Investing In The Stock Market Part 1
Investing is a way to use your money to generate more money without you explicitly monitoring it all the time. Once you understand how investing works, and start to invest, it can turn out to be really beneficial for the future. Once you start investing, your gains can grow exponentially, if it is done right. So starting early is always better. Hopefully, after reading this blog, you get a better understanding of how the Indian Stock markets work.
Everything in the world works based on trading; You give some item of value to get something equivalent in value. Trading has evolved with the growing economy, and a massive infrastructure has been built to maintain fairness in trade and to ensure no cheating can occur.
The following are the predominant markets where investors choose to trade,
- Share Market
- Derivatives Market
- Foreign Exchange
- Mutual Funds
In almost all countries, certain entities have been authorized to conduct trades in these markets, and they are called a Stock Exchange.
I won’t be explaining the above markets in detail as this post is primarily going to focus on trading in the stock market and more specifically, trading equity.
Shares and Equity
Equity is just a fancy word for stocks and is used interchangeably. When you buy equity, you are buying bits and pieces of a company. These bits and pieces are called shares, and when you own a share, you own a part of the company. The stock market is where shares of different companies can be bought and sold.
When a company decides to list itself on a stock exchange for the first time, it is called an Initial Public Offering (IPO). You might ask why a company might want to offer its shares or “company bits” to the public? Consider the following scenario, a company ABC wants to build a new office in Delhi, and they need to raise funds. They can do this in multiple ways,
- Borrow from a bank
- Sell existing assets
- File an IPO
Borrowing money from a bank means you would have to make sure that you make more money later on to cover the costs incurred now. The problem with that is that you can never really predict how your company is going to do in the future. Selling existing assets all the time to invest in something else isn’t indicative of a growing company.
Companies choose to file an IPO because they share the risk of running the business with you. When you own shares of a company, and the company is doing really well, the share prices increase, and you make a profit. But if the company doesn’t do well, the share prices drop, and you lose money (assuming you bought the shares at a higher price).
Who determines the price of shares? Well, in a way, the people participating in trading do. Initially, when a company files an IPO, they set a price for their shares with help from authorities and banks, and when trading starts, it’s the buyers and sellers who determine the future price of the share.
In a very general sense, when people think that a company is going to do well in the future, they would want to get their hands on some shares. When this demand is high enough, people would be willing to pay even a little extra (more money is better for the seller) to get shares. When this happens, it drives up the price of stocks.
When people think that a company is going to do bad, they would rid themselves of shares and might even sell at a lesser price (buyers would be more willing to buy if its cheaper). This drives down the prices. With the advent of social media and the internet, the welfare of a company is just a few clicks away and could change the price of shares at any time. The price of shares is ever so in a state of flux, but a prudent investor can learn to read between the lines and earn a profit. Simply put, it moves with respect to the demand.
Now let’s cover two essential words in the trading world. If it seems that the prices are in an upward trend, it is called a bullish trend. When it appears as if the prices are going to go down, then it is a bearish trend. Its called bullish because when a bull attacks, it bends down and attacks in an upward motion. Similarly, when a bear attacks, it has its claws at the top and swings it down.
Stock Markets in India
There are two major stock markets in India, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). There is no legitimate way to say one is better than the other as almost all the major companies are listed on both the exchanges. Although BSE has around three times more companies listed as compared to NSE, in terms of number of trades done per day, NSE has a much higher daily turnover. Also, NSE is considered to be the more technologically advanced version of the two, as it was the first to introduce electronic mode of trading.
Here are the key intermediaries involved in trading,
Securities and Exchange Board of India (SEBI): Makes sure business is conducted fairly
Depositories: Central Depository Services Ltd (CDSL) and National Depository Services Ltd (NDSL) are the two entities which offer and manage DEMAT (will explain later) accounts
Banks: An obvious intermediary which manages where money debited from and credited to
Depository Participant: An agent to the depositories, most banks and few other services act as an agent allowing you to create DEMAT accounts and maintain them
Clearing Corporations: National Security Clearing Corporation Ltd (NSCCL) and Indian Clearing Corporation Ltd (ICCL) are owned by NSE and BSE respectively, and they ensure a guaranteed settlement of transactions
Yes, these names are hard to remember, but you would rarely have to deal with any of the intermediaries in real life except for the bank and the depository participant. The bank, obviously for the money that has to be credited or debited, and the depository participant to manage the DEMAT account. These days, technology has made the integration of all these parts seamless and a trader can make a trade easily without having to worry about all the in-between steps.
Now you might be wondering what a DEMAT account is. A bank account is where money is stored in an electronic format. Similarly, a DEMAT or a Dematerialized account is where shares are stored electronically and is linked to the account owner. All shares that are bought or sold are added or removed from the DEMAT account.
Summing it Up
Richard Feynman, one of my favourite scientists, had a unique method of learning things. He believed that you have mastered a topic if you can explain it to a layman. I too, consider this to be true and is part of the reason why I want to write this series on trading. Another reason is that, when I was learning about trading, I found out that there were few quality resources that explain these things. I had a hard time consolidating all this information and getting a clear picture.
Hopefully, this blog gave you a basic understanding of how trading works in India, and all the intermediaries involved in executing a trade. More importantly, you should have an intuitive understanding of how a market moves and should be in a position to easily explain to others who are new to this topic.
This is part one of a series I plan on writing for introducing people to the world of trading. In the next blog post, I will be talking about the different ways to start trading in India and will be going into detail about the different types of orders that can be placed. After that, I will write blogs on different trading strategies that are used by traders.