How Stock Market Works

Chapter 2

Stock market works like any other markets where participants can buy or sell financial securities.It gives independent investors and traders to buy and sell stocks when they feel like.Money making in stock markets is risky process and should be done by trained professionals.

This does not mean,a beginner should not get involved in stock markets.A beginner in stock market should get trained properly before using there hard earned money for investing.

There is no other alternative to stock markets when compared with all other available investment platforms.Many investors make a mistake of buying stock at a high price rather buying it low.

Primary Markets

Investors can easily convert there investment into cash.Before a stock gets listed into secondary markets,stocks are first sold in the primary markets.And these primary markets are also called“NEW ISSUE MARKET(NIM)”.

And you can buy newly formed securities in these primary markets.Primary markets mainly involves transactions between issuers and investors.

You might have heard of IPO i.e Initial Public Offerings.Investors can buy stocks of these issued companies through IPO.Capital raised through these IPO is used for business development activities.

Stock Markets are also called as secondary markets

Now lets think these investors have invested for long period of time.What if they want to liquidate there investment ??So how do they liquidate(converting securities into cash) there investment??

Well this is why we have secondary markets.

Basically we call stock markets as secondary markets. Secondary markets allow traders and investors to buy and sell existing financial securities.Liquidating of securities is easy with secondary markets.

So to answer how stock market works,we need to look at few more important terms.Stock markets are run by stock exchanges.Stock exchange lists companies for market participants.When you buy or sell a stock,the transaction happens electronically through stock exchanges.

Few examples of stock exchanges are NASDAQ,NYSE,NSE and DOW JONES.All these exchanges are regulated by a separate body to prevent any fraudulent activities.US stock exchanges are regulated by Securities And Exchange Commission(SEC).

A stock exchange might have many other financial products like derivative contracts,mutual funds,ETF etc.Investors can buy and sell these listed financial instruments.

Ask and Bid In stock markets.

The price at which someone wants to buy a stock is called as bid price.And the price at which someone wants to sell there stock is called ask price.

Bid price can be called as buyer price which buyers are willing to pay and ask price can be called as seller price at which sellers want to sell there stocks.

The difference between ask and bid price is called spread.

Order Execution in Stock Markets

An order gets full-filled when bid and ask rates are matched.An order gets complete when there is a buyer and a seller for same stock and prices of there bids match with each other.This happens in just fraction of seconds.

Order matching used to be done manually through stock brokers during early days of stock market.Its simply an electronic auction market which doesn’t require buyer and seller at the same place anymore.

How stock prices are changed

Lets look at an example.Lets say there are four different market participants who wants to buy a particular stock of XYZ company.We can name the participants as Participant A, Participant B, Participant C and Participant D.

Assume that price of a single stock or share of XYZ company is quoting at 100$.Participant A and Participant D has enough reasons to buy XYZ company and thinks it could potentially go upto 103$ in a week time.So Participant A and Participant D buys “n” number of stocks or shares in XYZ company for 100$.

In next two day’s price of XYZ company reaches near 103$ and Participant B gets interested in XYZ company stock.So Participant B places an market order to buy XYZ company stock at current market price.At the same time Participant A places sell order on his XYZ company shares.

So a transfer of stock between Participant A and Participant B happens here.Now Participant A has made $3 profit from single share.This completes a transaction for him.Participant B on other hand holds stocks of XYZ company.Participant B is wants to sell his stocks when price reaches $106.

Now participant C looks at XYZ company stock price and gets interested in buying it.But participant C feels $101 is cheaper price than current market price of $ 103.So participant C places his buy order at $101 and waits for the price to come down.

At the same time participant B is hoping the price of XYZ to go up to $106 per share.Unfortunately price of XYZ stock starts to fall and reaches $101 i.e. 2$ less that his purchase price of $103.This creates a panic situation for participant B as he is loosing money now.So participant B places a sell order at current market price.

Ask and bid orders of participant B and Participant C gets matched at $101.Participant B completes his cycle of buying and selling XYZ stock and has limited his loss to $2 per share.

This is how stock market works.But why did the price drop from $103 to $101 ? Participant B sold his shares only after the prices dropped to $101.So what is the reason for price drop ?

There was also Participant D who bought shares of XYZ company for $100.When prices reached $103 Participant D did not sell his shares of XYZ company.After a while when participant D wanted to sell his shares of XYZ company,he could see bid offer of participant C.So participant D decides to sell his shares of XYZ company for $1 profit at $101.

As soon as the ask and bid orders of Participant D and Participant C matched,stock price of XYZ company fell from$103 to $101.After this drop,participant B also got panic and sold his shares of XYZ at $101 i.e. loss of $2 per share.

So above mentioned example shows how ask and bid works in stock markets.This continues like a chain of orders.

A buyer needs a seller and a seller needs a buyers.Transaction or order execution will not happen till ask and bid prices are matched.

Importance of Stock Brokers

Stock brokers provide you leverage and trading platform to buy and sell stocks.As a retail trader,you can not trade directly on the exchanges.You need to be a trading member in stock exchange to trade directly with them.So stock broker plays a role of intermediate agent between stock exchange and clients to complete a buy sell transaction.

Above provided examples and information helps you in understanding how stock market works in a clear way.

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