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How Does the Stock Market Work?

by kraju

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For a new investor the stock market is baffling, which probably helps to explain why so many people lose money when they invest. In this article, International Finance Magazine explains the different aspects of the stock market. The stock market is a place where you can buy and sell shares of different companies. New investors think the stock market as a short term investment vehicle where you can reap huge profit or heavy losses; however, this is not true. An in-depth understanding of the stock exchange market will help you make better and invest wisely. Let us begin with the basics:

A share of stock is literally a share in the company; academicians define shares as “A share is a share in the share capital of a company”. When you buy a share you are entitled to a small fraction of the assets and earnings of the company. Assets include everything the company owns including Building, Furniture, Fixtures, Cash etc and earnings are the revenue the company earns through selling its products or services. A company would need to share its assets and earnings with the public because it needs to raise capital, companies can raise capital through two ways to start their businesses or for diversification and expansion, the first one is through debt financing or equity financing. The disadvantage of raising money through loans and advances is the company has to pay interest on the borrowing which is a constraint in the longer run. By selling stocks, the company can raise capital with fewer obligations. Equity financing is better suited to companies because it distributes the risks of doing business among a large pool of investors. If the company falters, the promoters don’t lose all the money as the loss is borne by the shareholders of the company. The stock exchange operates at two different markets: Firstly, it is a market for the issuers who wish to raise equity capital by offering shares for sale to investors in an Initial Public Offering (IPO), this is also known as a new issue and the point where a company decides to ‘float’ on the stock exchange or where an existing company is looking to raise additional funds by issuing further shares. It is also a market for investors who can buy and sell shares at anytime, without directly affecting the entities in which they are buying the shares (for e.g. a secondary market). As a retail investor, you cannot buy or sell shares directly on a stock exchange such as London Stock Exchange, you have to place your orders through a stock exchange member firm, such Barclays stockbrokers who will then execute the order on your behalf. This process will require the retail investor to open a trading account, to be listed on the stock exchange a stock must meet the listing requirements laid down by that exchange in its approval process. It is also possible for a stock to be listed on more than two exchanges which will give more liquidity as dual listing on stock exchanges in different time zones will increase the hours during which you can trade the stock. Stock Exchanges use remarkable and highly reliable computer systems to handle the exchanges of stocks between buyers and sellers and to set opening and closing prices. For example, the NASDAQ has three separate components;

Interface: A place where broker dealers and market makers can gain access to the system.

Matching engine: A computer that connects sellers and buyers when their prices match

Quote services: Data feeding the buy and sell quotes that NASDAQ provides

In the United States, there are three main exchanges on which stocks are traded, the New York Stock Exchange, NASDAQ (National Association of Stock Dealers Automated Quotations), and the AMEX (American Stock Exchange). Most other countries have their own exchanges, in Japan it’s the TSE (Tokyo Stock Exchange), DAX in Germany and SENSEX in India, these are the markets where only stocks are traded. There are other markets such as the commodities market where oil and gold are traded. There also markets for bonds and currencies and sub-markets within all these markets.

Stock Averages

The Dow Jones Industrial Average, S&P 500, and the NASDAQ composite index are the broad market averages designed to give you a general idea of how companies traded in the stock exchange are doing. Dow Jones Average is the sum of value of thirty large American stocks including Exxon-Mobile, General Motors which makes up the index. The Standard and Poor (S&P) index is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market. These averages suggest the general health of the stock prices as a whole. If the economy is doing well, then the prices of the stocks rise en masse in what is known as bull market. If the stocks are not performing well, with falling prices it is called a bear market.

Why do Stock Prices Fluctuate?

Stock prices are not fixed, they tend to fluctuate from the second it is sold to the public, its price will rise and fall primarily because of changes in supply and demand, however, there are many reasons for a stock to fluctuate. An insider who holds significant stock, may want to diversity his overall portfolio and thus need to sell a large amount of stock, this will increase supply and likely to reduce the prices of the stock. Many investors watch insider selling to ascertain the health of the company. There are many things that may be considered news which is material to a certain company and its stock. Stock prices of a company fluctuate not only on the basis of financial performance of the company but also on the news related to its competitors, news about the economy, natural calamities and other factors which effects the economy of the country. An expert says “A very large portion of trades are from computer programs trained to make trades when certain apparent patterns are observed. Since these programs are not all designed in the same way, much of the supply and demand is a result of different algorithms with different “opinions” on what the stock is doing”.

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