Stock Market
WHATS THE FIRST THING WHICH COMES TO YOUR MIND HEARING THE WORD "STOCK MARKET" ?
1. Most people I talk to say, some person they know had put his money in the market and lost all of
it, and people blindly believe that and have a negative image about the market.
2. People who say they lost their money in it was probably their own fault, people blindly gamble
and at the end blame the market.
3. The truth is Indian stock market has so much potential that people can leave their day jobs and
start trading full time.
Basics :
What is a Stock ?
You’ve probably heard a popular definition of what a stock is: “A stock is a share in the ownership of
a company. Stock represents a claim on the company's assets and earnings. As you acquire more
stock, your ownership stake in the company becomes greater.” Unfortunately, this definition is
incorrect in some key ways.
To start with, stock holders do not own corporations; they own shares issued by corporations. But
corporations are a special type of organization because the law treats them as legal persons. In other
words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a
corporation is a “person” means that the corporation owns its own assets. A corporate office full of
chairs and tables belong to the corporation, and not to the shareholders.
This distinction is important because corporate property is legally separated from the property of
shareholders, which limits the liability of both the corporation and the shareholder. If the
corporation goes bankrupt, a judge may order all of its assets sold – but your personal assets are not
at risk. The court cannot even force you to sell your shares, although the value of your shares will
have fallen drastically. Likewise, if a major shareholder goes bankrupt, she cannot sell the company’s
assets to pay off her creditors.
What shareholders own are shares issued by the corporation; and the corporation owns the assets.
So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that
company; it is instead correct to state that you own 100% of one-third of the company’s shares.
Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out
with a chair because the corporation owns that chair, not the shareholder. This is known as the
“separation
So what good are shares, then, if they aren’t actually the ownership rights we think they are?
Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the
company’s profits) if and when they are distributed, and it gives you the right to sell your shares to
somebody else.
If you own a majority of shares, your voting power increases so that you can indirectly control the
direction of a company by appointing its board of directors. This becomes most apparent when one
company buys another: the acquiring company doesn’t go around buying up the building, the chairs,
the employees; it buys up all the shares. The board of directors is responsible for increasing the
value of the corporation, and often does so by hiring professional managers, or officers, such as
the Chief Executive Officer, or CEO.
For ordinary shareholders, not being able to manage the company isn't such a big deal. The
importance of being a shareholder is that you are entitled to a portion of the company's profits,
which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the
portion of the profits you get. Many stocks, however, do not pay out dividends, and instead reinvest
profits back into growing the company. These retained earnings, however, are still reflected in the
value of a stock.
Stocks – sometimes referred to as equity or equities – are issued by companies to raise capital in
order to grow the business or undertake new projects. There are important distinctions between
whether somebody buys shares directly from the company when it issues them (in the primary
market) or from another shareholder (on the secondary market). When the corporation issues
shares, it does so in return for money.
Companies can instead raise money through borrowing, either directly as a loan from a bank, or by
issuing debt, known as bonds. Bonds are fundamentally different from stocks in a number of ways.
First, bondholders are creditors to the corporation, and are entitled to interest as well as repayment
of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy
and will be made whole first if a company is forced to sell assets in order to repay them.
Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the
dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments that
bonds.
The same is true on the upside: bondholders are only entitled to receive the return given by the
interest rate agreed upon by the bond, while shareholders can enjoy returns generated by increasing
profits, theoretically to infinity. The greater risk attributed to stocks has generally been rewarded by
the market. Stocks have historically returned around 8-10% annualized, while bonds return 5-7%.
Types of Stocks
When a company is first founded, the only shareholders are the co-founders and early investors. For
example, if a startup has two founders and one investor, each may own one-third of the company’s
shares. As the company grows and needs more capital to expand, it may issue more of its shares to
other investors, so that the original founders may end up with a substantially lower percentage of
shares than they started with. During this stage, the company and its shares are considered private.
In most cases, private shares are not easily exchanged, and the number of shareholders is typically
small.
As the company continues to grow, however, there often comes a point where early investors
become eager to sell their shares and monetize the profits of their early investments. At the same
time, the company itself may need more investment than the small number of private investors can
offer. At this point, the company considers an initial public offering, or IPO, transforming it from a
private to a public company.
Aside from the private/public distinction, there are two types of stock that companies can
issue: common stock and preferred shares.
Common Stock
When people talk about stocks they are usually referring to common stock. In fact, the great
majority of stock is issued is in this form. Common shares represent a claim on profits (dividends)
and confer voting rights. Investors most often get one vote per share-owned to elect board
members who oversee the major decisions made by management.
Over the long term, common stock, by means of capital growth, has tended to yield higher returns
than corporate bonds. This higher return comes at a cost, however, since common stocks entail the
most risk including the potential to lose the entire amount invested if a company goes out of
business. If a company goes bankrupt and liquidates, the common shareholders will not receive
money until the creditors, bondholders and preferred shareholders are paid.
Preferred Stock
Preferred stock functions similarly to bonds, and usually doesn't come with the voting rights (this
may vary depending on the company, but in many cases preferred shareholders do not have any
voting rights). With preferred shares, investors are usually guaranteed a fixed dividend in perpetuity.
This is different from common stock which has variable dividends that are declared by the board of
directors and never guaranteed. In fact, many companies do not pay out dividends to common stock
at all.
Another advantage is that in the event of liquidation, preferred shareholders are paid off before the
common shareholder (but still after debt holders and other creditors). Preferred stock may also be
“callable,” meaning that the company has the option to re-purchase the shares from preferred
shareholders at any time for any reason (usually for a premium). An intuitive way to think of these
kinds of shares is to see them as being somewhat in between bonds and common shares.
Common and preferred are the two main forms of stock; however, it's also possible for companies to
customize different classes of stock to fit the needs of their investors. The most common reason for
creating share classes is for the company to keep voting power concentrated with a certain group.
Therefore, different classes of shares are given different voting rights. For example, one class of
shares would be held by a select group who are given perhaps ten votes per share while a second
class would be issued to the majority of investors who are given just one vote per share. When there
is more than one class of stock, the classes are traditionally designated as Class A and Class B, etc..
For example, billionaire Warren Buffett’s company Berkshire Hathaway has two classes of stock,
represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or
"BRK.A, BRK.B".
How Stocks Trade :
We saw in the last section that once a company completes an initial public offering (IPO), its shares
become public and can be traded on a stock market. Stock markets are venues where buyers and
sellers of shares meet and decide on a price to trade. Some exchanges are physical locations where
transactions are carried out on a trading floor, but increasingly the stock exchanges are virtual,
composed of networks of computers where trades are made and recorded electronically.
Stock markets are secondary markets, where existing owners of shares can transact with potential
buyers. It is important to understand that the corporations listed on stock markets do not buy and
sell their own shares on a regular basis (companies may engage in stock buybacks or issue new
shares, but these are not day-to-day operations and often occur outside of the framework of an
exchange). So when you buy a share of stock on the stock market, you are not buying it from the
company, you are buying it from some other existing shareholder. Likewise, when you sell your
shares, you do not sell them back to the company – rather you sell them to some other investor.
The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities or
trading hubs such as Antwerp, Amsterdam, and London. These early stock exchanges, however,
were more akin to bond exchanges as the small number of companies did not issue equity. In fact,
most early corporations were considered semi-public organizations since they had to be chartered
by their government in order to conduct business.
In the late 18th century, stock markets began appearing in America, notably the New York Stock
Exchange (NYSE), which allowed for equity shares to trade (the honor of the first stock exchange in
America goes to the Philadelphia Stock Exchange [PHLX], which still exists today). The NYSE was
founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers
and merchants. Prior to this official incorporation, traders and brokers would meet unofficially under
a buttonwood tree on Wall Street to buy and sell shares.
The advent of modern stock markets ushered in an age of regulation and professionalization that
now ensures buyers and sellers of shares can trust that their transactions will go through at fair
prices and within a reasonable period of time. Today, there are many stock exchanges in the U.S.
and throughout the world, many of which are linked together electronically. This in turn means
markets are more efficient and more liquid.
There also exists a number of loosely regulated over-the-counter exchanges, sometimes known
as bulletin boards, that go by the acronym OTCBB. OTCBB shares tend to be more risky since they list
companies that fail to meet the more strict listing criteria of bigger exchanges. For example, larger
exchanges may require that a company has been in operation for a certain amount of time before
being listed, and that it meets certain conditions regarding company value and profitability. In most
developed countries, stock exchanges are self-regulatory organizations (SROs), non-governmental
organizations that have the power to create and enforce industry regulations and standards. The
priority for stock exchanges is to protect investors through the establishment of rules that promote
ethics and equality. Examples of such SRO’s in the U.S. include individual stock exchanges, as well as
the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority
(FINRA).
The prices of shares on a stock market can be set in a number of ways, but most the most common
way is through an auction process where buyers and sellers place bids and offers to buy or sell.
A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which
somebody wishes to sell. When the bid and ask coincide, a trade is made.
Some stock markets rely on professional traders to maintain continuous bids and offers since a
motivated buyer or seller may not find each other at any given moment. These are known
as specialists or market makers. A two-sided market consists of the bid and the offer, and
the spread is the difference in price between the bid and the offer. The more narrow the price
spread and the larger size of the bids and offers (the amount of shares on each side), the greater the
liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially higher and
lower prices, the market is said to have good depth. Stock markets of high quality generally tend to
have small bid-ask spreads, high liquidity, and good depth. Likewise, individual stocks of high quality,
large companies tend to have the same characteristics.
In addition to individual stocks, many investors are concerned with stock indices (also called
indexes). Indices represent aggregated prices of a number of different stocks, and the movement of
an index is the net effect of the movements of each individual component. When people talk about
the stock market, they often are actually referring to one of the major indices such as the Dow Jones
Industrial Average (DJIA) or the S&P 500.
The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting
scheme and that it only consists of 30 stocks – when there are many thousand to choose from – it is
not really a good indicator of how the stock market is doing. The S&P 500 is a market cap-weighted
index of the 500 largest companies in the U.S., and is a much more valid indicator. Indices can be
broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market
sector. Investors can trade indices indirectly via futures markets, or via exchange traded funds
(ETFs), which trade like stocks on stock exchanges.
In india the stocks are traded in the BSE ( Bombay Stock Exchange ) and the NSE (National Stock
Exchange ) the difference in both being the Capital of the company
Types of Trade :
In this section, we discuss the practical matter of going about buying and selling shares of stock.
Individuals typically buy and sell shares by using a licensed brokerage firm or broker who makes the
actual trade. Historically, stockbrokers were hired only by wealthy individuals and families, but today
a wide range of brokerages exist for all price ranges. So-called “full-service” brokers offer a suite of
research, opinion, and expert advice and can offer a personal relationship between the broker and
the client. For more budget conscious clients, discount brokerages exist that offer a much more
bare-bones service offering, in some cases simply executing purchases and sales. Over the past two
decades, electronic trading has grown significantly, with many online brokerages offering both
research and opinion as well as trades at low prices, some asking as little as $5 or less per trade
in commission.
Regardless of the type of brokerage used, the mechanics of buying or selling shares is fairly uniform.
First, a stock quote is obtained. In the early days of stock exchanges, price information was
transmitted via tickertape – a long ribbon of paper that printed basic data via telegraph wire. That is
why today we still refer to stock quotes as the ticker.
A stock quote carries a lot of information including the current bid and offer (sometimes called the
ask) prices as well as the last price that traded. The bid is the highest price that somebody in the
market is willing to pay at a given time, while the offer is the lowest price that somebody is willing to
sell. If you are interested in buying shares, you will make a bid, and if you want to sell an offer. When
the price of a bid and offer coincide, a trade is effected.
In addition to this price information, data on trading volume (number of shares traded) is often
included. Stock quotes obtained online are often real-time quotes that confer second-by-second
details, and online quotes also often include charts and interactive tools. Stocks are quoted by their
ticker symbol, represented by between one and four capital letters, which are often loosely
representative of the company name. For example the ticker symbol for Microsoft Corp. is MSFT,
Caterpillar Inc. is CAT, and Apple Inc. is AAPL.
Market Orders and Limit Orders
Next, the type of trade has to be determined. A market order is simply an order that instructs the
broker (or online trading platform) to buy or sell shares at the best available price. If you wanted to
buy 100 shares of AAPL at market, and the quote shows: Bid: $139.80 (100), Offer: $140.00 (50),
Last: $139.95 (250). This tells us that the last trade was 250 shares at $139.50 and it indicates 50
shares are offered at $140.00. Suppose another 200 are offered at $140.05. Your market order
would buy the 50 shares at $140.00 and then purchase 50 more at the next best price at $140.05.
A market order does not guarantee the price you will get, but it does guarantee that you will get the
number of shares that you want, in this case 100. When an order is completed, it is said to be filled.
A market order is most often used in cases where the buyer or seller is most concerned with filling
the size of the order and not concerned with the price. A limit order specifies the price at which you
want to trade. For example, you may specify that you want to buy AAPL for $140.00 but no more, in
which case you would buy the 50 shares offered at $140.00 and then wait for some other seller to
come down to your price. Until that happens, the new quote would be Bid: $140.00 (50), Offer:
$140.05 (200), Last: $140.00 (50).
A limit order can also be designated all-or-none (AON), meaning that you won’t agree to buy your
shares unless you can get all 100 that you want. If the original limit order in this example were AON,
you would not buy the 50 that are offered until another 50 came along. Limit orders are used by
those who are primarily concerned with the price they want to receive, but they are not guaranteed
that the size of their order will be filled. Price versus getting filled on the size of your order are the
primary trade-offs between market and limit orders.
Stop Orders
Stop orders are contingent on a certain price level being attained to activate the trade. With a stop
order, your trade will be executed only when the security you want to buy or sell reaches a
particular price (the stop price). Once the stock has reached this price, a stop order essentially
becomes a market order and is filled. For instance, if you own stock ABC, which currently trades at
$20, and you place a stop order to sell it at $15, your order will only be filled once stock ABC drops
below $15. Also known as a stop-loss order, this allows you to limit your losses.
This type of order can also be used to guarantee profits. For example, assume that you bought stock
XYZ at $10 per share and now the stock is trading at $20 per share. Placing a stop order at $15 will
guarantee profits of approximately $5 per share, depending on how quickly the market order can be
filled. Stop orders are particularly advantageous to investors who are unable to monitor their stocks
for a period of time, and brokerages may even set these stop orders for no charge.
One disadvantage of the stop order is that the order is not guaranteed to be filled at the preferred
price the investor states. Once the stop order has been triggered, it turns into a market order, which
is filled at the best possible price. This price may be lower than the price specified by the stop order.
Moreover, investors must be conscientious about where they set a stop order. It may be unfavorable
if it is activated by a short-term fluctuation in the stock's price. For example, if stock ABC is relatively
volatile and fluctuates by 15% on a weekly basis, a stop-loss set at 10% below the current price may
result in the order being triggered at an inopportune or premature time.
Other Kinds of Orders
Orders may also be tagged with instructions regarding how long an order is good for. An immediate-
or-cancel (IOC) order is cancelled if the order isn’t executed right away. This is typically used in
conjunction with a limit order. When an IOC order is combined with an AON order, it is
designated fill-or-kill (FOK). A day order is a limit or stop order that is cancelled at the end of the
trading day, and will not be active the next morning. A good-til-canceled (GTC) order is active until
the instruction is given to cancel it, and may remain active for many days at a time or longer.
Margin Trading and Short Selling
In addition to the mechanics described above, many brokerages offer margin trading, allowing their
customers to borrow money to buy shares in excess of the amount of cash in their
account. Margin also allows for short selling, which is where a market participant borrows shares
they do not own in order to sell them with the hope of buying them back in the future at
a lower price. A short seller is betting that the price of a stock will go down, rather than up.
In addition to using a brokerage, there are two less common ways to own shares: dividend
reinvestment plans (DRIPs) and direct investment plans (DIPs). DIPs are plans by which individual
companies, for a minimal cost, allow shareholders to purchase stock directly from the company.
DRIPs are where the dividends paid by shares are automatically used to purchase more of those
shares (including fractions of a share)
