What are Stocks and how profits are made out of them??
Hello readers. I hope you are convinced that keeping your money in a savings account or a Fixed Deposit is not a financially intelligent decision. If you haven’t read my previous post about investing, please read that first here before proceeding further. If you have read it already, let us discuss what exactly are stocks and how we can trade them. As I am assuming that the people reading this article are a novice to financial markets, I am keeping this in simple so that it won’t confuse you with new terms.
a)What are stocks?
Let us assume that there is a guy named Rahul, who has a business plan which needs the capital of Rs.1,00,000. But he doesn’t have that much money. Let us say the maximum he can invest in his business is Rs.60,000. For him to make his idea to business he is in a deficit of Rs.40,000 which he can arrange in the following ways.
a) He can approach a bank for a loan of Rs.40,000 so that he can immediately start planning for his business start-up, or
b) He can create partners who are confident that his plan is going to make money in future and ready to take the initial business risk with him.
For a new business, the first option, ie. taking a loan from a bank to arrange the capital is not so wise. Because however the business plan is, if a person is new to a business, he cannot expect profits in the early days of business. In the first few years, the owner of the business should look for survival in that business arena. Once he gets the experience of handling the business, he can think of profits. But if he had taken a loan from a bank to start the business, that too in a huge sum, he need to pay very large instalments for the loan repayment every month in spite of not getting net profits out of the business which is a burden.
The second option needs someone to take the risk along with him to invest money. Let us say that he has convinced a person named Raju to invest money (Rs. 40,000). Now we can say Rahul has 60% ownership of the company and Raju has 40% ownership of the company. This can be done by dividing the total capital into shares and distributing them according to the percentage ownership of the investors. Please observe it a bit carefully.
Let us say that he has divided total capital into 1000 shares => 1,00,000/1000 = 100 rupees is the value of each share
Now, number of shares Raju gets = 60% of 1000 shares = 600 shares
number of shares Rahul gets= 40% of 1000 shares = 400 shares.
Now assume that the business yielded good profits and more investors are ready to invest in this company with an expectation of good profits. This means that the demand is increased for the share. The new investors either approaches Raju or Rahul to buy the shares. Without any doubt, these guys will demand more than they paid initially for each share, and hence the price of the stocks will increase. (Price of the stock is the price at which last trade was taken, also called as Last Traded Price in market terminology).
If you observed this example clearly, the price has increased due to the demand for the share. If the stock has a positive sentiment in the crowd and people are willing to buy it without considering the fundamentals behind the company, the stock price will mount upside even though the company is fundamentally weak.
This has just been written for your understanding purpose, but the actual process of dividing the shares is way more complex than this. Anyways, we are not going to use this theory in our day to day trade. In fact, most people don’t know how the process of dividing the shares starts but still makes good money(If you want to read further about this procedure, please visit http://zerodha.com/varsity/chapter/the-ipo-markets-part-1/ ). You might ask me how, but that is a topic for future articles. Trust me, you don’t need all this to trade on shorter time frames, but still, you should have an idea about this. Let’s move onto the next point.
b) How can a trader profits from the stocks?
Whenever there is a movement in the price of an asset, a typical trader has a chance of making money. As simple as that. We have seen in the above discussion that the price of the stock varies with demand and supply (supply is the total number of shares available for sale). The supply and demand changes each and every second in the market. If you can read that imbalance perfectly, you have a great chance of making money in markets. To read that properly, first of all, you must know the definitions of some words which we have studied in our high school like Price, Supply, Demand etc. which I will explain in the next article.
After reading all this, you might have understood that a stock is an asset like gold and real estate. It is not a lottery ticket or a slot machine to gamble. You must have a plan to make money out of it and it demands experience. It is simple but not easy and hard work is a must especially at the starting days of your career. People don’t understand this fact and they always treat trading like gambling. That is the reason why there is a very less success ratio in this business. I hope I can guide you in the correct direction.