Basics of Stock Market

Read Time: 4 mins

In the simplest way possible, let's learn how a stock market works, what drives the price of a share price, what are indices, how indices represent the position/health of a market, and how the overall market gets affected when an event such as a global pandemic occurs.

So what is a stock market?

A stock market is a place where people buy and sell shares, a subliminal analogy will be exchange websites such as eBay, OLX etc. What happens there is that person A is selling a share of company X and person B is buying that share from person A, but the catch is that the trading platforms(Zerodha, Angel Broking) act as an intermediate for regulation purposes & much more but those details are out of the scope of this blog.

So what makes one person sell a share and another person buy that same share.

Let's assume that Company X's share price is $10 and I think that the performance of the last few years is good so the price might go up to $12(guesstimate) in 1 year, so what I'll do is I'll buy shares of Company X, in order to make a profit of 20% in a year, which is a huge return. However, the person who is selling the share can sell because of multiple reasons:

• He/She might need money for something else
• Might have booked the desired profit
• Assume that he/she invested in Company X 2 years back when the price was $7, so he/she has already made a profit of $3 per share i.e. around 42%.
• Might think that the stock is overvalued(Higher than the actual value and will drop in value over time), so it's better to make an exit.
• How can one person think that the stock will go up and another that it'll go down?
• To understand this, pick any stock (MSFT/Tesla/Reliance Industries) and discuss with your friends the future price of that stock, you'll understand the above point.

So this is what we call trading, one person buying a share and one person selling a share and the brokerage firms are there to facilitate the transaction and to stop any form of solicitation.

What drives the share price?

One word "Demand". Demand is what drives the price of a share up or down. So if company X's share price is at $10 and more people think that it'll go up, people will buy it at $10 and as the demand is increasing the price will increase and more people will buy it at $10.5 and the $11 and so on. What this does is, it makes the share price overvalued because most of the investors are unaware of the actual worth and since a lot of factors come into picture while evaluating the actual & future worth of a company, so it is really difficult to do so.

This increased demand drives the share price and vice-versa. If people think that company X will not perform so the share price will go down.

So now we know how trading happens and what drives the price of a share. Now let's see what are indices, if you have ever tried watching market news, you would have definitely heard the words Dow Jones, FTSE100, NIFTY, Sensex and a lot more. So what are these terms, why are they the first thing that people ask when talking about the market?

These are what we call market indices, a market index is simply a collection of stock prices of companies. 

• The Dow Jones is a collection of the 30 largest companies of the US
• FTSE 100 is a collection of 100 largest companies of the UK
• NIFTY 50 is a collection of 50 largest companies of India

So the collective price represents the overall value of the market. So if NIFTY 50 is down, it means that the collective share price of the largest 50 companies in India is down. Remember, it is the collective price that is down, this doesn't mean that all 50 companies are down, some might be up, some might be down but the overall price is down.

So if you invest in an index fund(Dow Jones/S&P500/Sensex/FTSE100) that means you are investing your money in all the companies included in that index and the percentage share of a company in the index is predefined, so you don't have to do anything there. 

How does the pandemic affect a market?

As the pandemic has decreased a lot of activities, the life of most of the individuals is at a halt. No one in travelling/ going on vacation, so the hospitality market is down, People have stopped eating outside, so the food industry is down, also the FMCG supply chain was halted because of unexpected demands marking a crash there as well and these are just a few, so what happened as all the sectors came to a halt all the large corporations faced losses, people started taking money out of the market to buy bread as a lot of people lost their job. So this overall drops leads to a drop in the value of the market indices as well and once thing will start to come back to normal the indices will pick up the pace and will return to normal levels.

So these are the very basics of a stock market and if you need any more topics to be covered, let me know below!