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Kartik Vyas
Kartik Vyas • Dec 14, 2007

Share Markets - Basics ( all you wanted to know about how stock markets work )

A lot has been made over share markets and a lot has been lost too, still share markets fascinate most people. But a lot of us don’t know how share markets work , how do prices change so quickly , what drives these market prices, how do people make so much money, who decides the share prices and all such things. To answer all these questions and to make some basic things clear this article has been written.

Share is as the name suggests a share of your business. Shares, equities, securities, scripts are all used to refer to shares in some way or the other. Now what exactly is a share? Suppose I decide to come up with a company, I obviously need a lot of money. Now to arrange for the money I may take a loan, but with loan comes an obligation to pay fixed amount of interest even if I don’t make profit at the beginning. Also I may not be able to get huge amount of loan because I may not be ‘creditworthy’ enough as per the bank rules. Alternatively I may issue bonds stating that I owe this person/entity so much amount of money and I promise to pay an interest at the specified rate for the time for which I keep owing the money. But this, too, is like a loan only so is there any way wherein I don’t have to pay back on my debts till the time I am not making profits? Technically there is such a way … Shares.

Now if I need 100k and have 100k of my own what I do is that I sell 10k shares each of face value 10. Now I have 50% shares of my company and my shareholders own the other 50%. Now if and when I make profit I will have to share it with my shareholders as dividend. Also the price of my venture increases (the price of land appreciates, I decide to expand the business, my products do well in the markets etc. lead to the increase). So the venture that was started with merely 200k now is worth say 1000k , then the share price which was 10 at the start has now become 50. So even if no dividend was declared the shareholder made money. Now anyone else will also want to be a part of this success story by becoming a shareholder, so that person will offer to buy the shares at the current price and if any current shareholder wishes to sell the share he may sell and realize his money. This transaction will be a typical share transaction.

In a share transaction the buyer makes a bid for the shares as in ‘ I am ready to buy 10 shares of company X at 133’. It is just like you go to a vegetable shop and tell the vendor that I am ready to buy 1kg onion for 7. Now what the vendor will tell you is that the price at which onion is trading is 7.5 a kg. This is a price decided by him depending on some factors. But share markets are different. Here one agent or share broker does not decide the price. Share market is a perfect market, here the demand and supply decided the price. Confused? Let us see how actually it happens but before that lets see what is a perfect market.

In an imperfect market, all the bids and offers (bid is the price quoted by the buyer while offer is the price quoted by the seller) are not known to every market player. For example, in a vegetable or fish market, it is quite possible to get the same fish/vegetable for a different price from different venders who are trading at different prices just because you don’t know that at the other end of the market the same thing is sold at lower price. But in a perfect market all the offers and bids are displayed and known to each other. The computer-based systems make this possible. So in a share market the buyer always gets the lowest priced offer. For example if there is an offer to sell 100 shares of X at 17 each and even if you quote 18 for the same you will get it at 17 only provided that sum one else has not made any offer above or equal to 17 before you do. Basically, the share market i.e. stock exchange software accepts and stores different quotes (i.e. bids from buyers and offers from sellers) and records them. The traders can change their quotes by canceling the previous orders and creating a fresh order. All this happens electronically.
When a bid price matches an offer the deal is executed and the shares get traded. The value at which the share gets traded becomes the price of the share (thus, share prices are decided by supply demand). The prices of shares that are displayed on different websites or news channels in the ticker are nothing but the last traded prices of those shares.
Now to give you an example of the above consider the following.

Suppose two sellers send two quotes/orders to the stock exchange. First one offering to sell 100 for 20 and the other offering to sell 1000 at 19.5. These orders are recorded by the stock exchange and displayed as sell orders. Similarly some buyers as well send their orders to the exchange say buy 50 for 18, buy 2000 for 17.5 buy 3 for 18.5. All these orders will also be recorded and displayed by the exchange. Since no bid price matches the lowest offer price the trade will not take place. Now the seller who has to sell 1000 shares gets a bit desperate and decides to lower his selling price to 18.5. As soon as he does so 3 shares out of his 1000 are sold to the third buyer who bid 18.5 for 3 shares. So the price (i.e. the Last Traded Price LTP) of the share becomes 18.5. Now no further trade will take place unless some other bid price is raised to match the lowest offer price or an offer price is lowered enough to at least match the highest bid price. This is how share prices are decided. If the demand is high people will be ready to buy shares at a higher price and the prices will increase while exactly the opposite will take place if the demand is lower, causing the share prices to fall.

There are millions of investors and traders trading on the stock exchange at a time so thousands of orders are placed every minute and a lot of them are executed causing the last traded price to change constantly hence the share prices fluctuate so much. Share prices are determined by the fundamentals of the company i.e. the business of the company, its performance, its assets, balance sheet, its profit and dividend it offers. There is also a technical point of view of the company which concerns the market sentiment for the sector to which the company belongs, the government regulation that affects the company, performance of its peers etc. The fundamentals and the technicals of the stock along with the market perception of that company decided whether the price of the stock goes up or down. At the end of the day its all a ‘demand and supply’ game.
Mahesh
Mahesh • Dec 16, 2007
Hi KGV,

Thank you for such a valuable information on share market.
Kaustubh Katdare
Kaustubh Katdare • Jan 4, 2008
Finance is KGV's favorite topic. KGV, looking forward to more such informative articles from you!

Keep up the good work!

-The Big K-
crook
crook • Jan 10, 2008
No new articles on CE since my last visit 😔
nalinacmohan
nalinacmohan • Feb 24, 2010
share market - im very new to this. i was searching in many sites and finally got KGV's. great start for beginners to know share market.
Expecting more from you.
AllenMass
AllenMass • Jun 22, 2010
Share market - i'm very new to this. i was searching in many sites and finally got penny stocks market.That's good profitable site for small investment.
paritoshvn
paritoshvn • Jul 10, 2010
Thanks for very useful information. Can anybody trade in the share market. If yes can I join in this trading system. Please help.
Awesome post. Very neat explanation. 😀
saurabh2486
saurabh2486 • Aug 6, 2010
simply I would say 3 cheers to KGV ....................Thanks for such a valuable and easily understandable article................
keys_er_soze
keys_er_soze • Nov 13, 2011
I guess the Post is dead now. So I am not sure if I would get an answer to my question. Anyways, I am still posting it.
KGV wrote:
"Also the price of my venture increases (the price of land appreciates, I decide to expand the business, my products do well in the markets etc. lead to the increase). So the venture that was started with merely 200k now is worth say 1000k , then the share price which was 10 at the start has now become 50."
Well I am not sure the statement is correct in any sense. Otherwise, how can we explain the sudden falling and rising of share values.(even when the assets are growing) What I believe is share price is just the reflection of people's sentiments and has nothing to do with the company's performance. Now, the problem is that people's sentiments changes with company's performance as they believe that they will get a better divident if the company performs well. So far so good. But the fact is that a lot of companies have stopped paying dividents nowadays. e.g Google, Intel. And these are just to name a few big players. Most of the new companies never pay dividents. So, In such a scenario, it doesn't even make sense for people's sentiments to be linked to the performance of company.
Gandalf
Gandalf • Dec 3, 2011
No dear , there many issues considered when the prices are decided by the people

there is technical charts for short term traders
Fundamentals for long term share holders

Other terms judged are PE ratio (Profit to earnings ratio) , Margins , Revenues and off course the bottom line i.e the gross and net profits

In market turmoil long term buying comes in when the company levels look very interesing in terms of earnings and their growth and arepicked by fundamentalist , short term traders

For Details check this link
https://en.wikipedia.org/wiki/Stock_valuation

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