Thursday, June 18, 2009

How Stocks Trade & how price movement take place

Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. In the beginning most exchanges are physical locations where transactions are carried out on a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made electronically. Most of the markets use this type of trading only.

The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. Really, a stock market is nothing more than a super-sophisticated farmers’ market linking buyers and sellers.

Before we go on, we should know the difference between the primary market and the secondary market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company’s stock does not directly involve that company.

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don’t equate a company’s value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at Rs100 per share and has 1 million shares outstanding has a lesser value than a company that trades at Rs 50 that has 5 million shares outstanding (RS100 x 1 million = Rs100 million while Rs50 x 5 million = Rs 250 million). To further complicate things, the price of a stock doesn’t only reflect a company’s current value; it also reflects the growth that investors expect in the future.

The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn’t going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Market watches with extreme attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company’s results surprise (are better than expected), the price jumps up. If a company’s results disappoint (are worse than expected), then the price will fall.

Of course, it’s not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Chaikin oscillator or moving average convergence divergence.

So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn’t possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly.

The important conclusion grasp about this subject are the following:

  • At the most fundamental level, supply and demand in the market determines stock prices.

  • Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.

  • Theoretically, earnings are what affect investors’ valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors’ sentiments, attitudes and expectations that ultimately affect stock prices.

  • There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain everything.

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