Module 1 - Introduction to Stock Markets

 1. The Need to Invest

Learn about the importance of savings. Identify avenues to invest the savings in suitable investment vehicle. Compare historical returns generated by different assets, and know what to expect from you ..

Before we address the above question, let us understand what would happen if one chooses not to invest. Assume you earn Rs.50,000/- per month, and you spend Rs.30,000/-towards your day-to-day living; this can include expenses like housing, food, transport, shopping, medical, etc. The balance of Rs.20,000/- is your monthly surplus.

For the sake of simplicity, let us ignore the tax effect in this discussion.

To drive the point across, let us make a few simple assumptions –

1. 1. The employer is kind enough to give you a 10% salary hike every year.
   2. The cost of living is likely to go up by 8% yearly.
   3. You are 30 years old and plan to retire at 50, this translates to 20 working years.
   4. You don’t intend to work after you retire.
   5. Your expenses are fixed, and you don’t foresee any other expenses.
   6.  The balance cash of Rs.20,000/- per month is retained as hard cash.

Going by these assumptions, here is what the cash balance will look like in 20 years.

Years	Yearly Income	Yearly Expense	Cash Retained
1	600,000	360,000	240,000
2	6,60,000	3,88,800	2,71,200
3	7,26,000	4,19,904	3,06,096
4	7,98,600	4,53,496	3,45,104
5	8,78,460	4,89,776	3,88,684
6	9,66,306	5,28,958	4,37,348
7	10,62,937	5,71,275	4,91,662
8	11,69,230	6,16,977	5,52,254
9	12,86,153	6,66,335	6,19,818
10	14,14,769	7,19,642	6,95,127
11	15,56,245	7,77,213	7,79,032
12	17,11,870	8,39,390	8,72,480
13	18,83,057	9,06,541	9,76,516
14	20,71,363	9,79,065	10,92,298
15	22,78,499	10,57,390	12,21,109
16	25,06,349	11,41,981	13,64,368
17	27,56,984	12,33,339	15,23,644
18	30,32,682	13,32,006	17,00,676
19	33,35,950	14,38,567	18,97,383
20	36,69,545	15,53,652	21,15,893
Total Income			17,890,693

If one were to analyze these numbers, one would soon realize this is a scary situation. A few things are quite obvious –

1. 1. After 20 years of hard work, you have accumulated Rs.1.7Crs.
   2. Since your expenses are fixed, your lifestyle has not changed over the years, and you probably even suppressed your lifelong aspirations – a better home, car, vacations, etc.
   3. After you retire, assuming the expenses will continue to grow at 8%, the retirement corpus of Rs.1.7Crs is good enough to sail you through roughly 8 years of post-retirement life. 8th year onwards, you will be in a tight spot with literally no savings left to back you up.

What would you do after you run out of money in 8 years? How do you fund your life? Is there a way to ensure that you collect a more considerable sum at the end of 20 years?

At this point, you may think that the assumptions are simple and that real life does not work like this. I agree, and I won’t dispute that fact. However, the point to note in the above calculation is that no investments are made, hence the cash retained has a flat or zero growth.

Let’s consider another scenario where instead of keeping the cash idle, you choose to invest the cash in an investment option that grows at, let’s say, 12% per annum. For example – in the first year, you retained Rs.240,000/- which, when invested at 12% per annum for 20 years (19 years assuming you invest at the end of 1st year), yields Rs.2,067,063/- at the end of the 20th year. For those interested in math, here is how that works –

= 240000*(1+12%)^(19)

= 2067063

Dont worry about the math at this point. We will explain that later in this module (and several other modules in Varsity). Here is how the table looks if you choose to invest.

Years	Yearly Income	Yearly Expense	Cash Retained	Retained Cash Invested @12%
1	600,000	360,000	240,000	20,67,063
2	6,60,000	3,88,800	2,71,200	20,85,519
3	7,26,000	4,19,904	3,06,096	21,01,668
4	7,98,600	4,53,496	3,45,104	21,15,621
5	8,78,460	4,89,776	3,88,684	21,27,487
6	9,66,306	5,28,958	4,37,348	21,37,368
7	10,62,937	5,71,275	4,91,662	21,45,363
8	11,69,230	6,16,977	5,52,254	21,51,566
9	12,86,153	6,66,335	6,19,818	21,56,069
10	14,14,769	7,19,642	6,95,127	21,58,959
11	15,56,245	7,77,213	7,79,032	21,60,318
12	17,11,870	8,39,390	8,72,480	21,60,228
13	18,83,057	9,06,541	9,76,516	21,58,765
14	20,71,363	9,79,065	10,92,298	21,56,003
15	22,78,499	10,57,390	12,21,109	21,52,012
16	25,06,349	11,41,981	13,64,368	21,46,859
17	27,56,984	12,33,339	15,23,644	21,40,611
18	30,32,682	13,32,006	17,00,676	21,33,328
19	33,35,950	14,38,567	18,97,383	21,25,069
20	36,69,545	15,53,652	21,15,893	21,15,893
Total cash after 20 years				4,26,95,771

Your cash balance has increased significantly with the decision to invest surplus cash. The cash balance has grown to Rs.4.26Crs from Rs.1.7Crs,  a staggering 2.4x more than earlier (when you choose not to invest). Clearly, with the decision to invest, you are in a much better situation to deal with your post-retirement life.

Now, going back to the initial question of why invest? There are a few compelling reasons –

1. 1. Fight Inflation – By investing, one can deal better with the inevitable reality of life – the growing cost of living – generally referred to as Inflation.
   2. Create Wealth – By investing, one can build a bigger corpus by the end of the target period. In the above example, the period was up to retirement, but it can be anything – children’s education, marriage, house purchase, retirement holidays, etc
   3. Better life – To meet life’s financial aspirations.

1.2 – Where to invest?

Having figured out the reasons to invest, the next obvious question is – where would one invest, and what return can one expect with investing? When investing, one has to choose an asset class that suits the individual’s risk and returns profile. For example, one individual will be open to taking a lot of risk with his or her money, while another may want to take moderate risk, while another would want zero risk.

Think of an asset class as an investment vehicle defined by its risk and return characteristics.  The following are some of the popular asset classes.

1. Fixed income instruments
2. Equity
3. Real estate
4. Commodities (precious metals)

Fixed Income Instruments

Fixed-income instruments are investment avenues where your principal amount (the money you invest) is perceived to be safe. The entity pays an interest amount on the principal you invest. The bank’s fixed deposit scheme is the simplest example of a fixed investment instrument.  The interest paid could be quarterly, semi-annual or annual. The capital is returned to the investor at the end of the investment period, also known as the maturity period.

A few examples for fixed-income instruments are –

1. Bank’s Fixed deposits
2. Bonds issued by the Government of India (also called G Sec bonds and T Bills)
3. Bonds issued by Government related agencies such as GAIL, HUDCO, NHAI, etc
4. Bonds issued by corporate’s (Tata, Bajaj, Reliance, Adani)

As of October 2022, the typical return from a fixed-income instrument (bank’s FD) varies between 5 – 6%. Government bonds offer about 5.5%, and a few corporate bonds offer nearly 9 or 10%. The rates across different instruments vary because of the risk varies. The Govt bonds are considered the safest investment, with zero risk to your investment, because, well, the govt can’t cheat and run away with your money. Corporate bonds are risky, though; investment in corporate bonds can go to zero, and we have seen plenty of such examples in the past.

Equity

Investment in Equities involves buying shares of publicly listed companies. The shares are traded on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).

When an investor invests in equity, unlike a fixed-income instrument, there is no capital guarantee. However, as a trade-off, the returns from equity investment can be much better. Indian Equities have generated upwards of 12% CAGR (compound annual growth rate) over the past 10 to 15 years.

Investing in some of the best and most well-run Indian companies has yielded over 20% CAGR in the long term. Identifying such investment opportunities requires skill, hard work, and patience.

Real Estate

Real Estate Investment involves transacting (buying and selling) commercial and non-commercial land. Typical examples include transacting in vacant plots, apartments, and commercial buildings. There are two income sources from real estate investments: Rental income and Capital appreciation of the investment amount. The rental yield typically varies between 2-3%, which is not so attractive, in my opinion. The appreciation in land prices is in select pockets and is not uniform.

The transaction procedure can be quite complex involving legal verification of documents. The cash outlay in real estate investment is usually quite large. There is no official metric to measure the returns generated by real estate. Hence it would be hard to comment on this.

Things to note before investing

Investing is an integral part of financial planning, but before you start your investment journey, it is good to be aware of the following –

1. 1. Risk and Return go hand in hand. Higher the risk, the higher the return. The lower the risk, the lower the return.
   2. Investment in fixed income is a good option if you want to protect your principal amount. It is relatively less risky. However, you have the risk of losing money when you adjust the inflation return. Example – A fixed deposit that gives you 9% when the inflation is 10% means you lose a net of 1% per annum. Alternatively, the risk increases if you invest in a corporate fixed-income instrument.
   3. Investment in Equities is a great option. It is known to beat inflation over a long period. Historically equity investment has generated returns close to 14-15%. However, equity investments can be risky.
   4. Real Estate investment requires a significant outlay of cash and cannot be done with smaller amounts. Liquidity is another issue with real estate investment – you cannot buy or sell whenever you want.
   5. Gold and silver are relatively safer, but the historical return on such investment has not been very encouraging.

You can download the excel sheet used in the chapter to generate the two tables.

Key takeaways from this chapter

1. One has to invest, to secure his or her’s financial future.
2. The corpus you build at the end of the investment period is sensitive to the return percentage. A slight variation in the rate can significantly impact the corpus.
3. Choose an instrument that best suits your risk and return appetite.
4. Equity should be a part of your investment if you want to beat inflation in the long run.
5. A good investment practice is to build a portfolio that mixes all asset classes.

2. Regulators, the guardians of capital markets

Find out who and how the regulators govern the financial markets and also understand different types of financial market participants. Understand the need to regulate the markets. ..

2.1 – What is the stock market?

In the previous chapter, we established that investing in equities is vital to generate inflation-beating returns. Having said that, how do we go about investing in equities? Before we dwell further into this topic, it is essential to understand the market ecosystem and the many different entities involved in making our capital market journey smooth.

Just like the way we go to the neighborhood kirana store or a supermarket to shop for our daily needs, similarly, we go to the stock market to shop (read as transact) for investments. The stock market is where all the participants who wish to transact in shares go. Transact means to buy or sell shares in the context of stock markets. The primary purpose of the stock market is to help you facilitate your transactions. So if you want to buy shares of a company, the stock market helps you meet the seller and vice versa.

Unlike a supermarket, the stock market does not exist in a brick-and-mortar form. It exists in electronic form. You access the market electronically from your computer and conduct transactions (buy or sell). It is also important to note that you can access the stock market via a registered intermediary called the stockbroker. We will discuss the stockbrokers at a later point.

India has two stock exchanges – the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). There were many other exchanges earlier, but none of them survived. So when you talk about the stock markets in India, you are essentially referring to either NSE or BSE. Older stock exchanges like Bangalore Stock Exchange (BgSE), Madras Stock Exchange (MSE), Calcutta Stock Exchange (CSE) have either merged with BSE/NSE or shut shop.

2.2 – Market Participants and the need to regulate them

The stock market attracts individuals and corporations from diverse backgrounds. Anyone who transacts in the stock market is called a market participant. The market participant can be classified into various categories –

1. 1. Domestic Retail Participants – These are people like you and me transacting in markets
   2. NRI’s and OCI – These are people of Indian origin but based outside India
   3. Domestic Institutions – These are corporate entities in India
   4. Domestic Asset Management Companies (AMC) – Mutual fund companies like SBI Mutual Fund, HDFC AMC, Edelweiss, ICICI Pru, etc.
   5. Foreign Institutional Investors – Non-Indian corporate entities. These could be foreign asset management companies, hedge funds, and other investors.

Now, irrespective of who participates in the market, the agenda for all is to make profitable transactions. More bluntly put – to make money.

When money is involved, human emotions such as greed and fear run high. One can easily fall prey to these emotions and get involved in unfair practices. India has its fair share of such unethical practices. Given this, the stock markets need someone who can set the game rules (commonly referred to as regulation and compliance) and ensure that people adhere to these regulations and compliance, thereby making the markets a level playing field for everyone.

2.3 – The Regulator

In India, the stock market regulator is called The Securities and Exchange Board of India, often referred to as SEBI. SEBI aims to promote the development of stock exchanges, protect the interest of retail investors, and regulate market participants’ and financial intermediaries’ activities. In general, SEBI ensures:

1. 1. The stock exchange conducts its business fairly
   2. Stockbrokers conduct their business fairly
   3. Participants don’t get involved in unfair practices
   4. Corporates don’t use the markets to benefit themselves (Satyam Computers) unduly
   5. Small investors’ interests are protected
   6. Large investors with mega cash piles should not manipulate the markets
   7. Overall development of markets

Given the above objectives, it becomes imperative for SEBI to regulate all the entities which are involved in the market. All the entities mentioned below are directly involved in the stock markets. Malpractice by any of the following entities can disrupt what is otherwise a harmonious market in India.

SEBI has prescribed a set of rules and regulations for each entity. The entity should operate within the legal framework as prescribed by SEBI. The specific rules applicable to a specific entity are made available by SEBI on its website. They are published under the ‘Legal Framework’ section of their site.

Entity	Example of companies	What do they do?	In simpler words
Credit Rating Agency (CRA)	CRISIL, ICRA, CARE	They rate the creditworthiness of corporate and governments	If a corporate (or Govt) entity wants to avail loan (debt financing), CRAs check for creditworthiness and assign a rating, the basis on which other entities can decide to extend a loan or not.
Debenture Trustees	Almost all banks in India	Act as a trustee to corporate debenture	When companies want to raise a loan, they can issue debentures against which they promise to pay interest. The public can subscribe to these debentures. A Debenture Trustee ensures that the debenture obligation is honored
Depositories	NSDL and CDSL	Safekeeping, reporting, and settlement of clients’ securities	They act like a digital vault for your shares. The depositories hold your shares and facilitate the exchange of your securities. When you buy shares, these shares sit in your Depositary account, usually referred to as the DEMAT account.
Depository Participant (DP)	Most of the banks and few stockbrokers	Act as an agent to the depositories	You cannot directly interact with NSDL or CDSL. You must liaise with a DP to open and maintain your DEMAT account.
Foreign Institutional Investors (FII)	Foreign corporate, funds and individuals	Make investments in India	These are foreign entities with interest in investing in India. They usually transact large amounts of money, and hence their activity in the markets has an impact in terms of market sentiment.
Merchant Bankers	Karvy, Axis Bank, Edelweiss Capital	Help companies raise money in the primary markets	If a company plans to raise money by floating an IPO, then merchant bankers are the ones who help companies with the IPO process.
Asset Management Companies (AMC)	HDFC AMC, Reliance Capital, SBI Capital	Offer Mutual Fund Schemes	An AMC collects money from the public, puts that money in a single account, and then invests that money in markets intending to make the investments grow and generate wealth.
Portfolio Managers/ Portfolio Management System (PMS)	Capitalmind Wealth PMS, Motilal PMS, Parag Parikh PMS	Offer PMS schemes	They work similarly to a mutual fund except in a PMS; you have to invest a minimum of Rs.50,00,000; however, there is no such cap in a mutual fund.
Stock Brokers	Zerodha, Sharekhan, ICICI Direct	Act as an intermediary between an investor and the stock exchange	Stock brokers act as a gateway to the stock markets, giving electronic access to stock markets to facilitate transactions.

We will elaborate on some of these market intermediaries in the next chapter.

Key takeaways from this chapter

1. The stock market is the place to transact in equities.
2. Stock markets exist electronically and can be accessed through a stockbroker.
3. There are many different market participants operating in the stock markets.
4. Every entity operating in the market has to be regulated and can operate only within the framework prescribed by the regulator.
5. SEBI is the regulator of the securities market in India. They set the legal framework and regulate all entities interested in operating in the market.
6. Most importantly, you need to remember that SEBI is aware of what you are doing, and they can flag you down if you are up to something fishy in the markets!

3. The Stock Markets

We explore the basics of stock trading and understand what makes the stock move on a minute by minute basis. We also explore concept of return calculation. ..

3.1 – Public Limited company

Having understood the IPO process and the circumstances that lead a company to offer its shares to the public and raise funds,  we are now set to explore the stock markets a step further.

Once a company becomes publicly traded, the company is obligated to disclose all information related to the company to the public. The shares of a public limited company are traded on the stock exchanges daily. There are a few reasons why market participants trade stocks. We will explore some of these reasons in this chapter.

3.2 – What is the stock market?

As we discussed earlier, the stock market is an electronic marketplace. Buyers and sellers electronically express their points of view in terms of trade.

For example, consider the current situation of Infosys. When writing this, Infosys faces a management succession issue, and most of the company’s senior-level executives are resigning. The leadership vacuum is weighing down the company’s reputation heavily. As a result, the stock price dropped to Rs.3,000 from Rs.3,500.

Assume there are two traders – A and B.

A’s view on Infosys – The stock price will likely go down further because the company will find it challenging to find a new CEO. If A trades from his point of view, he should be a seller of the Infosys stock.

However, B views the same situation differently and has a different point of view. According to her, the stock price of Infosys has overreacted to the succession issue, and soon the company will find a great leader. The stock price will eventually move up.

If B trades from her point of view, she should be a buyer of the Infosys stock.

So at, Rs.3000, A will be a seller, and B will be a buyer in Infosys.

Now both A and B will place orders to sell and buy the stocks respectively through their respective stock brokers. The stock broker routes it to the stock exchange. The stock exchange has to ensure that these two orders are matched and that the trade is executed. This is the primary job of the stock market – to facilitate the transactions between different market participants.

A stock market is where market participants can access any publicly listed company and trade from their point of view as long as other participants have an opposing point of view. After all, different opinions are what make a market.

3.3 – What moves the stock?

Let us continue with the Infosys example to understand how stocks move. Imagine you are a market participant tracking Infosys.

It is 10:00 AM Infosys is trading at Rs.3000 per share. The management makes a press statement that they have found a new CEO expected to steer the company to greater heights. They are confident that the newly appointed CEO will do good things for the company.

Two questions –

1. 1. How will the stock price of Infosys react to this news?
   2. If you were to place a trade on Infosys, what would it be? Would it be a buy or a sell?

The answer to the first question is quite simple; the news is positive, so the stock price will increase. Infosys had a leadership issue, and the company has fixed it. When positive announcements are made, market participants tend to buy the stock at any given price, which cascades into a stock price rally.

Let me illustrate this further :

Sl No	Time	Last Traded Price	What price the seller wants	What does the buyer do?	New Last Trade Price
01	10:00	3000	3002	Buys	3002
02	10:01	3002	3006	Buys	3006
03	10:03	3006	3011	Buys	3011
04	10:05	3011	3016	Buys	3016

Notice that the buyer is willing to pay whatever prices the seller wants; this is when the market is said to be bullish. In a bullish market, the prices tend to move up.

So as you can see, the stock price jumped 16 Rupees in a matter of 5 minutes. Though this is a fictional situation, it is a realistic and typical behavior of stocks. The stock price increases when the news is good or expected to be good.

In this particular case, the stock moves up because of two reasons. One, the leadership issue has been fixed, and two, there is also an expectation that the new CEO will steer the company to greater heights.

The answer to the second question is now quite simple; you buy Infosys stocks because there is good news surrounding the stock.

Now, moving forward on the same day, at 12:30 PM, ‘The National Association of Software & Services company’ (NASSCOM) makes a statement stating that the customer’s IT budget seems to have come down by 15%, which could have an impact on the industry in the future. For those unaware, NASSCOM is a trade association of Indian IT companies.

By 12:30 PM, let us assume Infosys is trading at 3030. Few questions for you…

1. 1. How does this new information impact Infosys?
   2. What would it be if you were to initiate a new trade with this information?
   3. What would happen to the other IT stocks in the market?

The answers to the above questions are quite simple. Before we answer these questions, let us analyze NASSCOM’s statement in more detail.

NASSCOM says that the IT budget is likely to shrink by 15%. This means IT companies’ revenues and profits will likely go down soon. This is not great news for the IT industry.

Let us now try and answer the above questions…

1. 1. Infosys is a leading IT major in the country and will react to this news. The reaction could be mixed because there was good news specific to Infosys earlier during the day. However, a 15% decline in revenue is a serious matter, and hence Infosys stocks are likely to trade lower.
   2. At 3030, if one were to initiate a new trade based on the new information, it would be a sell on Infosys.
   3. The information released by NASSCOM applies to the entire IT stocks and not just Infosys. Hence all IT companies are likely to witness selling pressure.

So as you notice, market participants react to news and events, and their reaction translates to price movements! This is what makes the stocks move.

At this stage, you may wonder what would happen to a company’s share price if there is no news. Will the stock price stay flat and not move at all? The answer is yes and no, depending on the company in focus.

For example, let us assume there is no news concerning two different companies…

1. 1. Reliance Industries Limited
   2. Shree Lakshmi Sugar Mills

As we all know, Reliance is one the largest companies in the country, and regardless of whether there is news or not, market participants would like to buy or sell the company’s shares, and therefore the price moves constantly.

The second company is relatively unknown and, therefore, may not attract market participants’ attention as there is no news or event surrounding this company. Under such circumstances, the stock price may not move, or even if it does, it may be very marginal.

To summarize, the price moves because of expectations of news and events. The news or events can be directly related to the company, industry, or the economy as a whole. For instance, the appointment of Narendra Modi as the Indian Prime Minister was perceived as positive news, and therefore the whole stock market moved.

In some cases, there would be no news, but still, the price could move due to the demand and supply situation.

3.4 – How does the stock get traded?

You have decided to buy 200 shares of Infosys at 3030 and hold on to it for one year. How does it work? What is the exact process of buying the stock? What happens after you buy it?

Systems work seamlessly to ensure your transactions go smoothly.

With your decision to buy Infosys, you need to log in to your trading account (provided by your stock broker) and place an order to buy Infosys. Once you place an order, the following details are validated –

1. 1. Details of your trading account through which you intend to buy Infosys shares.
   2. The price at which you intend to buy Infosys
   3. The number of shares you intend to buy

Before your broker transmits this order to the exchange, the broker has to ensure you have sufficient money to buy these shares. If yes, then this order hits the stock exchange. Once the order hits the market, the stock exchange (through their order matching algorithm) tries to find a seller who is willing to sell you 200 shares of Infosys at 3030.

Now the seller could be one person willing to sell the entire 200 shares at 3030, or it could be ten people selling 20 shares each, or two people selling 1 and 199 shares, respectively. The permutation and combination do not matter. From your perspective, all you need is 200 shares of Infosys at 3030, and you have placed an order for the same. The stock exchange ensures the shares are available to you as long as sellers are in the market.

Once the trade is executed, the shares will be electronically credited to your DEMAT account. Likewise, the shares will be electronically debited from the seller’s DEMAT account.

3.5 – What happens after you own stock?

After you buy the shares, the shares will reside in your DEMAT account. You are now a part owner of the company to the extent of your shareholding. To give you a perspective, if you own 200 shares of Infosys, you own 0.000035% of Infosys at the time of writing this chapter.

By owning the shares, you are entitled to corporate benefits like dividends, stock splits, bonuses, rights issues, voting rights, etc. We will explore all these shareholder privileges at a later stage.

3.6 – A note on the holding period

The holding period is the period you intend to hold the stock. You may be surprised that the holding period could be as short as a few minutes to as long as ‘forever.’ When the legendary investor Warren Buffet was asked what his favorite holding period was, he replied ‘forever.’

In the earlier example quoted in this chapter, we illustrated how Infosys stocks moved from 3000 to 3016 in 5 minutes. Well, this is not a bad return after all, for a 5 Minute holding period! If you are satisfied with it, you can close the trade and move on to find another opportunity. To remind you, this is very much possible in real markets. When things are hot, such moves are quite common.

3.7 – How to calculate returns?

Now, everything in markets boils down to one thing. Generating a reasonable rate of return! All past stock market sins are forgiven if your trade generates a good return. Returns are usually expressed in terms of annual yield. There are different kinds of returns that you need to be aware of. The following will give you a sense of what they are and how to calculate these returns.

Absolute Return – This is the return that your trade or investment generates in absolute terms. It helps you answer this question – I bought Infosys at 3030 and sold it at 3550. How much percentage return did I generate?

The formula to calculate is – [Ending Period Value / Starting Period Value – 1]*100

i.e. [3550/3030 -1] *100

= 0.1716 * 100

= 17.16%

A 17.6% is not a bad return at all!

Compounded Annual Growth Rate (CAGR) – An absolute return can be misleading if you want to compare two investments. CAGR helps you answer this question – I bought Infosys at 3030, held the stock for two years, and sold it at 3550. At what rate did my investment grow over the last two years?

CAGR factors in the time component, which we had ignored when we computed the absolute return.

The formula to calculate CAGR is…

Applying this to answer the question…

{[3550/3030]^(1/2) – 1} = 8.2%

This means the investment grew at a rate of 8.2% for two years. As of today, the bank fixed deposit market offers 5.5% with capital protection hence, 8.2% return looks ok compared to a fixed deposit.

So, always use CAGR to check returns over multiple years. Use absolute return when your time frame is for a year or lesser.

What if you bought Infosys at 3030 and sold it at 3550 within six months? In that case, you have generated 17.16% in 6 months, which translates to 34.32% (17.16% * 2) for the year.

So the point is if you have to compare returns, it’s best done when the return is expressed on an annualized basis.

3.8 – Where do you fit in?

Each market participant has a unique style of participating in the market. The style evolves as you progress as a participant and witness market cycles. The participation style is also defined by the risk you are willing to take in the market. Regardless of what you do, you can be categorized as a trader or investor.

A trader is a person who spots an opportunity and initiates the trade with an expectation of profitably exiting the trade at the earliest given opportunity. A trader usually has a short-term view of markets.  Trader is alert and on their toes during market hours, constantly evaluating opportunities based on risk and reward. A trader is unbiased toward going long or going short. We will discuss what going long or short means at a later stage.

There are different types of traders :

1. 1. Day Trader – A day trader initiates and closes the position during the day. He does not carry forward trading positions overnight. A day trader is risk-averse and does not like taking an overnight risk. For example – Buy 100 shares of TCS at 2212 at 9:15 AM and sell it at 2220 at 3:20 PM, making a profit of Rs.800/- in this trade. A day trader usually trades 5 to 6 stocks per day, sometimes even more.
   2. Scalper – A type of day trader. A scalper usually trades very large shares and holds the stock for less time to make a small but quick profit. For example – a scalper buys 10,000 shares of TCS as 2212 at 9:15 and sells it 2212.1 at 9.16, ending up making 1000/- profit in this trade. On any given day, the scalper trades multiple times during the day. As you may have noticed, a scalp trader is highly risk-averse.
   3. Swing Trader – A swing trader holds on to the trade for a slightly longer; the duration can run anywhere between a few days to weeks. For example – Buy 100 shares of TCS at 2212 on 12th June and sell it at 2214 on 19th June.

Some of the successful traders are – George Soros, Ed Seykota, Paul Tudor, Micheal Steinhardt, Van K Tharp, Stanley Druckenmiller, and the late Rakesh Jhunjhunwala etc

An investor is a person who buys a stock expecting a significant appreciation in the stock. The investor is willing to wait for the investment to evolve. The typical holding period of investors usually runs into a few years. There are two popular types of investors.

1. 1. Growth Investors – The objective here is to identify companies expected to grow significantly because of emerging industry and macro trends. A classic example in the Indian context would be buying Hindustan Unilever, Infosys, and Gillette India back in 1990s. These companies witnessed huge growth because of the change in the industry landscape, creating massive wealth for their shareholders.
   2. Value Investors – The objective here is to identify good companies irrespective of whether they are in the growth or mature phase but beaten down significantly due to the short-term market sentiment, thereby making a great value buy. An example of this in recent times is stock tanking in the Covid crash of March 2020. Due to short-term negative sentiment, almost all the good stocks were beaten down significantly around March/April 2020, only to post a V-shaped recovery in the subsequent months.

A few successful investors are – Charlie Munger, Peter Lynch, Benjamin Graham, Thomas Rowe, Warren Buffett, John C Bogle, John Templeton, Mohnish Pabrai etc.

So what kind of market participant would you like to be?

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Key takeaways from this chapter

1. 1. A stock market is where a trader or an investor can transact (buy, sell) in shares.
   2. A stock market is a place where the buyer and seller meet electronically
   3. Different opinions make a market
   4. The stock exchange electronically facilitates the transaction of buyers and sellers.
   5. News and events move the stock prices daily.
   6. Demand-supply mismatch also makes the stock prices move
   7. When you own a stock, you get corporate privileges like bonuses, dividends, rights, etc
   8. The holding period is defined as the period during which you hold your shares
   9. Use absolute returns when the holding period is one year or less. Use CAGR to identify the growth rate over multiple years
2. Traders and investors differ on risk-taking ability and the holding period.

4. Commonly Used Jargons

Glossary of common stock market terms & associated concepts used in trading. We also explain in detail on how to short a stock. ..

This chapter aims to help you familiarize yourself with a few commonly used market terminologies and their concepts.

Let’s get started.

 Bull Market (Bullish) – If you expect the stock prices to go up, you are bullish on the stock price. From a broader perspective, if the stock market index is going up during a particular period, it is referred to as a bull market. Example – The market was bullish from mid-2020 to early 2022.

 Bear Market (Bearish) – If you expect the stock prices to go down, you are bearish on the stock price. From a broader perspective, if the stock market index goes down during a particular period, it is referred to as a bear market. Example – The market was bearish from early 2008 to late 2009.

 Trend – The term ‘trend’ usually refers to the general market direction and its associated momentum in the market. For example, if the market is declining fast, the trend is said to be bearish. If the market is trading flat with no movement, then the trend is said to be sideways.

 Face value of a stock – The face value (FV) or par value indicates the nominal value of a share. The face value is important from a corporate action perspective. We will discuss corporate action in a separate chapter. Usually, when dividends, stock splits, or bonuses are announced, they are issued, keeping the face value in perspective. For example, the FV of Infosys is 5, and if they announce an annual dividend of Rs.63/-, the dividend paid is 1260%s (63 divided by 5).

 52-week high/low – 52-week high is the highest price point at which a stock has traded during the last 52 weeks (which also marks a full calendar year); likewise, a 52-week low marks the lowest price point at which the stock has traded during the last 52 weeks. The 52-week high and low gives a sense of the range within which the stock trades during the year. Many traders believe that if a stock price reaches 52 weeks high, it indicates a bullish trend for the foreseeable future. Similarly, if a stock hits 52 week low, some traders believe it indicates a bearish trend for the foreseeable future.

 All-time high/low – This is similar to the 52 weeks high and low, with the only difference being that the all-time high price is the highest price the stock had ever traded from when it was listed. Similarly, the all-time low price is the lowest price the stock had ever traded from when it was listed.

Upper and Lower Circuit – The exchange sets up a price band within which the stock can be traded on a given trading day. The highest price the stock can reach on the day is the upper circuit limit, and the lowest price is the lower circuit limit. The limit for a stock is set to 2%, 5%, 10%, or 20% based on the exchange’s selection criteria. The exchange places these restrictions to control excessive volatility when a stock reacts to certain news related to the company. The criteria (in terms of exchange restriction) changes for derivatives stocks (and index); more on that later.

 Long Position – Long position or going long is a reference to the direction of your trade. For example, if you have bought or intend to buy Biocon shares, you are long on Biocon or planning to go long on Biocon, respectively. If you have bought the Nifty Index with an expectation that the index will trade higher, you have a long position on Nifty. You are considered bullish if you are long on a stock or an index.

 Short Position – Going short or ‘shorting’ is a term used to describe a transaction carried out in a particular order. This is a slightly tricky concept. To help you understand the concept of shorting, I’d like to narrate an old incident at work; this happened around mid-2014, if I remember right.

If you are a gadget enthusiast like me, you would probably recollect that Xiaomi (a Chinese manufacturer of smartphones) entered into an exclusive partnership with Flipkart to sell their flagship smartphone model called Mi3 in India. The price of Mi3 was speculated to be around Rs.14,000/-. If one wished to buy Mi3, he/she had to be a registered Flipkart user as the phone was not available for a non-registered user, and the registration was open only for a short time. I had promptly registered to buy the phone, but my colleague Rajesh had not. Though he wanted to buy the phone, he could not because he had not registered on time.

Out of sheer desperation, Rajesh walked up to me and made an offer. He said he would buy the phone from me at Rs. 16,500/-. As a trader at heart, I readily agreed to sell him the phone! I even demanded he pays me the money right away.

After I pocketed the money, I thought to myself, what have I done?? Look at the situation I’ve put myself into. I’ve sold a phone to Rajesh, which I don’t own yet!!

But then, it was not a bad deal after all. I agree I had sold a phone that I didn’t own. However, I could always buy the phone on Flipkart and pass the new, unopened box to Rajesh. My only fear in this transaction was, what if the phone price is above Rs.16,500?? In that case, I’d make a loss and regret entering into this transaction with Rajesh. For example, if the phone were priced at Rs.18,000, my loss would be Rs.1,500 (18,000 – 16,500).

However, to my luck, as expected, the phone was priced at Rs.14,000/-, I promptly bought it on Flipkart, and upon delivery, I handed over the phone to Rajesh, and in the whole process, I made a clean profit of Rs.2,500/- (16500 – 14000)!

If you look at the transaction sequence, I first sold the phone (that I didn’t own) to Rajesh, then bought it later on Flipkart and delivered it to Rajesh. I sold it first and bought it later!

This type of transaction is called a ‘Short Trade.’

The concept of shorting is very counter-intuitive to normal humans because we are not used to ‘shorting’ in our day-to-day activity unless we have a trader mentality 

Going back to stock markets, think about this straightforward transaction – on day 1, you buy Wipro shares at Rs.405, two days later (day 3), the stock moves, and you sell your shares at Rs.425. You made a profit of Rs.20/- on this transaction.

In this transaction, your first leg was to buy Wipro at Rs.405, the second leg was to sell Wipro at Rs.425, and you were bullish on the stock.

On day 4, the stock is trading at Rs.425, and you are now bearish. You are convinced that the stock will go back to Rs.405. Is there a way you can profit from your bearish expectation? You could, and it can be done by shorting the stock.

You sell the stock at Rs.425, and 2 days later, assuming the stock trades at Rs.405, you repurchase it.

If you realize the trade’s first leg was to sell at Rs.425, and the second leg was to buy the stock at Rs.405. This is always the case with shorting – you first sell at a price you perceive as high to buy it back at a lower price later.

You have executed the same trade as buying at Rs.405 and selling at Rs.425 but in reverse order.

An obvious question you may have is – How can one sell Wipro shares without owning them? You can do so, just like I sold a phone I did not own. So shorting is possible in the stock markets. The important point to remember is that when you short a stock, you must ensure that you buy back the stock the same day before the market closes. Of course, you can short a stock in the derivatives segment and carry forward the position for a few days. But at this point, ignore the derivatives bit and understand that all short positions in stocks (also called cash segment) have to be closed before the market closes. In other words, a short position in the cash market works only on an intraday basis.

To sum it all up…

1. 1. When you short, you have a bearish view of the stock. You profit if the stock price goes down. After you short, if the stock price goes up, you will end up making a loss.
   2. When you short a stock, ensure you buy the stock back the same day before the market closes unless you use derivatives to short.
   3. Shorting a stock is easy – you select the stock you wish to short and click on sell.

To summarize long and short positions…

Position	1st Leg	2nd Leg	Expectation	Make money when	You will lose money if
Long	Buy	Sell	Bullish	Stock goes up	Stock price drops
Short	Sell	Buy	Bearish	Stock goes down	Stock price goes up

Alright, let’s continue our discussion on commonly used stock market jargon.

 Square off ­– Square off is a term used to indicate that you intend to close an existing position. If you are long on a stock squaring off the position means selling the stock. Note when you close a long position, you have to sell the stock, and this sale is not considered a short position. Here you are merely closing an existing long position!

Squaring off a position means repurchasing the stock when you are short on the stock. Remember, when you repurchase it, you are just closing an existing position, and you are not going long!

When you are	Square off position is
Long	Sell the stock
Short	Buy the stock

 Intraday position – This is a trading position you initiate with an expectation to square off the position within the same day. For example, all short positions in stocks are intraday positions.

 OHLC ­– OHLC in stock prices refers to open, high, low, and close. We will understand more about this in the technical analysis module. For now, open is the price at which the stock opens for the day, high is the highest price at which the stock trade during the day, low is the lowest price at which the stock trades during the day, and close is the closing price of the stock. For example, the OHLC of ACC on 17th June was 1486, 1511, 1467, and 1499.

 Volume – Volumes and their impact on stock prices are important concepts that we will explore in greater detail in the technical analysis module. Volumes represent the total transactions (buy and sell put together) for a particular stock on a particular day. For example, on 17th June, the volume on ACC was 5, 33,819 shares.

 Market Segment – A market segment is a division within which a certain type of financial instrument is traded. Each financial instrument is characterized by its risk and reward parameters. The exchange operates in three main segments.

1. 1. Capital Market (CM) – Capital market segments offer tradable securities, such as stocks and exchange-traded funds (ETFs). So if you were to buy or sell shares of a company, you are essentially operating in the capital market segment. Shorting stocks, too, comes under the capital market segment. The cash market is sometimes referred to as the spot market.
   2. Futures and Options (FO) – Futures and Options, generally referred to as the equity derivative segment, are where leveraged products are traded. We will explore the derivative markets in greater depth in the derivatives module (Futures modules and Options Module)
   3. Currency Derivatives (CDS) – The CDS segment is where currency pairs like USD INR, EUR INR, JPY INR are traded. The trading is via futures and options; hence it’s called the currency derivative market.
   4. Wholesale Debt Market (WDM) – The wholesale debt market deals with fixed-income securities. Debt instruments include government securities, treasury bills, bonds issued by a public sector undertaking, corporate bonds, corporate debentures, etc.

These are some of the commonly used jargon. If you can think of any other, please comment below, and I’d be happy to decode that for you.

5. Clearing and settlement process

An introduction to the various macros economic factors that impact the performance of shares and stock markets. ..

5.1 – Market structure

The topic of clearing and settlement is super important to understand as it gives you a sense of the movement of money and funds between your account and, let’s just say, the stock market. For instance, when you buy a stock, say 100 shares of Marico, you need to clearly understand how long it takes for the broker to remit these 100 Marico shares to your Demat account. We can extend this to stock selling as well.

The lack of understanding of the clearing and settlement process could leave a void and leave you with many unanswered questions related to the market structure. Hence, for this reason, we will explore what happens behind the scenes from when you buy a stock to when it hits your DEMAT account.

We will keep this discussion practical with a clear emphasis on what you need to know about clearing and settlement.

5.2 – What happens when you buy a stock?

Day 1 – The trade (T Day), Monday

Assume on a Monday, you buy 100 shares of Reliance Industries at Rs.1,000/- per share. The total buy value is Rs.1,00,000/- (100 * 1000). The day you make the transaction is the trade date; brokers refer to this as the ‘T Day.’  The assumption is that you intend to hold Reliance Industries in your Demat account for a few days or maybe years, and it is not an intraday trade.

When you place an order to buy, the broker quickly validates if you have the necessary funds. In this example, the order will go through only if you have Rs.1,00,000/- in your trading account; it will be rejected otherwise. Assuming the trade is executed through Zerodha, the applicable charges are –

Sl No	Chargeable Item	Applicable Charges	Amount
01	Brokerage	Zero for Equity Delivery. For intraday, charges are 0.03% or Rs.20/- whichever is lower, per executed order	Zero
02	Security Transaction Charges(STT)	0.1% of the turnover	100/-
03	Exchange transaction Charges	0.00345% of the turnover	3.45/-
04	GST	18% of Brokerage + Transaction charges + SEBI charges	0.62/-
07	SEBI Charges	Rs.10 per crore of transaction	0.12/-
Total			104.19/-

Additionally, Rs.15/- towards stamp duty is applicable. Stamp duty is charged at 0.015% on the buy side. Hence the total applicable charges are Rs.119.19. Note that these rates are subject to change; you can visit Zerodha’s Brokerage calculator to figure out the exact applicable rate when you wish to carry out a transaction.

So an amount of Rs.1,00,000 plus 119.19 totaling Rs.1,00,119.19/- is required to carry out this particular transaction. Remember, the money is blocked in your account when you place a trade, but the stock is yet to hit your DEMAT account.

Also, on the T day, the broker generates a ‘contract note’ and emails you the copy to your registered email id.  A contract note is like a bill detailing all your daily transactions. You can save the contract note for future reference. A contract note gives you a break up of all daily transactions and the trade reference number. It also shows the breakup of charges charged by the broker.

Day 2 – Trade Day + 1 (T+1 day, Tuesday)

Brokers refer to the day after the transaction day as T+1 day. On T+1 day, you can sell the stock you purchased the previous day.  If you do so, you are making a quick trade called “Buy Today, Sell Tomorrow” (BTST) or “Acquire Today, Sell Tomorrow” (ATST). Remember, the stock is not in your DEMAT account yet. Hence, a risk is involved, and you can be in trouble for selling a stock you don’t own. This doesn’t mean every time you make a BTST trade, you end up in trouble, but it does once in a way, especially when you trade stocks that are not liquid enough. I’d encourage you to read this article to understand the risks of a BTST trade.

If you are a fresher in the market, I suggest you do not get into BTST trades unless you understand the risk involved. Continuing the example, from your perspective, nothing happens on T+1 day.

To summarize – On T day, you placed an order to buy 1L worth of Reliance shares. The broker validated that you have the necessary funds. Upon validation, the funds were blocked by the broker. On T day, the broker runs a post-trade process, where an obligation amount equal to what’s payable (for purchase) and receivable (for sale) is posted to their respective ledgers. The shares you bought will show up in your trading terminal with a ‘T+1’ tag, indicating that the shares are available for you to sell if you wish. But doing so results in a T+1 or BTST transaction with its associated risk.

Day 3 – Trade Day + 2 (T+2 day, Wednesday)

On Day 3, also called T+2, the settlement is due to the exchange. Assuming the purchaser and seller are trading via two different brokers, the funds are debited from the buyer’s broker’s pool account by the clearing corporation and credited to the selling broker’s pool account. Also, on T+2 day, the shares will reflect in the purchaser’s DEMAT account, indicating that you own 100 shares of Reliance.

So for all practical purposes, if you buy a share on day T Day, you can expect to receive the shares will be fully settled in your Demat account only by the end of T+2 day.

5.3 – What happens when you sell a stock?

The day you sell the stocks is again referred to as the ‘T Day’. The stock gets blocked when you sell the stock from your DEMAT account, and by the end of the day, the stocks are ‘earmarked’ for settlement. Please refer the next section to know more on earmarking.

Before the T+2 day, the earmarked shares are delivered to the depositary. On settlement day, the blocked shares are debited from your demat account and moved to the clearing corporation for payin. Against the debit of such shares, you’d have received a credit for the sale after deducting all charges. You may be interested to note that you will receive 80% of the funds on T+1 and the remaining 20% on T+2. In other words, the seller will be settled fully on a T+2 basis, just like how the buyer is settled.

What transpires between T day and T+2 is a complex settlement process involving the stockbroker, clearing corporation, depositary, and the stock exchange. Each entity uploads and receives multiple files to ensure the transaction goes smoothly. As far as you are concerned, you need to remember that equity transactions are settled on T+2 basis, meaning, if you are a buyer, you will get the shares on T+2, and if you are a seller, the funds are credited on T+2 basis.

5.4 – Earmarking and T+1 settlement

Earlier, for the settlement of a sell trade, the broker would be required to debit shares from a selling client, hold the securities in the broker’s pool account and transfer the securities to the clearing corporation (CC) on T+2. Upon transfer, the client would receive a credit of funds against the sale, and the transaction would have been said to be settled. It was usual practice for brokers to debit shares on T day or T+1 day and transfer it to CC on T+2 (since the settlement is on T+2).

From the time the shares were debited until they were settled, the client shares lie in the broker’s pool account, possibly allowing a broker to misuse these securities. SEBI identified this as a potential risk and introduced “earmarking” for settlement. In this new earmarking system, shares are no longer debited from the client’s account; they are only earmarked for settlement. Think of earmarking as a temporary hold on the securities towards an upcoming settlement for the sale transaction initiated by the client.

On settlement day, the shares are debited from the investor’s account and credited to the clearing corporation. This new process eliminates the need for brokers to hold client shares in their pool account, thereby eliminating the risk that comes along. The new earmarking process has been made mandatory from November 2022.

By the way, our regulators are continuously working towards safeguarding retail investors from any possible pitfalls and, in the process, improving the efficiency of the market structure. One such effort is to move to a T+1 settlement for all equity settlements by March 2023.

Exciting times ahead 

 

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Key takeaways from this chapter

1. The day you make a transaction, the trade date is referred to as the ‘T Day.’
2. The broker must issue you a contract note for all transactions by the end of T day.
3. When you buy a share, the same will be reflected in your DEMAT account by the end of T+2 day.
4. All equity/stock settlements in India happen on a T+2 basis.
5. When you sell shares, the shares are blocked immediately, and the sale proceeds are credited again on T +2 day
6. Earmarking of shares was introduced to ensure the securities dont move out of client’s demat account to the broker’s pool account