Stock Market and its operations

To know the Share market and its operations we will start with the meaning of term shares, share trading, stock market, derivatives etc

How  Stock Market operates

“A” is running a sole proprietorship firm by the name “A & sons”. It is into manufacturing of
garments. He started the business at a very small level and gradually expanded the
business. Now he plans to involve a friend of his, “B”, in the business so as to have more
money in the form of capital being pumped into the business. They both formed a Private
Limited Company with equal shareholding. “A & sons” is rechristened “AB Pvt Ltd”. It
becomes a Private Limited company having a separate legal identity. Now they plan of
expanding the business further. To do this they need to sell some shares of their company to
the public and raise requisite money. In order to sell the shares of the company to the
public, it has to be first listed on any of the recognized stock exchanges of the country. “AB
Pvt Ltd” gets listed on National Stock Exchange and becomes “AB Ltd”. Now it has become a
public limited company and can issue shares to the public through Initial Public Offering
(IPO). “AB Ltd” had a share capital of Rs 100 lacs. The same is divided into one lacs shares
of Rs 100 each. They sell 49K shares to the public at Rs 120 each (i.e. at a premium of Rs
20 per share) and keep balance 51K shares with them. This ways, “AB Ltd” pumps in money
in the business. This process of capital pumping in business is called raising money through
an IPO and the market is called primary market. The business is earning good profit
margins and the price of the share in the market is ranging in between Rs 140-150 per
share. 49K shares sold in the market are now traded on the stock exchange between the
buyers who make money out of it. This is called trading in secondary market. ”AB Ltd”
decides to raise the share capital further to Rs 500 lacs. The company now comes out with
Follow on Public Offer (FPO) of 4 lacs shares of Rs 100 each. The company has 4.49 lacs
shares being traded in the market. These are called free float shares. Some portion of the
profit earned by the company is distributed amongst the shareholders as dividend.
Let’s now understand the concept of shares and their trading in details:

· Shares are defined as ‘Total capital of the company divided into units of small
denomination’. Shares can be Equity Shares or Preference Shares. An Equity
Shareholder has right to vote and control affairs of the company, whereas a
Preference Shareholder gets certain preferential rights. It is customary to prefix rate
of dividend with preference share capital. Shares are traded on stock exchange.

· Stock Exchange is a government recognized place where buying and selling of shares
takes place. In India, presently we have 23 regional stock exchanges two national
exchanges namely, The National Stock Exchange (NSE) and Over the Counter
Exchange of India (OTC). Bombay Stock Exchange is the largest Stock Exchange in
India where maximum number of transactions takes place.

· A company which intends to issue shares to the public has to get its shares listed on
any of the stock exchanges. Listing means, the shares can be bought and sold on the
stock exchange. Listed shares are categorized under Group A or Group B (Group A
are rated higher than Group B) depending on the capital of the company and trading
volume of the shares of the company.

· Trading of shares - Earlier share trading was done by exchange of physical share
instruments between buyer and seller through an intermediary called registered
share broker, transfer agent etc. Share certificate gets endorsed in favor of
transferee by the authorized representative of the company on payment of some
stamp duty. Stamp duty is payable by the transferee. Trading was done on trading
floors of stock exchanges through open outcry system (Open outcry is a method of
communication between professionals on a stock exchange which involves shouting
and the use of hand signals to transfer information primarily about buy and sell
orders), which was later on modified to screen based trading. It is a system whereby
distant participants can trade with each other through computer network of the
brokers either by placing the orders or by inputting the quotes. In both the above
methods of share transfer by endorsement, the company reserves the right to reject
the share transfer on account of certain deficiencies in the transaction.

·What is Demat:

o It is the latest & current technology of share trading. Dematerialization (Demat)
of share certificates is the process of converting physical instruments in electronic
form. A demat account is opened with a Depository Participant (DP). A depository
participant is an agent of depository and a depository is a place where stocks of
investors are held in electronic form. Depository is the head office where all
technology rests and details of all accounts are maintained. Whereas, DPs are
branches that cater to the individuals who wish to open demat account. There are
only two depositories in India- National Security Depository Ltd (NSDL) and the
Central Depository Services Ltd (CDSL). There are over 100 DPs. A demat
account holder gets periodic statement of holdings and transactions. Conversion
of physical holdings in electronic form is mandatory for doing any transaction.
Benefit of electronic form over physical form lies not only in the speed but also
more transparency and safety, investor can do the transaction himself without
involvement of an intermediary, no rejection of transfer by the company, no
stamp duty being charged from transferor, no paper work etc. Existing shares are
surrendered to the DP and are sent to the respective companies for cancellation
after "Dematerialization". After this, depository account with the DP is credited
with the shares. The securities on Demat appear as balances in depository
account. These balances are transferable like physical shares. If required, these
"demat" securities can be converted back into paper certificates.

o A broker should not be mistaken to be a DP and visa versa. A broker is member
of the stock exchange, who buys and sells shares on behalf of his clients and for
himself. A depository participant on the other hand provides an account to hold
these shares. An investor’s DP can be separate from that of his broker. For
providing the services, the DP charges some fees for account opening, annual
maintenance and transaction charges. DP provides a unique BO ID (Beneficial
Owner Identification) Number which has to be quoted for all future-transactions.

o Some investors do the trading by involving the brokers. They open demat
account with the DP and use trading account of their broker for executing the
transaction. While selling the shares, order is placed with the broker and delivery
instruction is given to the DP. Demat account is debited by DP by the number of
shares sold and payment is received from the broker. While buying the shares,
depository account number is informed to the broker for crediting the shares in
the account. In such cases, certain amount is set aside with the broker by the
investor for doing the purchase transactions. Amount of money to be kept with
the broker depends from broker to broker. This is called Offline Share Trading.

o However, if the investor is doing trading himself, without involvement of broker,
he needs to open three accounts:
 Saving Bank Account- used for setting aside money for the sale/purchase
transaction
 Demat Account- used for holding the securities
 Share Trading Account-used for sale/purchase of equity shares through the
broker.
All these accounts are linked and self trading can be done without involving
the broker in between. Such kind of hassle free facilities are offered by
brokers like, ICICI direct, HDFC Securities, India Infoline, Reliance Money etc.
This is calledOnline Share Trading.

· After understanding share trading, let us know  function and
purpose of stock market:

Stock Market is one of the most important sources for companies to raise money.
This allows businesses to go public and raise additional capital for expansion. On the
other hand, the liquidity provided by the exchange allows investors to make quick
money by buying and selling shares. If securities are held for a longer duration, say
a year or more, the holder is entitled to earn dividend declared by the company out
of its profits. So it is a win-win situation for both the corporate and the investor.
However, this win-win situation may turn sour when the market index falls and share
prices dip leading to loss of the holder of securities and even the company whose
share price falls. Stock Market is affected by the dynamics of the economic/political
activities in the country & rest of the world.

· What is Market Index and how is it determined?
In India, there are two major Stock Exchanges, National Stock Exchange (NSE) and
Bombay Stock Exchange (BSE). Index of NSE is called Nifty and Index of BSE is
called Sensex. Index is a statistical measure of change in an economy or a securities
market. In case of financial markets, an index is essentially an imaginary portfolio of
securities representing a particular market or portion of it. It gives a general idea
about whether most of the stocks have gone up or down. Each index has its own
calculation methodology and is usually expressed in terms of a change from a base
value. Hence, a change in index is more meaningful if expressed in percentage terms
rather than absolute terms. Let’s understand calculation of Sensex. Sensex is
calculated taking into consideration stock prices of 30 different BSE listed companies.
The base value of the Sensex is 100 as on Apr’79. At irregular intervals, the Bombay
Stock Exchange (BSE) authorities review and modify its composition to make sure it
reflects current market conditions. Sensex is calculated using free-float market
capitalization method (Worth of the company in terms of its shares is called Market
Capitalization and worth of the shares of the company which are available for trade
on the stock exchange is called free float market capitalization). Under this method,
market cap of these 30 companies (used as sample for the entire universe,
considered based on certain criterions) is calculated for those shares which are freely
available in the market for trade. This figure is then prorated for the entire universe
to calculate sensex.
·
 Let us Know the terminologies used in Share Market and Share Trading:

o Open: Opening price of the share in the morning.

o High: Highest price of the share during the day.

o Low: Lowest price of the share during the day.

o Close: Closing price of the share at day end.

o Volume: Quantity.

o Bid Price: Buying price.

o Offer Price: Selling price.

o Bid Quantity: Total number of shares available for buying.

o Offer Quantity: Total number of shares available for selling.

o Buying and Selling of Shares: Buying is also called as demand or bid and
selling is also called as supply or offer.

o Shorting of Shares or Short Sell: First selling and then buying (this only
happens in day trading) is called as shorting of shares or short sell.

o Share Trading: Buying and selling of shares is called share trading.

o Day Trading: Buying and selling of shares on daily basis is called day trading or
intra day trading. Squaring off is done on the same day.

o Delivery Trading: In such type of trading, delivery of securities purchased is to
be taken in the demat account. For entering into this transaction, requisite
money needs to be there in the account. Once, the shares are purchased, they
would be deposited in the demat account in T+2 days. These shares can be
retained for as much time as the investor feels. In case of delivery trading, first
purchase is done then only sale can be done, unlike day trading.

o T+2: Trading day plus 2 days.

o Transaction: One complete cycle of buying and selling of shares.

o Squaring Off: This term is used to complete one transaction. For every purchase
a corresponding sale is required and vice versa.

o Limit Order: In limit order the buying or selling price has to be mentioned and
when the share price comes to that price, then the order will get executed with
the price mentioned at the time of placing order.

o Market Order: The market order gets immediately executed at the current
available price.

o Stop Loss Order: They are limits set by traders at which they will automatically
enter or exit trades. An order to buy or sell is placed in the market if price
reaches a specified limit. A stop loss order is set to limit a trader's potential loss.
The stop loss is placed below the current price (to protect a long position i.e.
when share is to be purchased) or above the current price (to protect a short
position i.e. when a security is to be sold). Limit Order and Stop Loss Order are
used together.

o Fundamental Analysis in Indian Share Market: It is a method of analysis of
shares of a company for long term investments based on organization’s plans,
results, collaborations with foreign counter parts etc.

o Technical Analysis in Indian Share Market: It is method used by day traders
and short term investors by studying the price movement charts, quantity traded
charts, support and resistance levels, technical indicators etc.

o Insider Trading: It is trading of a corporation's stock or other securities by the
corporate insiders such as officers, key employees, directors, or holders of more
than 10% of the firm's shares. It is buying or selling of a security by someone
who has access to material, nonpublic information about the security. Insider
trading may be legal or illegal. Insider trading is legal once the material
information has been made public, at which time the insider has no direct
advantage over other investors. Illegal insider trading occurs when privileged,
non-public information is used to trade on corporation’s stock or other securities.
It may include the purchase or sale of shares prior to the disclosure of a
corporate news release or the purchase or sale of shares on the basis of
information that would never be disclosed to shareholders.
After being through with normal share trading, let’s move to derivatives and
their trading:

o The term derivative has its origin in the word “Derived”. It refers to an asset
which has no independent value of its own but is derived from the value of
underlying asset. It therefore means a forward, future, option or any other hybrid
contract of pre determined fixed duration, linked for the purpose of contract
fulfillment to the value of as specified real or financial asset or to an index of
securities.

o Derivative trading in India takes can place either on a separate and independent
Derivative Exchange or on a separate segment (index) of an existing Stock
Exchange. Derivative Exchange/Segment function is a Self-Regulatory
Organization (SRO) and SEBI acts as the oversight regulator.

o Forwards Contract: It is one to one bi partite contract, to be performed at a
future date and specified price. It offers lot of flexibility to the parties to design
the contract and suffers from poor liquidity and default risk.

o Futures & Options are forms of exchange regulated forward trading in which a
transaction is entered into today, and settlement of the same will happen at a
future date.

o Futures Contract: It is an agreement between two parties to sell and purchase
a specified asset at a specified future date and price. The actual transaction will
not be executed till the arrival of specified date and it is mandatory on part of
both the parties to honor the transaction. It is a structured/regulated form of
forwards contract.

o Options Contract: It is a refined form of futures. In this type of transaction,
premium is paid by buyer of the option to the seller of the option at the time of
entering into the contract. By paying this premium, buyer of the option purchases
the rights from the seller. This premium gives the buyer of the option the right
without the obligation to buy/sell the underlying asset on a specified date and at
a specified price. Buyer is also called holder of the option and seller is also called
writer of the option. Hence, option in securities means a contract for the
purchase or sale of a right to buy or/and sell securities in future.
 An option to buy is called Call option
 An option to sell is called Put option.
 An option exercisable on or before expiry date is called American Option.
 An option exercisable only on expiry date is called European Option.
 Price at which option is to be exercised is called Strike Price/Exercise Price.
 Date of execution of option is called Expiry Date.

o Both futures and options can be settled either by cash settlement or by delivery.
Cash settlement is a method used in certain future and option contracts whereby,
upon expiry or exercise of the contract, the seller of the financial instrument does
not deliver the actual possession (delivery) of the underlying asset but cash is
exchanged between the seller and the buyer, being the difference between spot
price and futures price. Payment of cash depends on the contract terms.

o Futures and Options based on stock index are called index futures and index
options. Here the underlying asset is index. Index, derives it value from the
prices of securities that constitute the index. Such contracts cannot be delivered,
hence are cash settled on expiry.

o Type of derivative market traders:

 Hedgers: A hedger makes an investment in a way to reduce the risk of
adverse price movements in the underlying assets by use of futures.

 Speculators: A speculator selects investments with higher risk in order to
earn profit from an anticipated price movement. More sophisticated investors
will also use a hedging strategy in combination with their speculative
investment in order to limit potential losses.

 Arbitrators: An arbitrator purchases an underlying asset in one market and
sells in another, thereby taking advantage of price discrepancy in two markets
and making profits out of it.