With the changing demography of India, the younger working population has realized the importance of investment as a source to generate extra income and is looking for avenues to generate higher returns instead of parking their money in low-interest bearing instruments like fixed deposits or recurring deposits.
Most people looking for higher returns today have taken the indirect route of mutual funds, and most people are still wary of directly investing in the stock market, be it as an investor or as a trader.
The main reason people shy away from investing in stock market is because they feel stock market is an endeavour that requires immense expertise in financial domain.
Although it does require some amount of financial awareness and knowledge, it is not as complex as people make it out to be. It seems complex because of an overload of information and opinions regarding stock market. So, don’t worry; it is natural to feel a bit lost when you start any journey, and the stock market is no different.
With this blog, I will try to clear the clutter by giving you a complete overview of how the stock market works.
The Demand and Supply rule
Stock market functions on similar lines on which any other market operates i.e. the concept of Demand and Supply. Let me explain with a simple example from our day to day life. The price of onion increases when there is a shortage of supplies of onion due to factors like bad harvest, or transportation strikes. On the other hand, a surplus of supplies brings down the prices. Similarly, rise and fall of stock prices is governed by the same phenomenon of demand and supply.
But how is this supply or demand created? Every private company that wishes to go public and get listed has to go through a process called Initial Public Offering or an IPO. An IPO is a method by which a company issues its shares for the first time to the public via Primary Market. Before getting listed on the stock exchange, newly issued shares are first offered to both institutional as well as retail investors in the primary market. Major portion of the issue is reserved for the “big players” or institutional investors while a small portion of the issue is offered to retail investors.
The IPO process continues for a period of 3-7 days where both type of investors can bid their purchase order based on the price band of the shares. If the demand for the shares is high, the stock goes oversubscribed or else it goes undersubscribed. Also, the number of shares to be issued is decided by the investment banks based on the capital required to be raised by the company. These newly issued shares create the supply.
After the IPO process, the company decides a date on which it will list the stock on the stock exchange (NSE or BSE). Based on the popularity of the shares during IPO, it can open at a higher or lower price on the stock exchange on the listing date. A higher price opening can result in Listing Gains for the investors. When the stock gets listed, it enters the Secondary Market where actual trading takes place.
Now, investors can trade these shares with other investors on an Intra-day time frame (i.e. buying and selling the stock on the same day) or on a Delivery time frame (i.e. holding the shares for one or more days) based on their preferred style of trading. The two type of trading positions that can be taken by an investor are Long Position (Buy low – Sell high) or Short Position (Sell high – Buy low). Short selling or Shorting is generally done with derivatives instruments.
The change in price of stocks in the secondary market is driven by demand and supply. As we know, the number of shares outstanding in the market is limited to the shares issued during the IPO.
How does the demand of stocks increase or decrease?
Whenever there is some positive news about a company, or when investors have a positive outlook for its future prospects, the demand for the share increases resulting in an increase in the share price. A negative news or negative investor outlook, the opposite happens and brings down the price.
How does the supply of stocks increase of decrease?
The number of shares outstanding in the market can be increased in case company decides to go for an FPO, stock split or issuance of stock dividend.
- FPO: An FPO stands for Follow on Public Offer where a company issues additional shares to the public over and above what it had issued during an IPO. Generally, this process is conducted via private placement.
- STOCK-SPLIT: A stock-split generally happens when a company decides to make its shares more affordable to the public. A 3-for-1 stock-split, for example, means that for every 1 share that an investor holds, there will now be 3. If a person has 100 shares at the price of Rs.30 each, then after a 3-for-1 stock split, he will have 300 shares at the price of Rs 10 each. Therefore, the total market value of a person’s holding remains unchanged. However, now there are more shares available in the market and the shares are more affordable for the public to invest.
- BONUS SHARES: Bonus shares are additional shares given to the current shareholders of a company without any additional cost, based upon the number of shares that a shareholder owns. These are company’s accumulated earnings which are not given out in the form of dividends, but are converted into free shares. If a shareholder holds 100 shares at Rs 50 each, and companies issues 1:1 Bonus shares, he will get 100 more shares for free. So now, shareholder holds 200 shares at Rs 50 each, and the value of his shareholding has doubled, and also increased the number of shares available in the market.
Though the price change is driven by supply and demand, this movement is majorly impacted by the institutional investors like mutual funds, banks, hedge funds etc. as they have huge amount of funds, it is easier for them to dictate the direction in which the price will move. So, to prevent price manipulation and protect the retail investors, the stock exchange has imposed a price band bordered by an upper circuit and a lower circuit. Whenever the stock price hits an upper circuit or lower circuit, trading is suspended for the remainder of the session. This helps to prevent the sudden spike in the price that can be created by the institutional investors with huge capital which can be detrimental to the retail investors.
Not only stock price, even the Nifty Index itself has an upper and lower circuit, which if hit, results in suspension of trading for 45 minutes. While individual stocks routinely hit upper and lower circuits now and then, the Nifty index itself rarely does so.
However, earlier this year, Nifty hit the lower circuits, on 13th March 2020 and 23rd March 2020, which led to 45 minutes halt in trading. The last time Nifty had hit the circuit limit was in May 2009 when it had hit the upper circuit just after 2009 Lok Sabha results.
So with this article, I have tried to demystify the working of the stock market in the simplest terms possible from a beginner’s perspective. Hope it has helped you in understanding the basics about the stock market.
Please mention in the comments below if you would like me to write on any specific topics related to stock market, and I will write a post on it in the days to come.
Until next time, keep learning and keep growing.