10/02/2014 12:17:28 Free Membership Login

how does the stock market work

The main purpose of the whole stock market setup is twofold: 1)a company lists or goes public, to get money from investors for use in expansion, settling debts, etc., and 2) for investors to get into and buy into companies easily, no matter how small their share size is. 

Companies go public by offering a specific number of shares in their company to the public through the stock exchange. Investors then can use the stock exchange to buy and sell stocks of companies that they are interested in. While this basic description of how the stock market works is adequate enough to understand what the stock market is, to get a better understanding of how it actually works it will be important to learn about some of the terms that are commonly used when discussing the stock exchange including stock prices and market capitalization.

The first term that you may hear when you start learning about how the stock market works is stock prices. Stock prices are the price that a specific stock sells for. This price is set by several market factors including the health of the economy, trading trends, spending trends, and financial or technical reports put out by a company or an independent third party. The next term that you may hear about is market capitalization. Market capitalization is the value of the company or the stock that is being offered. To calculate the market capitalization of a company, or stock, simply use this formula: The number of outstanding shares X the price of the stock = market capitalization of the company.

After you learn about the basics features of the stock exchange you will next need to learn how to buy and sell shares. To buy a stock you will need to establish some kind of investment account. In most cases you will open an investment account with a stock broker that works at a local firm. However, today you can also open an online investment account and make trades without the help of a stock broker. After you have set up your account you will need to fund it before you can make a purchase. Once your account is funded you will be able to enter your order for a stock purchase. When you are ready to sell your shares you will either tell your stock broker that you want to sell X number of shares of Company A, or you will need to enter a sell order via your online investment account.

Once active in stocks, you will have to familiarize yourself with the following terms:

  • Stock: The ownership units of a company are referred to as stock.
  • Stock price: The price for which a specific stock sells is the stock price. Health of the economy, the trends that prevail in trading and spending influence the stock prices. These prices also depend on financial and technical reports put out by the company.
  • Offering price: The price of the stock presented in the final prospectus at the time of issuing the stock is known as the offering price.
  • Underwriter: To sell its stock, the company hires an investment banker for help. The process is underwriting and the person hired is known as the underwriter. He mediates between the public and the issuing company. The process of underwriting works in one of the following ways:
    1. Best effort arrangement: The investment banker acts as an agent trying to sell maximum possible issues at market prices.
    2. All-or-none arrangement: The company withdraws the issue from the investment banker in case he fails to sell all the stocks previously issued to him.
    3. Negotiated Underwriting: The issuing company and the issuer negotiate the terms of issue and price.
    4. Firm Commitment: The underwriter buys all the stock from the company and sells it to the public.
    5. The company may opt for competitive bids from the investment bankers and appoint the top bidder as their undertaker.
  • Prospectus: It is a legal document presenting the financial facts about the offering company. A prospectus includes the offering price, the other costs involved in investing, the company history, its management team, legal opinions about the issue, the underwriting method and the SEC’s disclaimers. Prospectuses are sent to all those who want to buy the primary offering. They are made available to the customers before any transactions are performed. Customers should read them before purchasing any offering.
  • Broker-Dealer: Broker is someone who facilitates trade between customers. He does not bear any risk in the trade. He charges commission. Dealer is someone trades for his own securities and for others. He assumes some risk in the transactions. A broker-dealer plays either of the roles at a time. Brokers and dealers must be registered with the National Association of Securities Dealers and follow the rules set by it.
  • Stock market Index: It is a way of measuring the stock market as a whole. Many indices are combined by financial firms and used to measure the performance of portfolios.
  • Market capitalization: It is the value of the stock that is being offered. Its value is the product of the number of outstanding shares of the company and price of the stock.  Calculating the market capitalization of a stock is done by using the following formula -Number of Outstanding Shares X Price of Stock = Market Capitalization of the Company
  • Bull m  arket: It is characterized by increase in the confidence of the investors in anticipation of capital gains in future. A famous example of a bull market was the one formed in the 1990s when US and other financial markets had grown at an exceptionally fast space.
  • Bear market: Investors anticipate losses and take to selling. A bear market is characterized by pessimism in the market. The period of early 1930s that marked the beginning of the Great Depression is a famous example of a bear market.
Going through the details:
 
After a company decides to go public, the first step it takes is to file registration statements with the Securities and Exchange Commission and wait for 20 days before the sale of stocks. When issuing the stock, a final prospectus containing offering price of the stock is brought about. The underwriter buys all the company stocks to sell them to the public. He decides the markup price for his offering. The new price holds his service charges. During that period of 20 days, the issues of stocks can be advertised. Representatives can send preliminary prospectuses containing information about why the stocks are being sold, to the customers.  This paragraph was taken from buzzle.com, and 20 days may be the standard for Wall street but not for the Philippines  Here, the company must wait for the SEC to approve or deny the application to issue its IPO.
 
Once a company goes public, the law of supply and demand takes into effect, as the market commands the price based on the number of tradeable floated shares.  Hence, the more people that want to buy the stock for whatever reason, the more that the stock will go higher and vice verca.  
 
When a business makes money, the price of its shares rises. On the same lines, if the business suffers from losses, its share prices fall. Buyers and sellers of shares are watchful about the company business. Based on the financial conditions of the business and their speculations, they decide when to buy and sell company shares. This has a large impact on the type of the market, largely influencing the economy. 
 

With the new corporate structure in place, people begin buying and selling their shares. People invest for different reasons. Those looking for a steady return on investment may buy shares of a profitable company that issues regular dividends.  Risk-takers on the other hand may buy shares of a fast-growing company (or at least one that people assume will be fast-growing someday) in hopes of selling them for a profit later. The more extreme forms of speculation are based on the "greater fool theory." You can make a foolish investment in the hopes of selling it to an even greater fool later on.

 
Profits can be made in three ways:

1) by selling the stock at a higher price than it was purchased at

2) by holding on to the stock until you get dividends, which some companies give in varying amounts, frequencies
3) by participating in a tender offer.  This is a special case when another company buys a large percentage of the company of the stock you're holding.  In some cases, they are required to buy the public shareholders's stock as well.
 
A company may continue being listed if it complies with requirements like listing fees, continued update and disclosures, financial statements, all of which varies from SEC laws of differing countries.  
 
A company can be delisted for violation or non compliance of SEC requirements, and if the company goes bankrupt.  Some exchanges follow a market capitalization rule for delisting a stock from their exchange.
 
Where does the money go?

1)In the first step just at the IPO phase when a company goes public, the money goes directly FROM the hands of subscribers, TO the pockets of the companies.  It is like getting a loan from the bank without having to pay it back!
 
2)When a stock is already listed, all the buy sell trades go directly from the hands of the selling shareholder to the hands of the buying shareholder
 
FEES PAID

Varying stock exchanges have varying fees and amounts like VAT Value Added Tax, Transaction costs, Documentary Taxes, Sales Tax, and commissions. 
 

Comments

  1. Tin Perez says:

    PSE Academy (www.pseacademy.com.ph) provides a comprehensive, interactive, and practical web-based investor education for market participants, would-be equity investors, and the public in general.

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