Stock market: what is it and how it works

What is a stock market 01

A stock market is where stocks, bonds, currencies and other assets are traded. The concept of market has implications not only for the transfer function of securities, but also for other transactions in securities, such as issuance and taxation. It also allows for fair pricing.

Characteristics of the stock market

The securities market has certain features:

• it always has a fixed trading platform, such as the stock market of the New York Stock Exchange (NYSE);
• there must be a specialized mechanism for selecting goods (assets) that meet certain requirements;
• established trading procedures on time and standards;
• all transaction processing is centralized;
• the activities of all market participants are controlled by authorized bodies;
• there are official quoted prices of assets.

The exchange requires a multi-component infrastructure for full operation. The first is the functionality of the exchange itself – trading platforms and other systems. Professional participants operate on the exchange – this is its investment part. These include banks, brokers, dealers and other organizations involved directly in securities trading. The trading process is supported by technical participants – clearing centers, depositories, registrars. Finally, an important part of the Exchange's operations is information support – it interacts with news agencies and the business press.

Participants of the stock market

There are three types of participants involved in securities trading:

• Issuers – companies that issue and sell their securities;
• Investors – individuals or companies that buy securities;
• Professional participants – people or companies whose activities are officially connected with the exchange. These are brokers who enter into transactions on behalf of investors, banks, dealers and management companies

In addition, such status may be obtained by individuals who have passed a specialized certification, in which case they may conduct transactions in a certain type of securities.

What is a stock market 02

The change of this status is always reflected by indices – indicators of dynamics of different groups of securities:

• Virtually every trading platform has the exchange index. For example, in the US, these are the S&P500 indices, as well as the NASDAQ. The New York Exchange (NYSE) acts as their provider, i.e. it is actually responsible for the correctness and continuity of the calculation. It is important to realize that such indices do not reflect the value of all stocks that are traded on the trading platform. Most often stock indicators are counted for a certain number of stocks – mostly securities of the most expensive companies or stocks with the highest trading volumes.
• The international index includes securities of different countries. An example of such an index is MSCI or The World Index. Such broad indices can cover geographic sectors such as Europe, Asia, North America.
• The sector index refers to the capitalization of securities in a particular domestic market in America, Asia or European exchanges.
• The industry index includes securities of specific sectors of the economy. These can be indexes of IT companies, oil and gas, pharmaceutical companies.

Indexes are calculated using several formulas:

• The market capitalization index takes into account the market capitalization of companies. That is, the more expensive the issuer, the greater its weight in the index. According to this formula, the sum of the prices of all stocks is multiplied by their number and divided by a specific convenient figure, it can be a round number such as 10 or 100. This is how the S&P 500 index is calculated.
• The equally weighted index is calculated so that the weight of each stock in the index is equal. Company A has a capitalization ten times higher than company B. However, in an equally weighted index, the share of company A will be the same as the share of company B.

Weighting by price is the classic method. It is the simplest, and it is what the world's oldest and most established indexes, such as the Dow Jones or Nikkei, rely on. According to the formula, the value of all index assets is divided by their number.

There are also Laspeyres, Paasche and Fisher formulas used to calculate price indices. Other methods of indexing the state of the markets take into account such indicators as volatility, minimum variability and others.

The index allows you to assess the demand for shares, the situation in the industries, assists in making a forecast for future changes in the value of securities. Index data is used in technical and fundamental analysis. It enables speculation, risk hedging, and arbitrage between different trading platforms.

Indices on its own can serve as the underlying asset for derivative securities such as futures or options.

How to trade on the stock market 03

A private investor cannot independently trade on the stock exchange, including the securities market. To access the trading floor, he/she needs a broker – an expert who has a special license that allows him to make transactions with assets. Such an intermediary is not an individual, but a brokerage company. However, it is also possible to deal with private experts.

Besides choosing a broker, it is necessary to open a brokerage account – where the investor will transfer funds and the broker will withdraw funds to buy securities. And vice versa, to sell them.

The broker also acts as a tax agent. Once an investor receives income from transactions, he or she is liable to pay income tax on the profit. The broker makes all the settlements and the investor's brokerage account receives the cleared amount.

Once the transaction has taken place and the securities have been acquired into ownership, a record of this and the securities themselves are kept in the depository. It is a financial market participant that accounts for and holds assets.

Broker and depository services are always paid; they can be included in the transaction as a percentage or paid separately according to the established tariff.

Technical and fundamental analyses 04

At the core of some strategies is speculation – trying to capitalize on the difference in buying and selling assets. The market is very fast, with hundreds or thousands of transactions occurring in a matter of seconds that change the value of securities. To predict the maximum benefit from transactions, professionals use analytical methods that take into account quote prices, indices, market volatility and other indicators.

Technical analysis is an analysis based on the study of past price changes in securities. It is used to determine when to buy or sell. Traders visualize prices in the form of various charts (lines, "candles", etc.). You can detect patterns or price behavior on these charts. These patterns indicate further price movement and assist in deciding whether to make a trade.

In addition to patterns, the technical analysis uses various estimates – indicators. Indicators are averages of price indicators or price trends. Indicators can be superimposed on the price chart, such as moving average or Bollinger lines, or they can be displayed on a separate scale and, for example, take values from 0 to 100 (stochastic oscillator, MACD). Indicators that show on a separate scale and whose values represent coefficients and ratios are called oscillators. Buying or selling signals are given when the indicator crosses a certain level. The oscillator also allows you to see overbuying and overselling levels. In general, technical analysis deals with the quote prices of securities, without taking into account the market and economic indicators in the country and the world.

Fundamental analysis is the analysis of the financial health of securities industries, the economic standing of countries, and the safety and capitalization of companies. It can be said that fundamental analysis shows the real value of assets. For companies, fundamental analysis actually assesses the financial health of the business, the market as a whole, competitor deals, and forecasts possible investments and dividends. It is very useful for long term strategies.

The difference between fundamental and technical analysis is that fundamental analysis is based on the financial standing of the company, its position in the market and industry and tells you how cheap or expensive a company's securities are relative to the securities of similar companies. The technical directly indicates the moments to make a trade. Experienced investors can use both analyses for trading.

Stock market returns 05

The yield is the difference between its value at different periods of time, expressed as a percentage. In other words, to get a return, you have to buy at a low price and sell at a high price. This difference becomes income.

An additional source of profit can be income from the securities themselves – stock dividends, bond coupons or profits from mutual funds.

Reinvestment allows you to increase your income by investing profits from securities in new securities.

Return on investment in securities can be calculated using a formula where financial investments at the beginning of the period are subtracted from financial assets at the end of the period and the result is divided by the same figure of financial assets at the beginning of the period. The resulting number should be multiplied by 100%, and this will be the yield percentage.

Example. An investor invested ₽500k in securities at the beginning of the year. At the end of the year, the total value of his portfolio was already ₽550k. Thanks to the formula, we can calculate that the yield for his/her strategy turned out to be 10%.

It should not be forgotten that the yield should take into account broker's, depositary's, registrar's commissions, taxes and possible withdrawal interest.