Investing in stocks is a lucrative way of creating wealth over the long term. Many investors are nevertheless unsure about the ways in which the stock markets work.
Stocks are also known as equities or equity securities. Companies may choose to make their shares available for the people to invest in. Stocks are an aggregation of the shares while a share is basically a unit of stocks. Buying a stock gives one a section of ownership over a company’s earnings and assets.
The role of stock markets is to ease the sale and purchase of stocks. They can be bought and sold by companies, institutional investors and individual investors.
Let us take a look at the two prime components of stock markets, the primary market and the secondary market:
The primary market
The initial process of publicly trading a stock is called initial public offering (IPO).
In IPO, a company sells shares, which is a piece of itself to investors. It helps them raise capital. It is this initial sale which comprises the primary market.
The secondary market
Post the IPO, each of the following stock trades typically take place among investors, and the company is not involved. A few of the top stock exchanges in India are the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). They facilitate purchase and sale of stocks among investors.
A significant majority of stock trades occur over secondary markets, in between investors. Just as an example, if one wants to buy shares of Ambuja Cements Ltd (NSE: AMBUJACEM), one hits over the buy button, at his broker’s website.
So the investor would be buying the shares that another investor has chosen to sell. He wouldn’t be buying those from Ambuja Cements Ltd directly.
How stock prices are determined in stock markets:
It is also important to know how stock prices are determined in stock markets. It is characteristically the forces of demand and supply which govern the stock market prices.
At any point of time, there’d be a maximum price, which an investor would be ready to pay for a certain stock.
Similarly, there’d be a minimum price, that another investor would be willing to sell his stock for.
Overall, it is an auction, in a way. A few investors bid for the stocks that a few investors are willing to sell.
In the event a stock is in a high demand, then investors are going to buy the stocks at a quick rate. This would be quicker than the sellers want to sell those stocks. The prices for stocks would then move higher.
But on the contrary, if there is a scenario wherein there are more investors selling a stock as compared to buying it, the market prices are going to drop.
It is not always going to be easy to buy or sell stocks by oneself. This is where the role of market makers is exceedingly important. With the market makers in place, one can always find buyers and sellers as well. The marketplace is hence always has high levels of liquidity.
Market makers are the intermediaries in between the buyers and sellers. They continually buy and sell shares, and also buy and sell the quotations for shares.
The advantage of having a market maker in place is that an investor would not have to wait for another investor to want the exact number of shares. A market maker will instead buy the shares with an immediate effect.
Market makers are characteristically financial institutions or large banks. They are obliged to buy or sell the shares at the prices they quote.
Trading in stocks comes with some uncertainties. While an investor is not aware of what stocks he must invest in, making profits may be difficult.
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