How The Stock Market Works

What You Need To Know Before You Start Investing In The Stock Market ... Obviously, before you can start investing your money in the stock market, you need to know how the market works. You need to know who the players are, and what the rules are which you need to follow. If you already know this stuff, then that's great, you can skip over this and just go straight on the the next section. If you are new to it all, then this part is a bit of a background look into how it all works, and how you can get started.

What are shares?

Shares, as the name implies, gives the share-holder a part-ownership of the company offering them. If you own shares in a company, essentially you are a part owner of the company. Not generally a very large part, but a part all the same.

Why do companies offer shares?

Companies looking to raise finance for the expansion of their existing business, to takeover another existing business, or to raise capital for a new business venture will offer shares to the public as a way of generating or raising money.

When a company offers shares for the first time, this is called a "float"; subsequent offerings within the same company are generally called "issues". As an owner of shares in a company, you are known as a "shareholder".

Initial public offerings (IPO's) and floats are often handled by stockbrokers, who will make the offer available to their client base, giving them fist option to buy these shares. If there are any shares left after that, the general public is then given a chance to participate if they wish, and purchase some shares in the offering company.

If all shares in the company are bought before it lists on the stock market, it is said to be "fully-subscribed", if not; it is "under-subscribed". If there are more people willing to purchase the shares than what there are shares available on offer, then it is said to be "over-subscribed".

The initial public offering (IPO)

When a company wants to list its shares on the stock market, they put together what is called a "prospectus". A prospectus gives potential investors an overview of the company, and the activities, which the company is engaged in. It also explains what it is the company is intending on doing with the raised money, along with projected returns and future growth etc. There are very strict guidelines set about by the governing stock markets, about how companies must operate and present their information to their potential shareholders.

The prospectus gives you a breakdown of the company, how much money they currently have, how much debt they owe, who the directors are, and what their positions and financial interests within the company are. It also tells you what the company is projecting to earn, and how they anticipate on spending their future profits.

If you are happy with the company and its proposal (prospectus), you can apply to purchase some shares in it. This can generally be done by completing the accompanying application form and attaching a cheque for the right amount of money.

If you are successful in acquiring your shares, the money will be debited from your account, and you are now a shareholder, and will be notified by the company. If not, you will be notified, and your cheque will be sent back to you.

Often, you may be issued some shares, but not the exact amount you asked for.

If the offering is oversubscribed, they may be able to offer you some shares, but not all of the shares you applied for as they may need to split up some parcels in order to cater for all of the other subscribers. If this is the case, you will be notified of how many shares you were allocated, debited for that amount, and refunded the difference.

The issue price

Because this is the first initial offering for the company, they really do not have any idea of what price the shares will be once they reach the open market, and are made available to all of the traders. The company therefore set a price which they feel should reflect what the shares are worth, based on their opinion of what the shares are worth. This is the "issue price".

The issue price is the price you pay for your shares if you buy them directly from the company, or the issuer, before they reach the market.

Once they hit the market, the issue price may have no bearing at all on how the rest of the market feels about them. They could go up or down dramatically when they first reach the open market, and often do.

There have been many occasions where the shares have gone up or down by as much as 200-300% or more from their initial issue price on the first day of trading.

For this reason, I personally generally never buy shares directly from the float, as there really is no telling what may happen, and you really have to rely on your own "gut instinct" as to what you think might happen.

Then the shares hit the stock market

As the shares start trading on the market, their price will change on a daily basis depending on many different factors. These factors will influence how people feel about the share, which will reflect accordingly in the share price.

Over the days, weeks, months, years to follow, the share price will change and continue to fluctuate. The price of the shares after a few weeks of trading could be a long way off from the initial issue price. The price will vary according to peoples perception of how well the company is performing, how well it has performed in the past, and more importantly, how well they feel it will perform in the future.

Making Money in the Stock Market
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