How Do Stocks and the Stock Markets Work?

How Do Stocks
and the Stock
Markets Work?

Even during the pandemic, stock trading did not rest. In fact, the popularity of stock trading increased, with the total value of equity trading worldwide reaching $32.5 trillion in the first three months of 2020. As at November 30, the US stock index S&P 500 had gained 12.62% for the year. If this sounds incredible, the tech-laden Nasdaq 100 had surged more than 40%. This wasn’t the case only in the United States, with Japan’s Nikkei 225 adding 12.63%, the Shanghai Composite Index spiking 11.74% and Germany’s DAX 30 rising 0.64% during the same timeframe.

To the naked eye the popularity of stock trading is apparent but there is more to it. To appreciate its popularity, it is essential to explore how the stock market works and some of its unique features.

What are Stocks?

A stock represents the ownership of a publicly traded company. While its complete equity is known as “stock,” a unit of this equity is called a share. As the name indicates, the ownership of a share makes you a part owner or shareholder of a publicly traded company.

The portion of the public company that a person owns will depend on the total number of shares issued and the size of an individual's position, i.e. number of shares of stock. Stock trading is carried out through a stock exchange. With the advent of online trading, most traders buy and sell stocks via an online broker.

What are the
Different Types of

Publicly traded stocks can be of several types, the most frequently traded
being common stocks and preferred stocks.

Common Stocks

This category of stocks comes with ownership rights, which means that the stockholder is not only entitled to any appreciation in the price but also gets the right to vote at the company’s shareholder events. Moreover, companies that are performing well reward their shareholders through dividend pay-outs.

Preferred Stocks

This type of stocks provides part ownership of the company to their holders. These shares get a preference over common stocks in the company’s earnings and assets in case of liquidation. So, a shareholder owning preferred shares is entitled to receive funds before those who hold common stocks in case the company goes bankrupt and its assets are sold to recover funds.

Stock trading is mostly carried out in common stocks. This can be further classified on the basis of voting rights.

How Do
Stocks Work?

A trader makes a profit when the value of their holding appreciates. The basic idea behind buying stocks is to choose companies that are performing well and are poised for growth.

This contributes to a raise in the stock's price which translates into a profit for shareholders. Another benefit of stock investing is to earn dividends which is the distribution of company profits. A shareholder also has voting rights for the selection of the company’s board of directors and other important decisions, such as a merger or an acquisition.

How Are Stocks
Bought and Sold?

Stock trading is mostly done via online brokers that are connected to stock exchanges around the world. Buying and selling a stock means you are buying shares from another holder and not the company directly.

Initially stock trading was carried out manually, where traders used verbal and hand signals to buy and sell large blocks of shares on the trading floor of an exchange. However, technological advancements have made manual methods redundant and given way to electronic trading. These modern systems match sellers and buyers much more efficiently, resulting in faster execution and lower trading costs. Electronic trading provides more liquidity, while allowing greater transparency into the stock trading process. Investors can trade by opening a trading account with an established and regulated broker for faster execution, minimal slippage, tighter spreads and top-tier liquidity.

In the 21st century, stock trading has become much easier. Investors can now open a brokerage account with an online broker and carry out trades in a matter of seconds. Technologically advanced trading platforms that are offered cater for short terms investment strategies as they are very easy to use. Trader can view market prices on individual stocks or market indices in real time. This makes it very easy to own stock in some of the world's biggest companies including Apple and Amazon. As a result, an increasing amount of trade is being conducted without the need for financial advisors and stock brokers.

While most stocks are traded on exchanges, some are bought and sold over the counter (OTC), where the buyers and sellers trade through a dealer or a market-maker dealing in those stocks. These OTC stocks do not meet the requirements of being listed on stock exchanges and are not subject to public reporting guidelines like the listed stocks. Most traders are wary of such stocks due to regulatory concerns, which is why the volume traded in OTC stocks is significantly lower than the trading volumes of stocks listed on stock exchanges. Due to this, trading in OTC stocks involves much large spreads.

What is the Role of
Stock Exchanges?

The stock market is a place where stocks are bought and sold through a network of
exchanges. The top ten stock exchanges in the world by market capitalisation are:

Name of Stock Exchange Region Market Cap in USD
NYSE (New York Stock Exchange) USA 25.53
Japan Exchange Group Japan 5.1
Shanghai Stock Exchange China 4.67
Hong Kong Exchange Hong Kong 4.23
Euronext Europe 3.67
Shenzhen Stock Exchange China 3.28
LSE (London Stock Exchange) UK and Italy 2.92
TMX Group Canada 1.75
BSE (Bombay Stock Exchange) India 1.51

Companies list their shares on one or more exchanges to raise funds. Once listed, these shares are available for purchase and sale by investors. The share price is driven by the market forces of demand and supply. The higher the demand for the shares of company A, the higher will be company A’s share price. The higher the sellers of the shares of company B, the lower will be company B’s share price.

While this is true, the demand and supply of the shares of a particular company are influenced by several factors.

What Are the Main Factors Impacting the
Demand and Supply of Stocks?

A company’s stock price or share price represents the worth of the company in the minds of investors. All investors aim to buy shares at low
prices and sell at higher prices to book a profit. Varied perceptions and expectations come together to determine a company’s share price, or
a price at which investors wanting exposure are willing to buy and investors wishing to offload their holding are willing to sell.

The factors affecting the share price of a company are:

Fundamental Factors

  • Size of company and its history of outperformance

  • Market capitalization

  • The present and projected earnings of the company

  • The track record of the management team and any changes in top executives

  • New growth initiatives planned by the company (like entering new markets, launching new products or services, addressing a new segment of the population, etc.)

  • The marketplace in which the company operates (including the level of competition, how differentiated the company’s offerings are versus its competitors, how price sensitive the customers are, etc.)

  • Growth in the industry or segment to which the company belongs

  • The political landscape in the geographies in which the company operates (whether there is political stability, whether the ruling political party supports the industry to which the company belongs)

  • The regulatory environment

  • Share buybacks

  • Dividends offered

  • Insider transactions

  • Actions of a large investor or institution

  • M&As (mergers and acquisitions planned by the company)

  • Risks related to the company

Technical Factors

  • Technical analysis – This is based on the past performance of the company’s stock. It uses historical price trends to make projections of future share prices.

  • Inflation - This has a strong inverse correlation with valuations, meaning the lower the inflation rate, the higher are the multiples. Of course, deflation is an adverse backdrop for any company and negatively impacts share prices.

  • Availability of substitutes – Stocks compete for a place in an investor’s portfolio. Therefore, the demand for stocks is a function of the availability of other options, like government bonds, corporate bonds, foreign equities, forex, commodities, metals, and real estate.

  • Investor demographics – Studies have shown that middle-aged investors favour the stock market. This is because these investors are at a stable stage in their careers and have greater risk appetite. Older investors, who tend to include more stable asset classes, have a low demand for stocks.

  • Liquidity – This refers to the investor interest in the stock of a company. Shares of larger companies tend to have much higher liquidity than smaller, lesser known firms.

  • Economic releases – Economic data announced by the government or leading agencies indicate the health of the economy. Since a company’s performance is dependent on the economic growth of the region in which it operates, such releases impact the share price.

Market Sentiment

This refers to the overall market mood as well as the mood towards the particular stock. Sometimes, a company’s share price will rise without any obvious improvement in the company’s performance or any news that benefits it. The upturn may be driven by overall bullishness among market participants. For instance, during the pandemic, certain tech giants reported substantial profit growth. The overall euphoria sent the shares higher of even those tech companies that had not announced a significant rise in profits. At times, the bullish or bearish sentiment in the US stock market impacts the mood for Asian and European stocks.

Some experts consider investor sentiment has the herd psychology (or the tendency to follow others in determining how to trade a stock), while others define it as the tendency of the market to adopt a myopic view and dwell on a single event or news.

What is an IPO?

An IPO, or initial public offering, refers to the market launch of the shares of a company. When a firm is established, it is unlisted in the stock exchange. After a company grows beyond a certain size, it may decide to offer its shares to the public. IPO is a prestigious way for companies to raise funds for financing growth.

The creation of a public company and the formation of a security is recognised as the primary market transaction. After being listed on a stock exchange, it is very easy for institutional investors and individuals to buy and sell shares in a company.

Global exchanges such as the world famous New York Stock Exchange on Wall Street represent the secondary market.

IPOs represent an exciting option for traders and investors as they carry the potential of outsized returns. While there is no certainty of returns, it is possible to buy shares of a well managed and healthy company at a relatively low price by investing in its IPO.

The world’s largest IPO are:

Name of Company Industry Date of IPO Amount Raised
Alibaba Group Holding Ecommerce September 18, 2014 $21.8 billion
AIA Group Hong Kong-based insurance company October 21, 2010 $20.5 billion
General Motors Automobile November 16, 2010 $20.1 billion
Agricultural Bank of China Ltd. Banking July 7, 2010 $19.2 billion
ICBC Bank China-based bank October 20, 2006 $19.1 billion
NTT DOCOMO, Inc. Tokyo based telecom October 22, 1998 $18.4 billion
Visa Inc. Debit and credit card processing March 18, 2008 $17.9 billion
Enel Gas and electric November 1, 1999 $17.4 billion
Facebook Social media May 1, 2012 $16 billion
Deutsche Telekom German telecom November 17, 1996 $13 billion

What are Share
CFDs and How Do
They Work?

Traders can take advantage of price fluctuations in the stock market is by trading share CFDs (or contracts of difference). Share CFDs allow investors to speculate on the price movements of the underlying stock without buying or owning the shares. CFDs are highly leveraged instruments, giving traders the opportunity to magnify their exposure to the chosen stocks. As traders invest only a fraction of the total exposure, CFDs allow investors to speculate on the shares of companies that have a higher share price than the funds they may have available.

Online brokers offer CFD trading through advanced trading platforms such as MetaTrader 4 and Iress. Trading in CFDs is unique as investors are able to capitalise on bull markets (rising prices) and bear markets (falling prices). The bid-ask spread is the different between the buy and sell prices and is impacted by the liquidity in a particular instrument.

How to Determine
Whether the Stock
Market is Rising or

The overall movement of the stock markets is gauged by the performance of indices, which are formed by the grouping of specific stocks that meet certain criteria. When traders talk about stock markets moving higher or lower, they are referring to the advance or decline in one of these major stock indices.

How to Trade
Stock Indices?

The movement in an index is a reflection of the movement in its component stocks. This similarity in component stocks of an index could be in terms of market capitalisation or the sector to which they belong. Market capitalisation refers to the total market value of a company’s outstanding shares and is calculated by multiplying the outstanding shares by their current share price. According to this, companies are categorised into large-cap, mid-cap, and small cap.

Another classification standard for indices is the industry to which a company belongs. Some of the common industry groups for forming indices are:

  • Energy

  • Metals

  • Healthcare

  • Information technology

  • Financial

  • Real Estate

  • Utilities

The formation of indices on the basis of sector classification allows investors to build their investment portfolios on the basis of their financial goals and risk tolerance. Investors having low tolerance for risk can invest in stocks or indices whose constituent stocks have stable prices and offer good dividends, such as Utilities and Healthcare. On the other hand, aggressive investors with a higher risk tolerance can invest in indices related to more volatile segments, such as Energy and Information Technology.

While indices trading is possible through exchange traded funds (ETFs) and index funds, a popular option that allows investors to speculate on price movements in indices is CFDs (contracts for difference). CFD trading does not involve actually buying the underlying financial instrument. It equates to entering into a contract to buy or sell a security based on one’s speculation about its future price movement. CFDs allow traders to profit from both a rise and fall in share prices. An investor can enter into a long or a buy position, if they believe that the underlying index will appreciate in the future or enter into a sell or short position if they believe that the index will fall.

The reasons for the growing popularity of indices trading is that this allows investors to achieve diversification without having to purchase a variety of stocks as well as to participate in the global stock markets.

Some of the popular CFD indices are:

Indices Symbols
Australia 200 index Cash AUS200
US 30 Index Cash US30
Euro 50 Index Cash EURO50
CAC40 Index Cash FRA40
German 30 Index Cash GER30
Hang Seng Index Cash HK50
Japan 225 Index Cash JP225
US 500 Index Cash US500
UK100 Index Cash UK100
US Tech 100 Index Cash US100
China A50 Index Cash CHINA50
Singapore 30 Index Cash SING30

What Do I Need to
Begin Stock Trading?

If you wish to own shares, all you need is a computer and a stable internet connection to begin stock trading. However, it is best to not jump into this without some knowledge and practice. Try to get a basic idea of how stocks and stock markets work. It is also a good idea to gain some understanding of the factors that impact the stock market that you wish to participate in.

You then need to identify a reputable and regulated broker. Choose a broker that offers extensive resources to help you get familiar with trading and a range of tools to conduct fundamental and technical analysis to take trading decisions. Established brokers also offer market insights, charting tools, economic calendar, and news updates to help their clients make informed decisions.

After opening a demo or live trading account with the broker, you can download MT5 (MetaTrader 5) on the device(s) of your choice. MT5 is compatible with Windows, Mac, Android, and iOS.

How to Manage Risk
in Stock Trading?

Stock markets are exciting because of the vast trading opportunities they offer. However, this also means there is risk in stock trading. Apart from learning more about the markets and stocks, new traders need to know how to manage risks.

Some risk management techniques followed by more experienced traders are:

  • Portfolio diversification – not just within the stock market but among asset classes including mutual funds such as index funds and ETFs.

  • Use of stop loss orders – to limit potential losses in case the market moves in the opposite direction to your expectation. A stop loss order is an instruction given to the broker to automatically sell a security or offload a position when the price falls below a certain level. This helps you protect your account from excessive losses if the market does not move in your favour.

  • Invest in stocks of companies that are non-cyclical in nature

  • Invest in large-cap companies and avoid small-cap stocks

  • Limit the size of each trade to a fixed percentage of your capital or funds available

  • Invest in broad markets such as the Dow Jones Industrial Average (Dow Jones)

Stock trading can be interesting and exciting, provided you have the time to learn about the market and different companies. This is the reason many traders choose indices trading, as it doesn’t require you to remain abreast of different stocks.

The global nature of stock trading and the trading opportunities it provides make it extremely popular.

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Source - database | Page ID - 972

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