocks in the market is determined based on supply and demand. If the demand is high for any stock it will result in an increased price and vice versa. Yet, there are certain external factors that affect the demand and supply like the economy of a country, company financials, industry attractiveness, market trends, news, etc.

The prices of stocks are decided through a bidding process where the buyers and sellers place their bids. The highest price that the buyer is willing to pay is the ‘bid’ price and the price at which the seller wishes to sell is the ‘ask’ price. The difference between the bid and ask price is the spread. The spread is an important parameter as it also defines the liquidity of the stock. The wider the spread is, the less liquid the stock is. The volume of bid and ask decides the movement of stock price

What is the difference between stock trading and stock investing?

Investing and trading are two different approaches to generating profit through the stock market. In trading, a person holds a stock for a very short period more often for a day, whereas, when we talk about investing, the investor has a long-term outlook on its investment. It could be for one year or ten years.

Trading requires the use of technical analysis which includes analyzing charts, price movement indicators, etc. Whereas in Investor uses fundamental analysis which requires going through companies’ financial statements, management overview, etc. to determine how good a company prospect are.

What is a Bull Market/Bear Market/Market Correction?

A bull market means that the stock market is on the rise and the sentiments of investors are positive. When the market is rising continuously it is said to be a bull market or bullish. When there is a bull market and prices of the stocks continue to rise and are not supported by any evident reasons.

For example, let’s say the economy is not doing good or the company hasn’t reported good financial results and yet prices of the stocks continue to rise, it is said that the market has become pricey or overvalued.

In a bear market, it is reverse. Generally, when there is a 20% fall in price, the market is in a bear market territory. How long bear markets will keep going fluctuates fiercely relying upon the particular circumstance. Some can keep going for only half a month, while some bear markets can last years.

So when the market declines from its high by around 10-20%, it is not a bear market rather, it is said that the market has corrected itself. As per the Schwab Center for Financial Research, between November 1974 and mid-2020, 22 times the stock market correction happened and only 4 out of that 22 advanced into a genuine bear market.

What is a stock market bubble?

A stock market bubble happens when the prices of stocks rise aggressively due to speculation or FOMO (fear of missing out) such that it outpaces the intrinsic value of the stocks.

The Dot-com bubble in the 1990s is a precedent of a stock market bubble. During the Dot-Com bubble, people started investing in companies operating in the Internet domain without looking at the fundamentals like what the company does, or is it going to sustain itself in the long run. That is how stock market bubbles are created.

However, it is to be noted that not every time there is a surge in the stock price of a company necessarily means it is in a bubble. It could be justified by its future growth, order book, high revenue, or any positing rating or news.

How stock market bubbles are created?

Stock market bubbles are created when the investors start buying stocks based on purely market sentiment or when there is a herd mentality resulting in a sharp increase in prices of stock which cannot be warranted by the fundamentals of the underlying company. This continuous increase in price results in overvaluation.

It generally starts with the advent of new products or low-interest rates and people have cheap money in their hands to invest. Then they enter into markets and demands for stocks starts to increase and sellers increase the price, resulting in an inflated price of stocks. Now this sudden price increase creates momentum in the market and it creates a sense of missing out among other individuals and they start to invest in the same stock causing the prices to inflate further. And this euphoria created the bubble.

What happens when a stock market bubble pops?

When the sources/news which led to a sharp increase in the price of the stock starts vanishing or the companies fail to meet the expectations of the investor, the bubble starts to pop, causing a sharp decline in the stock prices which is termed as a correction.

Sometimes, the panic and fear are so high that prices of the stock fall below their intrinsic value and often become undervalued. After a few companies collapsed, it created panic among the investors and caused the bubble to burst.

How can you make money from Stock Market?

There are various ways one can make money through the stock market. Followings are three major ways:

  1. Share Buybacks- The share buyback is a program through which a company buys its own shares and then destroys those shares. For that reason, current shareholders increase the ownership percentage of the company without spending any more money out of shareholders’ pockets. Companies notify buyback of shares beforehand.
  2. Dividends – Dividends are cash that is distributed among all the shareholders from the profits of the company. If you are holding let’s say 100 stocks of IBM which pays a regular quarterly dividend of 1.24$, then you will be receiving 124$ each quarter the company declares the dividend. Generally, companies notify when they wish to declare a dividend and set a record date (cut off). If you buy the stocks of that company before the record date, you will receive the dividend as well.
  3. Capital Gains – When you sell your stocks, the profit you have earned is capital gains. It can be Long term capital gains called LTCG or short-term capital gains called STCG. These capital gains are taxable as per your country’s tax laws.
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