The Basics Of Stock Market

Lesson -> The Share Markets

6.1 - Overview

We now have a better understanding of the IPO process and the real reasons behind the company's transition to secondary markets.

Public companies are liable for all information about the company. Stock exchanges trade the shares of public limited companies on a daily basis.

Stocks are traded for a few reasons. These are the reasons that will be discussed in another chapter.

6.2 - What is the stock market?

As we have discussed in chapter 2, stock markets are the electronic market. Buyers and sellers can meet to trade their points of view.

Take, for example, the current Infosys situation. Infosys, which is currently facing succession issues, has seen its top management leave the company. The company's reputation is being severely affected by the leadership vacuum. The stock price fell to Rs.3,000 from Rs.3,500. Stock prices respond to any new information about Infosys management changes.

Let's say there are T1 and T2.

T1's view on Infosys: The stock price will likely fall further as the company finds it difficult to find a new chief executive.

If T1 trades according to his point of view, he should sell the Infosys stock.

T2 however sees the situation differently and has a completely different perspective. He believes that Infosys' stock price has overreacted to succession issues and that the company will soon find a great leader. The stock price will then move upwards.

If T2 trades according to his view, he should buy Infosys stock.

At Rs. 3, 000, T1 will be a seller and T2 will buy in Infosys.

Both T1 and T2 can now place orders to buy and sell stocks through their respective stock brokers. It is obvious that the stock broker routes it to stock exchanges.

Stock exchanges must ensure that the orders match and trades are executed. This is the main job of the stock exchange - to create a marketplace for buyers and sellers.

Stock market participants have the ability to trade on any publicly traded company. Markets are made up of different viewpoints.

6.3 - What is the stock's movement?

Let's continue the Infosys example and see how stocks move. Imagine yourself as a market participant following Infosys.

It is 10:00 AM on 11 th June 2014. The Infosys price is 3000. Management announces to the media that they have found a new CEO to lead the company to greater heights. They have confidence in his abilities and are certain that the new CEO will do more than they expect.

Two questions -

  1. What will happen to the stock price at Infosys after this news?
  2. What would you trade on Infosys? What would it be? A buy or a sale?

The answer to the first question is simple: the stock price will rise.

Infosys was plagued by a leadership problem, but the company has since fixed it. Positive announcements lead to stock market participants buying the stock at any price, which in turn leads to a stock price rally.

Let me show you.

You will notice that the buyer will pay whatever price the seller asks for. This buyer-seller reaction tends to push the share price higher.

As you can see, the stock market jumped 16 Rupees within 5 minutes. Although this scenario is fictional, it is very real and is typical of stock behavior. Stocks prices tend to rise when there is good news or expect to be good news.

Two factors are responsible for the stock's rise in this case. The first is that the leadership problem has been resolved. Second, it is expected that the new CEO will lead the company to greater heights.

The answer to the second question is simple: you should buy Infosys stock considering that there is good news surrounding the stock.

The National Association of Software & Services Company, also known as NASSCOM, will make a statement at 12:30 pm. Many people don't know that NASSCOM is a trade association for Indian IT businesses. NASSCOM has a significant impact on the IT industry.

The NASSCOM releases a statement stating the customer's IT budget appears to have fallen by 15%. This could have an impact on future industry trends.

Let's assume that Infosys trades at 3030 by 12:30 pm. Few questions for you.

  1. What does this information mean for Infosys?
  2. What would you do if you could start a new trade using this information?
  3. What would happen to other IT stocks on the market?

These questions have simple answers. Let's take a closer look at NASSCOM before we answer these questions.

According to NASSCOM, the IT budget of customers is expected to shrink by 15%. This means that IT companies' revenues and profits are likely to drop soon. This is bad news for IT companies.

Let's now attempt to answer these questions.

  1. This news will be received positively by Infosys, a major IT company in the country. There was good news for Infosys earlier in the day. A 15% drop in revenue is serious news and Infosys stock prices will likely trade lower
  2. If one wanted to start a new trade on Infosys, the price would be 3030
  3. The information released from NASSCOM applies to all IT stocks, not just Infosys. Therefore, all IT companies will likely feel the selling pressure.

As you can see, market participants react to news events and price movements are the result. This is why stocks move.

You may be asking a valid and practical question at this point. What if there's no news about a company today? Is the stock price going to remain flat or will it move?

The answer is yes or no depending on which company you are focusing on.

Let's say, for example, that there is no news about two companies.

  1. Reliance Industries Limited
  2. Shree Lakshmi Sugar Mills

Reliance, as we all know is the largest company in the country. Market participants want to purchase or sell shares of the company, regardless of whether or not there is any news. Therefore, the price fluctuates constantly.

This second company is relatively unknown, and may not be of interest to market participants as there are no recent news items or events. In such situations, the stock price could not change or be marginally affected.

The expectation of news or events is what causes price movements. News or events can directly relate to the company, industry, or economy in general. The positive news of Narendra Modi being appointed Indian Prime Minister was a good example. This led to a significant movement in the stock market.

Sometimes there wouldn't be any news, but the price can still move because of the demand or supply situation.

6.4 - How is the stock traded?

You decide to purchase 200 shares of Infosys for 3030 and keep it for one year. It works! How do you buy it? What happens when you have purchased it?

There are many systems that are well-integrated.

After you have made the decision to purchase Infosys, log in to your trading account provided by your stockbroker and place an order for Infosys. After placing an order, an Order ticket is generated with the following information:

  1. Your trading account details through which you plan to purchase Infosys shares are revealed.
  2. The price you plan to purchase Infosys
  3. How many shares do you plan to purchase

Your broker must verify that you have enough money to purchase these shares before he transmits the order to the exchange. This order ticket will be sent to the stock exchange if you are able to confirm that it is true. The stock exchange will match your order with a seller to offer you 200 Infosys shares at 3030 once the order has been placed.

The seller could be one person who is willing to sell 200 shares at 3030, or 10 people selling 20 shares each. Or it could be two people selling 1 or 199 shares. It doesn't really matter what combination or permutation you choose. You only need 200 Infosys shares at 3030 to place an order. You can order shares on the stock exchange as long as there is a market for them.

After the trade has been executed, the shares are electronically credited to your DEMAT bank account. The shares will also be debited electronically from the seller's DEMAT account.

6.5 - What happens when you own stock?

The shares you have purchased will be placed in your DEMAT account. To the extent that you have shared, you are now part of the company's ownership. For example, if 200 shares of Infosys are owned, you would own 0.000035%.

You are entitled to a few corporate benefits as a result of your shares being owned, such as dividends, stock splits, bonuses, rights issues, voting rights, and so on. All these privileges are discussed at a later stage.

6.6 - A note about the holding period

The holding period is the time you plan to keep the stock. It may surprise you to learn that the holding period can be as short as 30 seconds or as long as forever. Warren Buffet, the legendary investor, answered "forever" when asked about his favorite holding period.

In the previous chapter, we demonstrated how Infosys stock changed from 3000 to 3016 in just 5 minutes. This is a great return for a 5-minute hold period. If you are satisfied with the trade, you can close it and look for another opportunity. Real markets allow this to happen, just so you are clear. These moves are common in hot markets.

6.7 - How do I calculate my returns?

Everything in markets boils down to one thing. A reasonable rate of return is possible!

All your stock market mistakes are forgiven if your trade earns a good return. This is what matters.

Returns are often expressed in terms of annual yield. You need to know about the different types of returns. Here are some examples of how you can calculate them.

Absolute return - This refers to the absolute return your trade or investment generated. This helps answer the question: I bought Infosys at 3550 and sold it at 3030. How much percentage return did I generate?

To calculate the same, use [Ending period Value / Starting period Value - 1]*100

I.e. [3550/3030-1] *100

= 0.1716 * 100

= 17.16%

A 17.6% return isn't bad at all!

Compounded Annual Growth Rate (CAGR) Trying to compare two investments can lead to misleading results. This question can be answered by CAGR. I purchased Infosys at 3030, held it for 2 years, and then sold it at 3550. What was the growth rate of my investment over the past two years?

CAGR factors were included in the time component, which we neglected when computing the absolute return.

CAGR can easily be calculated by using the following formula:

This will help you answer your question.

[3550/3030] (1/2) - 1 = 8,2%

The investment grew at 8.2% over 2 years. An 8.2% return seems a little unattractive when you consider that the Indian fixed deposit market has a return of almost 8.5% with capital protection.

When you are looking at returns for multiple years, it is important to use CAGR. If your timeframe is less than one year, you can use absolute return.

What if Infosys was purchased at 3030, and then sold at 3550 in 6 months? You have now generated 17.16% over 6 months, which is equivalent to 34.32% (17.16% * 2) per year.

The point is that if you want to compare returns, it is best to do so on an annualized basis.

6.8 - How do you fit in?

Every market participant is different and has a unique approach to participating in the market. As they experience market cycles and progress, their style changes. The risk they are willing to take in the market also defines their style. They can be classified as either traders or investors, regardless of their work.

A trader is someone who sees an opportunity and initiates a trade with the expectation of profitably exiting at the earliest opportunity. A trader has a very short-term view of markets. Traders are alert during market hours and constantly evaluate opportunities based upon risk and reward. He doesn't care if he goes long or short. Later, we will talk about what it means to go long or short.

There are many types of traders:

  1. Day trader: A day trader opens and closes a position during the day. He does not keep his position. He is not risk-averse and doesn't like to take the overnight risk. An example of this is he would purchase 100 shares at TCS at 9:15 AM, and then sell them at 2220 by 3 PM for Rs.800/. Day traders typically trade between 5 and 6 stocks each day.
  2. ScalperA day trader is a type of day trader. He trades large amounts of shares but holds the stock for a shorter time in order to make a quick profit. To illustrate, he would buy 10,000 shares of TCS 2212 at 9:00 and then sell it at 09:15 at 2212.1. This trade nets him a 1000/- profit. He would place many of these trades on a normal day. Scalp traders are highly risk-averse, as you might have noticed.
  3. Swing TraderSwing traders hold onto their trades for a longer period of time. This can range from a few days up to several weeks. He is more willing to take risks. He might buy 100 shares of TCS at 12:2212ThJune 2014 and then sell it at 2214 on 19Th June 2014.

The world has witnessed some of the most successful traders: Ed Seykota and George Soros, Paul Tudor, Micheal Steinhardt, Van K Tharp, Stanley Druckenmiller, etc.

Investors are people who purchase stock in expectation of significant stock appreciation. He is willing and able to wait for the stock to develop. Investors typically hold their investments for a few years. There are two types of investors that are most popular.

  1. Growth InvestorsThis is a way to find companies that are likely to grow because of emerging industry trends and macro trends. In India, a classic example would be the 1990s acquisition of Hindustan Unilever and Infosys. These companies saw huge growth due to the changes in the industry landscape, creating enormous wealth for their shareholders.
  2. Value InvestorsThis is a way to find great companies, regardless of their growth or maturity phases. However, they should be beaten down by the market sentiment and thus make a great value investment. L&T is a good example. L&T suffered a significant decline in value due to negative sentiment. It was significantly reduced around August/September 2013. From 1200, the stock price plummeted to 690. L&T's stock price of 690 is a low-cost company and thus a great investment. It paid off eventually, with the stock price dropping to 1440 in May 2014.

Charlie Munger and Peter Lynch are some of the most famous investors that the world has ever seen: Benjamin Graham, Benjamin Graham, Thomas Rowe. Warren Buffett, John C Bogle, and John Templeton are just a few.

What kind of market participant do you want to be?

To Summerize

  1. Stockmarket: A place where investors or traders can trade (buy, sell) shares
  2. Stockmarket: A place where buyers and sellers meet electronically
  3. Markets are shaped by different opinions
  4. The stock exchange facilitates electronic transactions between buyers and sellers
  5. Stock prices are affected by news and events on a daily basis.
  6. Stock prices can also move due to a mismatch in demand-supply
  7. Stock ownership gives you corporate privileges such as bonuses, dividends, and rights
  8. The holding period is the time that you keep your shares for.
  9. Absolute returns are used when the holding period exceeds 1 year. To determine the growth rate for multiple years, use CAGR
  10. Investors and traders differ in two aspects: risk-taking ability, and holding period.