Investing in stocks is a proven way to build wealth and secure your financial future. In the last few years, the number of investors has grown steadily in te Indian stock market. People have become more aware of how to invest in stocks directly, and modern-day brokers are also helping in the process by sharing investing tips and stock market knowledge that will create a generation of informed investors.
Understanding how the stock market works is the first step to start as an investor.
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. Secondary markets allow investors to buy and sell shares issued during the initial public offering (IPO).
Few simple points to know about how the Stock Market works:
Working of the Stock Market
Before you learn the basics of trade, it is essential to know about how does stock market work? Here is its working explained in detail:
The Stock Exchange Board of India (SEBI), stock exchanges, brokers, and traders/investors
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 oversee the Indian stock market functions orderly, without hiccups. The board is responsible for maintaining market transparency and integrity so that general investors can invest without worries. Exchange, 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. And 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.
Primary market: In simple terms, the primary market is the place where companies list themselves for the first time in the exchange to become publicly traded companies.
Companies need to borrow from the market to finance their business plans. One way to do that is by selling partial ownership of the company to general shareholders, requiring issuing an IPO or initial public offering.
When companies issue shares for the first time, they get listed in the primary market. We have discussed how to apply for IPO in the section below.
Secondary market: Theoretically, the secondary market is the destination where traders buy and sell equities. Once listed, company stocks become available for trading in the stock exchange, where the price movement happens based on changes in the supply and demand factors. Traders are the primary participants in the secondary market, and so are investors. It is the trading platform where buyers and sellers meet directly.
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.
Understanding the pricing mechanism in the stock market
The price of stocks in the market is driven by demand and supply factors. When there are more interested buyers, the price of the share appreciates. Similarly, the price decreases with the decrease in demand. One tip to make money in the stock market is to determine the correct value of the stocks. It requires calculating the fair value of the share. Or you will end up purchasing overpriced stocks.
Company’s share price depends partially on its market capitalisation value, which is the total of company’s stock price multiplied by the number of outstanding stocks. Since a change in stock price affects a company’s market cap, it ends up altering your return from the investment.
The share price is the outcome of the changes in demand and supply factors. 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.
How does the stock market work?
Now let’s begin our understanding of how the stock market works. Much like any other market, the stock market is a platform where buyers and sellers come together to negotiate prices and make trades.
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 exchange 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. Indices move upward or downward depending on the performance of underlying stocks, and 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 bid price and seller needs to reduce 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. This document comprises information about the company—shares being diluted, price band, and other details. 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. This platform is a medium offered for the initial investors to exit their share market investments. In addition, investors who failed to receive allotment during the IPO are given the opportunity to buy shares on the secondary market.
Broking agencies (registered with SEBI and the stock exchange) are intermediaries between the investors and the Indian stock market. 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. A confirmation is received from the stock exchange and sent to both the buyer and seller.
Historically, this procedure was manual and thus time-consuming and cumbersome. However, with online trading platforms, the entire procedure of matching buyers and sellers is done through the internet. This has reduced the transaction time to a few minutes.
Nonetheless, there are thousands of potential investors and converging all of them in one location is impossible. Stock exchanges and broking agencies play a crucial role in this situation.
This occurs when an order is placed by brokers on behalf of their clients on the exchange where it is processed. There are several parties involved in the entire processing. When buyers and sellers are matched, the stock exchange sends a confirmation to both parties to avoid defaults. The executed trades are settled, which is the process where the buyer receives the shares and sellers receive their funds. The Indian stock market adopts the T+2 settlements, where the settlement occurs within two working days from the day of the transaction.
Following the stock market basics and understanding how it works will help make investing profitable and prevent investors from taking unnecessary risks.
However, to begin investing in stocks, you will need a Demat account and a trading account. a Demat or dematerialised account is essential to receive delivery of stocks or any form of investment. Nowadays, the process has become quick and smart with online account opening. Select a reputed broker in the market and complete the online account opening process for your first Demat.