How Does the Stock Market Work?

You may have heard that investing in stocks can be a great way to create wealth and it is certainly true. To earn inflation-beating returns most investors invest in equity markets.  However, for a beginner, the first thing that comes to their mind is what’s the mechanism behind the stock markets? If you're curious, here's a rundown on how does the stock market works? Let’s begin. Before we even talk about how the stock markets work, let us first understand how the stock markets came into existence?

History of The Stock Markets

In 1600 AD, The Dutch East Indian Company engaged hundreds of ships to trade in precious things such as Gold, Porcelain, Spices and Silks across the globe. But running this huge operation was not cheap. In order to fund their shipping expenses, the Dutch East Indian Company approached the citizens and individuals in the coffee houses. In exchange, they offered a share of the profits that the trip would make. This smart practice allowed the company to afford shipping to distant places and earn more profits for themselves and their savvy investors. From selling these shares in small coffee houses to shipping to ports across the continent.

The Dutch East Indian Company unknowingly invented the world’s first stock market. Since then, companies have been collecting funds from investors to support all kinds of businesses. Today, the stock market plays an important role in the growth of an economy. However, as time passed, the mechanism of the stock markets has drastically changed from how it was originally incarnated. So, now let us understand what is a stock market and how does the stock market function? 

What is the stock market?

The stock market is popularly known as ‘the share market’, ‘the equity market’ or ‘The Share Bazaar’. As the names suggest, a stock market is a marketplace where buyers and sellers meet to trade in stocks of publicly listed companies.

How does the Stock Market Work?

1. Primary Markets

Let us imagine a new company named ‘Delicious Sauces & Jams’. It decides to list on the market and raise capital for the first time. Hence the company would advertise itself to investors by means of an Initial Public Offering (IPO). The investors who think that the business could be profitable will buy the stocks of the company. Buying stocks of a company makes those investors partial owners of the business, they receive dividend and they get voting rights. Their investment helps the company to grow and to become more successful. 

Why do company issues share in the IPO?

• Grow and expand in new markets and countries
• Launch new products
• Branding and visibility
• Reduce Debt 

Why do investors buy stocks? 

• Participate in the growth of the company
• Earn regular income in the form of dividends
• Earn bonus shares to increase their shareholdings
• To acquire voting rights and be a part of key decisions.

2. Secondary Market

After a share is listed, it enters the secondary markets. Here, the share price fluctuates as per the demand and supply of the share. For example, notice the kids playing seesaw in the garden. If you observe closely, out of the two children sitting on the edges of the seesaw, the heavier child would always weigh the seesaw down. Similar to a seesaw, the stock markets have two edges,

• Demand 
• Supply

This seesaw of supply and demand is influenced by various factors. Companies are under the influence of market forces such as,

• The fluctuating price of raw materials
• Changes in production technology
• Changing labour costs… and a lot more

Because investors are worried about such changes they predict if the prices are going to go up or fall.

• If more people are selling a stock, the stock price will fall.
• If more people are buying a stock, the stock prices will rise.  

So, these demand and supply variables cause the day to day noise in the markets which causes the prices of shares to fluctuate. 

3. Financial Intermediaries

There are various intermediaries involved from buying a share till the time it reaches your Demat account. The intermediaries play a very important role in the execution of trades according to strict SEBI guidelines.  These ‘behind the scene’ intermediaries involve,

• The Regulator
• The Stock Exchange
• The Stock Broker
• Depository and Depository Participants
• Banks
• NSCCL and ICCL

The Regulator

In India, the stock markets regulator is called the Securities and exchange board of India (SEBI).  In general, the objectives of SEBI are,

• Protect the interest of investors.
• The Stock Exchanges, brokers and sub-brokers conduct their business fairly.
• Prevention of malpractices.
• The overall development of markets.

The Stock Exchange

Imagine a vegetable and fruit market place. Here, the vendors meet their potential customers and conduct the trade. Similarly, a stock exchange is a place that brings different parties together.

• The companies
• Shareholders
• Investors 

In India, we have two major stock exchanges. 

• National Stock Exchange (NSE)
• Bombay Stock Exchange (BSE) 

Did you know? BSE is India's & Asia's oldest stock exchange was started 140 years ago under a banyan tree!

The Stock Broker

The stockbroker is an important financial intermediary you need to approach before you start investing in stocks.  These stock brokers are registered with the stock exchange and hold a broking license. Your stockbroker is the gate through which you can enter the stock market. Firstly, you need to open a trading account with a broker of your choice. A trading account helps you carry buy and sell transactions in the stock market.  So for trading in the stock markets, you might need to interact with your broker. Here are a couple of different ways you can do it.

1. You can visit the stockbroker and ask him to place a trade on your behalf.
2. You can place an order on a call. The dealer would execute the trade and confirm the status while you are available on the call.
3. Placing the trades yourself using a trading platform provided by your broker. Once you log in to the trading terminal, you can view the live price and place orders yourself.

A stock broker would provide you with all the basic services you will need such as,

• Access to the trading application
• Provide margin to trade
• Call and trade facilities
• Issuing a contract note for transactions
• Provide you with back-office login
• Help you transfer funds easily between bank account and trading account.

Depository and Depository Participant

Let’s say if you visit a supermarket. At the counter, you pay the bill and collect the receipt. The receipt you collect assures you that the goods you just bought belong to you. Similarly, when you buy a share, the share certificate claims your ownership of the stock.  However, till the year 1996, the share certificates were available only in paper format. But today the share certificates are available in digital format and transferred to your Demat account. There are two depositories that offer Demat account services. 

• The National Securities Depository Limited (NSDL) and 
• Central Depository Services (India) Limited

There is no difference between the two as they both operate under strict SEBI regulations. As you cannot walk into the NSE office to open a trading account. Similarly, you cannot walk into the depository office to open a Demat account.

So, How do you open a Demat account?

To open a Demat account, you need to contact a Depository Participant (DP) like Samco.

Banks

Banks play a significant role in your trading journey. They help in fund transfer from your bank account to your trading account.  At Samco, you can link multiple bank accounts to your trading accounts to transfer funds and trade.

NSCCL and ICCL

National Security Clearing Corporation Ltd (NSCCL) and Indian Clearing Corporation Ltd (ICCL) are the subsidiaries of NSE and BSE. They help to settle the transactions you place while trading. Now you must be thinking, what happens when you place an order on your trading platform and how does stock trading works?

How Are Your Orders Processed?

Note:  It takes Trading day + 2 days for the shares to get deposited in your Demat account. For example, if you conduct a trade today, your shares will be deposited in your Demat account by the day after tomorrow (two working days). While this process might seem lengthy and complicated. But in reality, the order matching takes place in microseconds.  BSE is the fastest stock exchange in the world with a response time of 6 microseconds.

How is the market trend analysed?

The market trend is analyzed by a very simple strategy. It is done by observing a few major stocks among different industrial sectors.

• If the majority of selected stocks in the sector are moving up, means the market is moving up.
• If the majority of selected stocks in the sector are moving down, means the market is moving down.

So, to identify the trend of the markets the Stock Exchanges have come up with their indexes named as,

• S&P BSE Sensex representing the top 30 performing stocks of the Bombay stock exchange
• CNX Nifty representing the top 50 stocks of the National Stock exchange.

S&P stands for Standard and Poor’s. It is a global credit rating agency. S&P has the expertise in evaluating the index and BSE has owned this license. Hence the BSE index carries the S&P tag. CNX Nifty mentions the joint venture of the National Stock Exchange and CRISIL. Hence, the NSE index carries the tag ‘CNX’ which stands for CRISIL and NSE Index. Both the indexes, Nifty and Sensex gives us minute by minute information about how all the market participants perceive the future of the markets.  The movements in the Index reflect the changing expectations of the market participants. 

• When the index goes up, it is because the market participants think the future is prospering.
• When the index dips, it is because the market participants think the future is not favourable.

So we hope, the concept of ‘How does the stock markets work’ is clear to you. In India, a Demat and trading account is necessary if you want to enter the stock markets. Stock brokers like Samco provide you with a robust trading platform through which you can make profitable trades.  So, open a Demat account with Samco today and get access to a unique 3-in-1 Investment account.

• Demat account
• Trading account
• Mutual Fund investing account

Get started on a journey to create infinite wealth with Samco today!