Understanding basic concepts of Stock Market

By admin
Feb 2nd, 2012
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Understanding basic concepts of Stock MarketAll of us know what a stock is? Well, even if we do, the below information may help brush up our basics. A stock market basically provides for a meeting place for buyers and sellers. One can go to a stock market and buy shares of an ABC company from a seller who already holds shares of that company. The stock market helps the buyers and sellers agree mutually on a price.
There can be two types of market based on the source one is buying shares from.
  • If you want to buy shares of a company ABC, you don’t directly buy them from the company. You buy it from a seller who already owns some shares of ABC. This market is the secondary market. Now the question can be how does the owner already have these shares if you cannot buy them from the company itself?
  • The answer to the question is in the definition of primary market. In a primary market the company sells its share, which is nothing but in general terms ownership in the company, to the investors in an IPO (Initial Public Offering). This arranges for a secondary market, as now the shares are with some investors who can sell them to the interested buyers.
The most basic question from a beginner point of view could be, why does a company sells shares to the public? Suppose ABC, the company in our discussion, wants to expand its business, but does not have the capital to do so. In such a case ABC can raise the capital from the market by bringing an IPO and selling its shares to the investors. These shares then float in the secondary market and can change hands any number of times.
Next we move on to how a trader buys or sells. While trading (buying or selling of shares) one can book different types of orders. Few of them are listed below:
  • Market Order: This is the simplest of all. You tell your broker to buy or sell securities/shares on your behalf at the current market price of that security. Another point to note here is that one cannot trade directly in the market. He always has to go via a broker.
  • Limit Order: This order can be used to enter or exit the market. In a buy limit order you tell your broker the maximum price (which is below the current market price) you are willing to pay for a purchase. While in a sell limit order when you already have a position, you specify a minimum price (above current market price) that you are willing to accept for a sale. E.g. Suppose ABC is currently trading at Rs 155 per share. You want to buy 100 shares of ABC but think that it is too costly and you are willing to pay only Rs 152 per share. In such a case you can put a buy limit order to the broker who will execute your order as soon as the market price of ABC touches Rs 152 per share. Now if you are a seller and are not willing to sell below Rs 157 per share, you can put a sell limit order to wait for the time the price reaches to Rs 157 per share.
  • Stop Loss Order: This order is placed when you try to limit your loss over a security. Suppose you buy 10 shares of ABC at Rs 152 per share. In the worst case you don’t want to lose more than around 10%. You can put a stop loss order at a price of Rs 135 per share. If the price is going up,good for you, but in case it falls sharply, your order will be executed at the market price (a market order) as soon as the price reaches Rs 135 per share. This order can be used when you know you will not be able to monitor your stocks for quite a while. Now suppose the price rises to Rs 165 per share. In such a case you can change your stop loss price to Rs 160 per share, thus ensuring yourself a profit of Rs 8 per share. Now when the stop loss order is converted to a market order, it is filled against the best available price after a stop limit is reached, which in case of very volatile markets, could be significantly different from the the stop price.
  • Stop Limit Order: This is a combination of stop loss and limit order. As the stop price is reached, the order becomes a limit order instead of becoming a market order as in the case of stop loss. Suppose a stock is trading currently at Rs 100 per share. You want to buy the stock only when it starts showing signs of serious upward movement. You can put a stop limit order with a stop price of Rs 108 per share and a limit price of Rs 110 per share.
There are other types of order as well, but the most common types have been touched upon in the above section.
Let’s come back to the markets. There are different types of markets around the world. Markets can exist
  • Physically (real) or
  • Electronically (virtually).
In a physical market the buyers and sellers or the brokers are actually present at a common location. E.g. NYSE, New York Stock Exchange. While in case of an electronic market, trading is done electronically, over the internet. E.g. NASDAQ, National Association of Securities Dealers Automated Quotation. In a layman language the difference is pretty similar to the difference in going to a shop personally for the purchase or buying it online. Most of the markets these days are electronic markets.
Let’s now see what is the purpose of a stock market?
A stock market is the most important source of raising money for companies by selling ownership in the company to the investors. Some of the companies even participate in the secondary market of their own shares to increase the liquidity, which is the ease with which a security can be bought or sold.
Suppose ABC brings an IPO and sells its shares to the investors. Now the shares can only be traded in secondary market. Suppose there is no or very less number of buyers for these shares, the initial owners will not be able to sell off their shares easily. These shares are hence not liquid. This situation might also bring the price of the shares down as there is very less demand for these shares in the secondary market.
A stock market generally indicates the health of a country’s economy. If the stock market is going up the economy is considered to be a growing economy.
The other commonly used terms are Index and Exchange. What is an index? Is it same as the exchange? Many would say yes. But clearly this is not the case.
An index like Nifty or Sensex is different from NSE or BSE. NSE is an exchange where the stocks/shares of a company are listed, while Nifty is an index which captures share prices of 50 companies out of all companies that are listed on NSE. Similarly Sensex has 30 companies associated. Not any company can list on an exchange. There is a list of criteria for a company to fulfill before getting listed on any exchange. The criteria list can differ from exchange to exchange.
Now on an exchange shares are not the only security that is traded. Derivatives are also traded. On certain exchanges commodities like wheat, rice, soybeans, gold, silver etc can also be traded.
The exchange e.g. BSE (Bombay Stock Exchange) removes any counter party risk. This is possible because a buyer cannot directly go to a seller or vice versa. They have to go via an exchange. Hence the buyer never really knows who the seller is. The counter party for both buyers and sellers in this case is the exchange. There are other trades as well, which are not done on an exchange. They are called OTC trades or Over the Counter trades. We are not covering OTC trades here but one difference can be pointed out here that unlike exchange trades OTC trades are not standardized.
In the end let’s briefly talk about a trading strategy, short selling. What does it mean?

It basically means that you sell a security even without owning it, by borrowing it from somebody else, mostly your broker. When you do this you open a position in market. You hope to buy back the security, which is called covering your short position, at a lower price. So the basics behind short selling is that when you short sell, you expect the price of the security to fall, so that you can buy it back cheaply, thus making money in the process.

Well, these were a few basic terms used in the finance domain related to the stock market and a brief description about them. There are innumerable more, and we will try to cover others as well in the more posts to come.

5 Responses to “Understanding basic concepts of Stock Market”

  1. Judith says:

    Hi there, i really thank you for your help. We are planning to invest but we do not have any understanding of the meaning of concepts like close, high, low, daily move, dividend yield, PE, Day’s volume.

  2. Raj The Hero says:

    This is really good for beginners who like me don’t know a single word about share market.After reading this article I think that even that single word is hard to recollect as there is noting interesting in it to read. Any way those who really want to time pass like me sitting in office can avail this pleasure of reading this article.
    Thanks..
    (Anonymous)

  3. Chulbul Pandey says:

    This is really very interesting article i ever read in my life. The article is just like same as i wish in my dreams and my dream comes true!!!!
    The Basic concept of Stock market are so simple that i don’t understand a word of it but still it’s good to read.
    Really don’t want to but for formality THANKING YOU.

  4. The most basic concept of the stock market is the idea that each share of stock represents a small portion of ownership of a corporation.

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