Stock Market-How It Works?

Last Updated on January 24, 2023

All of us have heard once in our life a term stock market, but only few actually have in-depth knowledge of what the stock market actually is and how it works,?

Stock Market Meaning

A stock market is a market where stocks of the companies’ are traded. It is not actually a physical market where one person visits and buy or sell goods in exchange for money. The trade of scrips/shares is done through an electronic medium between traders’, brokers and companies’.

Stock market are of two types i.e. primary market and secondary market. There is also an unofficial type which is known as a grey market.

In past times companies’ stocks or share certificates were issued in physical form. The value of the share purchased, company name, detail of broker, date and time, share face value, company’s address, and all mandatory details was printed on the certificates.

After digitalization and technological advancement the method of stock trading change significantly. Nowadays, the exchange of stocks is done in non-physical form through electronic media.

For the purpose of trading in stocks, a dematerialization account and a trading account have to be open via broker/brokerage firms. All the traded stocks are settle in the digital form and stored in the demat account of the holder.

The Euronext Amsterdam is considered the world’s first stock exchange and the first company listed on the stock exchange was Dutch East India company.

The value of a company’s share is determined by the fluctuation in price due to supply and demand, market sentiments and other factors.

A stock market is comprise of stock exchanges, depositories, brokers, corporates or companies, traders, Primary market, investors’, regulatory bodies, financial products, and clearinghouses.

Definitions

1. Primary market

It is the initial market where public companies offer their stocks for sale for the first time. The companies decide how much portion of the stocks they want to offer and each share of a company has a face value.

A price band or a fixed price is determined by the companies on which they wanted to offer its shares. The term for the offer of the company’s shares is called “initial public offering or IPO“. If the companies wanted to offer more stocks then they have go through a “follow-on public offer or FPO”.

2. Stock Exchanges

It is also called as a secondary market for trading securities. A stock exchange is a place where the stocks of public companies are traded after an IPO. Companies have to list their stocks on the recognized stock exchanges for further trading.

These exchanges facilitate the trade of securities through electronic transfer of stocks in the Demat account of the traders and investors.

The stock exchange charge a minimal amount from the brokerage firm/broker on every trade done by the traders who are registered with the brokers.

On stock exchanges, huge number of companies’ stocks are traded every single day. The exchanges provide facilities for intraday trades and cash-&-carry trades.

The stock exchanges provide platform for trading of securities such as bonds, derivatives, ETF, and mutual funds along with stocks. The exchanges are major part of the stock market.

3. Corporates/Companies

Companies and corporates are the organizations that performs business activities. These are public companies that offer stocks for the purpose of raising capital and these stocks later list on stock exchanges for further trade. The stock exchanges provide a platform for companies to trade their shares in the stock market.

4. Brokers

These are the persons or brokerage firms who are registered as brokers in the stock market. The brokers execute trades on the behalf of their clients and charge fees or commission for the services. They are also known as stockbrokers. They include full-service brokers and discount brokerage/firms.

They also function as depository participants. A broker facilitate the opening of the Demat account of the client. To provide Demat account facility they have tie-ups with the depositories. Services offer are leverage trading, trade records, trade recommendations, advisory services, and many more.

5. Depositories

These are the institutions that hold shares, bonds, mutual funds, debentures, or any other type of securities in dematerialized form in their accounts. Like banks and financial institutions hold money in bank accounts, similarly depositories hold financial securities in electronic form. Depositories charge fees for each transaction made through Demat account and maintenance of securities.

6. Traders

They are individuals or firms who perform trade in the stock market. Traders do the exchange of shares through buying and selling and earns from these transactions. The stock exchanges provide facilities for trading in securities during the trading hours in a working day.

7. Investors

They are individuals, firms or institutions who buy stocks for the purpose of investment. Stocks of companies also acts as an investment avenue and help in wealth creation. Investors buy stocks and hold the position for days or months and get benefit from the value appreciation by selling those stocks or get dividend as an income.

8. Financial Products

It include shares/stocks, mutual funds, options, futures, exchange-traded funds, index funds, bonds, debentures, T-bills and other financial products allowed to be traded on stock exchanges.

These financial products function as a mean for both income generation and wealth creation for individuals, firms, institutions and investors’.

9. Clearing Houses

As its name depicts the clearings houses validates the buying and selling transactions between buyers and sellers of stocks. They clear the settlement of stocks, other securities and funds between the parties of trade i.e. buyers, sellers, banks, brokers.

The clearing houses take the opposite position in trade i.e. in the case of multiple buyers the clearing house act as a seller in multiple trades that reduce the risk of defaults by the parties and the cost of transactions also gets low. Margin requirement is being imposed on traders to avoid the risk of defaults.

10. Regulatory Bodies

It is an institution specially created to regulate, provide guidelines, and to promote the entity. In countries where stock market exists, there is a regulatory or governing body present.

These regulatory body makes sure that the stock market trade practices are performed in a fair manner and according to the norms specified.

It watches over any malpractices performed and provide a grievance redressal platform to the traders’ and protect investors from any misconduct from any party who are the part of stock market trading.

It also promote and perform awareness programs for the development about the stock market. Generally, it is any government body that is formed by the government of the countries for the purpose of regulating trade practices on capital markets.

How Stock Market Works?

Companies list their stocks on the stock exchanges. The owners’ of the companies convert a particular percentage of ownership into a number of shares and offer it for sale. These are public companies which are allow to trade their stocks in the open market.

Example: Let say, four-person started a partnership company ZYXI. Each of the partner has proportionate percentage of ownership according to the capital they invested in the company. They decide to make company’s expansion and for that purpose they need more capital.

The method chosen is to raise capital by issuing shares to the public through an IPO. A certain percentage of ownership; for example out of 100% ownership say,30% is converted into the number of shares through which capital is being raised. Each share has a value which has to be paid to own it.

So, basically, when someone purchases a share of the company, that person is actually purchasing an ownership in the following company.

Companies offer their stocks for sale in the primary market through the process of an IPO. A prospectus of the company is prepared which contains the details regarding the issue offer, dates of issue, number of shares, price of a share, company information, and details of the participants who are managing the IPO.

The investors can apply for the IPO offline by filling a physical form and submit it to banks or through an online process, as many banks and brokerage firms provide the facility to submit application online for an IPO.

The stocks issued through IPO process then listed by the issuing company on the stock exchanges for further trading in the market. It is a vast platform as huge volumes of shares are traded here and large number of traders are conducting trade of the stocks.

According to the demand and supply, the market value of companies’ shares listed on stock exchanges fluctuates in upward and downward direction. There are also various other factors that affect the price of a share. Traders and investors put bid to buy or sell stocks through their broker account in the stock exchange.

The brokers or brokerage firms have their accounts registered with the stock exchanges. They open Demat account of their clients and provide them a unique code to identify them.

Traders’ cannot trade directly on the stock exchanges, instead the brokers do the bidding on behalf of their clients. Brokers are the middle man between their clients and the stock exchanges.

As now the stock trading is performed online through electronic media the trouble of going through loads of formalities and paperwork is reduced.

Clients put buying or selling orders of the shares from their Demat account and the brokers convey those orders to the stock exchanges. Then the stock exchanges process and execute that order by finding a suitable order for the same.

Example 1: Sam put an order to purchase 100 units of shares of company ABC at Rs.100 through its trading account. Now, Sam’s broker conveys that order on behalf of Sam to the stock exchange. The stock exchange accepts the order and puts that order in the queue until an equivalent opposite order to sell at Rs.100 is matched.

Sara another person wants to sell 100 units of shares of the same company ABC at Rs.100. She put a selling order through its trading account and her order conveys to the stock exchange by her broker. The stock exchange then accepts the order and search for the buy order for the same.

As soon as both the orders match, the stock exchange executes the orders. After verifying all the details, the stock exchange perform settlement of the shares in the respective Demat account of the traders.

The settlement of 100 units of shares takes trading plus two days i.e. T+2 days which is called rolling settlement. After T+2 days, 100 units of shares of company ABC debit from Sara’s Demat account and credit in Sam’s Demat account at Rs.100 per share. The depositories hold shares in the name of Sam until the next trade perform by him.

For Sara, after deducting broker commission, taxes, stamp duty, and depository charges, the amount of sale proceed will credit to Sara’s account.

The stock exchanges along-with providing a platform for buy and sell of stocks also provide various other facilities like major stock exchanges introduce their own market index. These indexes are formed by the accumulation of companies with different market capitalization and their share price.

Different stock exchanges have their own method of calculation for index rate. These rates are treated as a benchmark for assessing the performance of the index and of the stock market.

Example: “Sensex” of Bombay stock exchange (BSE) in India is a market index consist of 30 largest financially sound companies and their stocks. According to BSE’s prescribe criteria, a benchmark rate is set. This rate is used to assess the volatility of the 30 selected companies’ stocks.

Investors and traders follow these benchmark indexes to analyze the stock market. Accordingly, they select the buy or sell position in the stock market.

Stocks can also be traded via over the counter (OTC) market. It is a market where two parties enter into a trade contract directly without the intervention of the stock exchanges. The dealers of stocks and other financial instruments deal with the buyer or seller of the stock and execute the trade.

Over the counter is not standardized like the stock exchanges, so there is not much liquidity and trade transparency. The parties involve in trade might also face the risk of default by either party.

Stocks are consider as the riskiest investment avenue as the stock markets are highly volatile. Without proper knowledge and research one may result in losing all funds invested in stock market. But, also the highest return is gain from these volatile securities.

All the participants whether the investors’, regulatory bodies, brokers, stock exchanges or any other party participate in the providing services related to stocks and related securities are together form a market known as a stock market.