S&P, Dow Jones, Nikkei, FTSE, Russell have become part of our everyday experience. Television and radio broadcasts over the world have hundreds of reports daily with experts analyzing every move of the stock market. Daily newspapers have reports from analysts linking events across the globe to movements of the stock market indices. Yet most common people lack an understanding of how capital markets work. In this article, I will limit the discussion to stocks but it can be extended to other assets as well. Let us first understand what is a stock market.
A capital market or stock market is a platform that brings together buyers and sellers to aid transfer of ownership of assets from sellers to buyers. The market doesn’t own the assets but simply provides a platform that aids interaction between market participants.
Qualities of a good stock market
A good market has to provide sufficient liquidity. Liquidity is the ability to trade quickly at a price that is not significantly different from the price of a previous transaction, assuming no new information is available. Most stocks that are part of a major index are fairly liquid.
The market should have timely and accurate information about the price and volume of past transactions. The transaction costs, which include the brokerage fee and the exchange charges, should be low. Finally, the market should be able to adjust prices as new information becomes available.
Organization of a capital market
A capital market can be divided into primary markets and secondary markets. Secondary markets are what matter to most of us, although an understanding of what private markets do is important.
When a private company wants to raise capital from the public for the first time, it can sell its common stock through an initial public offering (IPO). Sometimes, public companies listed on a stock exchange need additional capital to grow and can issue new shares on the primary market at prices close to current market price of the firm’s stock. IPOs and seasoned issues are offered in primary market. In primary markets exchange of ownership is between a company and investors.
What happens if an investor owns shares of a company and wants to sell them? The investor may go back to the company and ask them to buy back his share but the company may be in need of capital and may not be willing to buy back the investor’s share. This is where secondary markets come into play. There are many different secondary markets – national stock exchanges such as New York Stock Exchange, regional markets such as Philadelphia Stock Exchange, etc. For most of us, stock market exchanges are more relevant.
The New York Stock exchange is the largest secondary market in the U.S. with more than 2000 listings. The exchange is open daily from 9:30 AM to 4 PM for trading. A company may have listings on multiple exchanges. Each stock exchange has its own requirements on what companies are allowed to list on that exchange.
To trade on an exchange, you need to have a brokerage account. I will talk about brokerage accounts and the trading process in another article.
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