What is the Stock Market? How does it work?

A stock market is where the exchange of securities take place these securities can be of many types such as stock, bonds, commodities etc. these all will be explained one by one as we go through the journey of discovering the stock market. Mostly, this market is used by corporations to raise their equity and debt from means other than banks. However, that does not mean that it is only restricted to the corporate world. In our discussions, we will see how even government utilizes this market in favor of the economy. So without further a due, let’s discuss the necessity of the stock market 

Necessity of Stock Market 

From a Corporate point of view, stock market is important as a means of raising money. Through stock and trade, companies raise their necessary equity while through trade the general public engages in earning money from money. Therefore, companies use stock market to generate cash from the public. 

Other than that, companies also engage in the stock market to build up a good perception in the mind of its customers. The better the company performs, the better its shares and the better its perception to the public. Therefore, companies keep their customers loyal to their company by making them part of their system. Hence, companies have lots of reasons why they would want to engage in the stock market but why do governments choose to join the stock markets too. 

The first reason is rather generic. Like corporations, governments too need to raise money in order to perform certain projects and activities. Hence, by issuing, say treasury bonds, they are able to raise money from the general public without the negative pressure of taxation. In this way, government is able to engage its public in its operations with a win-win situation. 

However, that is not all that the governments do through the stock markets. Many governments have indulged this financial market to carry out their monetary supply. To boost the economy, sometimes governments need to increase or decrease the money supply in a country. They do so through either selling government owned stock or through buying them from public. If they sell government owned stocks, then the money supply is reduced. On the contrary, if they choose to buy the stocks from the general public, the money supply in the economy is increased. Hence in this way, government remains deeply connected with the stock market for the betterment of its economy. 

Comparison with Different Market 

The stock market is filled with different kind of securities that are traded to and fro. These are of many kinds having different characteristics too. However, it is important for us to compare the stock market to other kind of markets in which we can invest too. We will also discuss briefly the pros and cons of these markets in comparison to the stock market for a better understanding. 

Stocks Market are where the company traded securities are floated. As we have discussed earlier, companies raise their capital though two means, 1) Debt and 2) Equity. Sometimes, it is preferable for the companies to have more equity then debt as this increases their financial leverage; a company’s ability to pay its short term and long term debts.

Other times, it is actually quite for a company to raise capital through debt. This occurs when the company is relatively new to the market. Since it is quite hard for banks to determine the position of the company, banks either charge an extremely high interest to the company or choose not to lend at all. In such cases, issuing shares is the only option that a company has. The company does so through IPO’s as discussed earlier. Hence, we can say that issuing shares have a number of uses to the company. 

However, it is not just the company that reaps the benefits of shares. When these shares are traded in the secondary market, there are many people who make lots of revenues out of stock and trade. What happens is that as the company generates more profits, price of the shares in their secondary market increases through increased demand. The ability of an investor to predict this increase so that he can sell a previously purchased share on a higher price is how you make an earning in the stock market. In today’s world, many soft wares have been developed that are capable of performing stock forecast for you. However, you don’t always have to rely on stock forecast as you can build your own templates to achieve the same goal more accurately.

Other than that, it is important to know the types of stocks available to the investors. Although there are many types and subtypes of shares, the important classification is based on two. 1) Common Stock and 2) Preferred Stock. If you choose to invest in common stock, then you may or may not receive dividends, monthly or quarterly cash payments. However, you will have a stake and ownership in the company. Moreover, you will also have a voting right in the board meeting. These type of stocks are not traded in a large percentage as the person with more common stock can even vote out the CEO. 

Preferred stock on the other hand, offer no ownership but a fixed amount of dividends as long as you hold the stock. In either category, you can choose to sell the shares if you feel they have reached their maximum price in order to make profits. 

So issuing shares and indulging in the stock and trade is beneficial for both the companies and investors as whole. The only thing that you should know is how to use investing and issuing wisely.

Bonds are another type of securities that a companies or governments uses to finance their capital and projects through the capital in the Bond Market. It is a loan that an investor lends to the company or the government with a trust that it will be paid back at its maturity along with interest payments. Investors can use bonds more or less the same way as they would use stocks. Just as in preferred stock, investors in bonds will receive fixed income payment on a monthly or quarterly basis as discussed earlier. Bonds also have their maturity i.e. their expiry date upon which investors will receive both their interest payment and their full price which they paid in the beginning, just as you would sell your stock after holding it for a while. 

However, companies see bonds from a very different angle. Since it is a kind of loan, companies don’t classify bonds as equity but as debt. Although, it might appear strange in the beginning, companies actually have a very valid reason to issue bonds instead of preferred stocks. The reason is that interest is actually deducted from the profit that reduces the companies tax. Hence, those companies who want to cut their taxes use bonds as a cheaper alternative to stocks.  

As for the government, it mostly uses bonds to finance their project or control the money supply as discussed before. You, as an investor, can use bonds as a secure investment with guaranteed interest payments. Therefore, if you are an investor with low risk, bonds in the best option for you. 

In comparison to the stock market, bond market also possesses a crucial advantage. In case the company announces bankruptcy, bond holders are the first ones to get paid. Hence, this is another market that you can consider.

ForeX trading is also a great way for investors to earn money in the Foreign exchange market Foreign exchanges, or banks, buys foreign currencies to create this market. After that the general public can trade the local money for foreign currencies hoping to earn from the difference in exchange rates over time.

The mediums of foreign exchange earn through the difference in buying and selling prices of foreign currencies. Normally, these mediums have a lower buying rate and a higher selling rate as compared to the general public, you can still earn through investing in different currencies over some time.

The exchange rate constantly changes as long as the macro environment factors are in place. Therefore, investing in foreign exchange is also a viable method for you to become part of stock and trade. 

Commodities is also a growing market of trade. In this market, the buying and selling of commodities, or goods take place. Generally, those goods that are universal are traded in this market. By universal goods, we mean those goods that have a similar demand regardless the taste and preferences of different markets across the globe. 

Commodities traded in the Commodity market can be further classified as two. 1) Hard commodities which are those commodities that have to be extracted or mined and are natural. While 2) Soft commodities are from the agricultural sector such coffee, beans, rice etc.

To invest in this market, you can either buy shares of those companies that depend on certain types of commodities. Say for example, that you predict an excess supply of oil. This, will most likely, decrease the oil prices creating a good market for the companies that rely on oil. You can then, expect the share prices from the oil sector to increase and thus generate a profit out of selling the shares. Other ways to invest in this market is to have futures contract with the seller. A futures contract will occur if you decide with the buyer to purchase certain amount of commodity at a predetermined price in future. If you expect the prices to rise from the price you set, you can automatically make a profit out of selling those commodities at a higher price. 

Blockchain Investment is a relatively new type of market in the stock and trade business. In this market, electronic money such as Bitcoin and Ethereum are traded. 

This is a new found market that has gained quite popularity in recent years. It functions pretty much like the foreign exchange market. You can buy these currencies in exchange of your local money if you feel the prices these bitcoins are expected to rise. Once it does, you can either redeem those bitcoins for your local currency or even use bitcoin as a means of transactions. 

This is an extremely creative innovation regardless of the ethical questions asked about its validity. 

You can begin stock and trade in this market by creating an online wallet. Through either bitcoin mining or purchasing, you can add bitcoins to your bitcoin account and cross your fingers for increasing prices. Once they reach their upper limit, you can quickly redeem those coins as your own currency before devaluation. Again, there are stock forecasting options that are available for bitcoins as well. Hence, this is a great market for investors who want to generate money through this innovation.  

Although, Stock and Bond Market have some features that are similar to each other, the last three types of markets are quite different. Unlike, the first two, these markets are mostly driven through demand and supply. Hence, if you believe that you can accurately predict the price direction then these last three markets are where you should consider investing.  

How Stock Market Operates 

We have discussed before what a stock market is. Now is the time to discuss what kind of actions take place within this market so we can explain how the stock market actually operates. 

To understand this, we need to first see how companies raise their capital from equity. In its initial days, the company only accepts investment through a few close members. This type of investment is known as closed doors. However, this type of investment is not part of the stock market. Below we will see the company’s journey into the stock market at different stages.   

Primary Market 

This is the first time company offers its shares to the general public. These shares are known as IPOs or Initial Public Offering. The prices of these shares are generally low from their actual price in order to create demand. 

This allows the company to generate the initial equity that it requires or the projects that it needs funding for. Normally, these shares are traded through OTC’s and brokers and our purchased for the first time in the market. These will be explained in detail later on. 

When those same shares are traded among people themselves, then those shares have reached the second stage. 

Secondary Market

This market deals with the trading of shares among the people themselves. Investors perform stock forecasts to predict whether the stock prices are rising or not. If they are, then they would quickly purchase those shares at the lower price to sell them at a higher price later on. In this way the trading in the secondary market begins. 

There are many platforms through which these exchanges take place and are the center of discussion below 

Types of Platform in Stock Market 

There are many different platforms that facilitate the operations of the stock market. These platforms are necessary for investors as they provide them with a platform to start investing. These are discussed in detail below 

Exchanges 

Stock Exchanges are where most of the giant companies trade their shares from. These are the companies that are listed and secure. Furthermore, to enhance the trading experience, exchanges are also regulated by government bodies to ensure that unethical practices are avoided. Therefore, exchanges are one platform through which buying and selling of securities take place

OTC

OTC’s or over the counter market is also a platform that facilitates trading. Here, the companies that couldn’t be listed trade their stocks. Most companies issuing IPOs tend to get attracted to these markets as it hard and costly for them to get listed on exchanges. However, a few big giants, such as Microsoft also trade their securities from this platform. 

Here the dealers and market makers create the market for investors to trade in. 

ETFs

Exchange Traded Funds otherwise known as ETFs are another type of platform. They operate through an index based on a collection of securities. Many new firms have opened up that support such kind of trade. As they are based on a collection, this type of investment is safer for most investors. 

There are many other notable platforms, specially, electronic mediums that are continuously making investment easier and safer for investors.

Types of Players in a Stock Market 

You can always choose to be directly involved with companies to be a part of their stock and trade, however, sometimes it is a lot safer and easier for you to take help from the intermediaries that exist within this market. 

Realizing the potential of this market, many intermediaries have developed to enhance the trading culture and ensure that both the investor’s and company’s security is kept in mind. Even though, the trading history is filled with scandals, these intermediaries have still made trading a lot safer from what it was before. Some of these players have been mentioned below 

Brokers or stockbrokers are registered representatives from different brokerage firms. Their basic function is to act as a representative on behalf of the investor to buy and sell securities. In exchange of their services, brokers receive a certain amount of commission while the investors make profits through this process. 

Since, these brokers are more experts on shares and their trends, it is better to invest through a broker than without an intermediary. 

A broker also provides you with different benefits such as the latest information, stop loss sell options and much more. Therefore, aligning yourself with a reputable brokerage firm can help you a lot in your investment career. 

Market Makers are also broker-dealer making sure the liquidity of the market. These players issue the bid and ask prices that facilitates the stock and trade market as whole. 

Other than that, they also keep an inventory of shares to raise their prices. This is why they are known as market makers, as they engage themselves in developing the market for the investors in its initial stage. This is extremely crucial for newer set of companies as their shares are not normally traded at a very good price.

Market makers also make sure that their clients securities are being traded well in the market and hence, their role in this market is of much importance.  

Portfolio Managers are there to facilitate investors who want to invest in portfolios. Portfolio investment takes place when investors want to diversify their investment into different categories. However, doing so takes a lot of knowledge, time and expertise that not everyone can afford. 

Hence, portfolio managers act as experts who diversify your investments for you. Therefore, if you are looking for playing safe and making a higher earning through diversification but don’t know how to, portfolio managers are the people you should consult with.  

Investment Banks act as intermediaries between companies and investors. Since, banks have developed a strong public perception of safety, many people believe that their investments should be carried out through banks.

Like other mediums, investment banks to have a specialized team of experts who decide where and what amount will be invested and in which categories. Investment banks also have portfolio managers and a team of experts to determine the trends in the market using stock forecast. For all these services, investment banks charge a commission fee while ensuring safety for the investors. Hence, investment banks play a crucial role in the stock and trade market.  

Custodians have the basic role of safeguarding the investors. Their role is to secure customers from loss or theft of securities. They do so by creating a safety account for all investors that protects them against such incidents. 

Custodians also aid in the transfer of securities as the trade occurs between different parties. Hence custodians have the major role in the stock market and are essential to the system.  

Characteristics of an ideal Stock Market

We have gone through a lot of information about the stock market, however the real stock markets are not all efficient. According to the efficient market hypothesis, a market will be efficient if the prices of stocks reflected all the data that is available to everyone. However, the various financial crisis and the various scandals such as that of Enron, prove to us that this theory seldom holds value in today’s market. Nevertheless, here are a few characteristics that should exist in an Ideal Stock Market.   

Transparency is the first characteristic of an ideal stock market. If in a market both the selling and buying price, while the data for the rising prices is also shared completely, only then we can say that the market is transparent. 

This however, seldom occurs as insider trading is still common specially in developing countries. Other than that, companies such as Enron have once betrayed the trust in stock market by misleading prices. Hence, we still have time to achieve transparency goal.   

Security of all Transactions is another important factor that contributes to the efficient stock market. According to this characteristic, it is important for stock exchanges to verify that all the participants in the market are compliant of the rules and regulations. 

To ensure and enhance trade between securities, it is important to build the trust among the public. If any buyer or seller were to default, then that trust will automatically be broken. 

Hence, it is an important feature of efficient markets to ensure the safety of its players. 

Fair Dealing is basically when all the participants in the market are made aware of any offers, prices and transactions occurring in the stock market. They should also complete the task of matching potential buyers to the potential sellers of securities.

This goal is being close to be achieved as many exchanges are now being automated. Since, there is no broker involved, the concept of biases in on an end and the era of efficient market is on the rise. However, for developing countries which are yet to introduce automation still face this problem.

Protection of Investors is a necessary tool that an ideal stock and trade market should possess. This is because the nature of investors in the stock market is quickly changing. Before the advent of digital age, only the wealthy and knowledgeable investors would come into this business. However, as the times advance many online forums have been developed that have destructed many barriers from entering the stock market.

Although, it is good to see the growth of this market, it is extremely easy for the newer investors to get tricked by the different players in the market. Even if they are not, these new investors can incur a major loss due to investing in a riskier mode of finance. 

Therefore, the stock exchange market should make sure that such investors are protected against by imposing restriction for them to trade in riskier types of securities.   

Operating Under Regulation means for the stock exchanges to operate according to the rules and regulations of the government. Although, it is one thing to say for the exchanges that they operate under the law, it is completely different for them to actually demonstrate. 

Governments often impose many rules and regulations to keep exchanges from conducting unethical activities. Therefore, in an ideal stock market, it is necessary for the company to operate under the rules and regulations of its state. 

Conclusively, stock market is quite vast market with different players playing their role. After this detailed analysis, hopefully, stock market would be pretty clear for you and now you must be ready to start investing. With the necessary knowledge of modes, players and platforms of stock market, you are now well prepared for starting your career in the stock market. Although be careful to analyze the stock market in your country for inefficiencies to better prepare yourself for any kind of situation.