mechanism of stock trading

Mechanism of

Stock Trading

A Simple story

This is a storyOf, • How a company/business is formed• Buying and selling of shares• Rising and decline of share prices• Etc...

Company/Business is formed

Meet Siril.

Siril is a farmer. He understood the demand for

coconuts. He had an idea to start a coconut

plantation to meet this demand. So he bought some

land and equipment using a loan. The only problem

was that he lacked enough money to buy coconut

saplings. He had Rs 2,500 but the saplings cost

Rs.5,000. What could he do?

Company/Business is formed

Initial Public Offering

for raising capital

Siril

meets 5 good friends of his

“My friend Nimal, I want 500 rupees from you, But I’m not sure if I could pay it back as a loan. But I can promise you that I will give you a precentage of my harvest to you”

Nimal: “OK friend, I’ll give you the money...”

Initial Public Offering for raising capital

What did Siril do?

He offers his friends a share of his business

Initial Public Offering for raising capital

a Partner or

a Shareholder

The coconut plants grew rapidly

1st year harvest = 100 coconuts

• As Siril paid 50% for the saplings.So he kept 50 coconuts and decided

to share the rest among the friends, 10 per each

• They can use or sell them

Distinction Between Being a Partner and Being a Shareholder

A General Meeting was held by the investors

• They discussed weather they get their coconuts or ask Siril to sell them and give them the money

Decision made: – do the 2nd

• So Siril sold the coconuts and gave his friends the money received

Distinction Between Being a Partner and Being a Shareholder

And also Siril issued a small note saying,

“Siril and Company” “You have one share guaranteeing you,

10% of the company’s profits”

Distinction Between Being a Partner and Being a Shareholder

Trading occurs on Siril’s undervalued Shares

Now Siril’s plantation is very much richer

Production : 500 coconuts

• He sells each for Rs.20 and he got a revenue of Rs.10000/=

Earnings of per share holder = Rs.1000

Siril buys more saplings with his Rs.5000/=• Those plants are also now productive and Siril

now owns a Rs.20000/= revenue creating coconut plantation

Trading occurs on Siril’s undervalued Shares

Sunil, a neighbor of Siril,

sees this and wants to join in (More investors)

Nimal, who’s a share holder of Siril’s company

willing to sell his share

So Sunil likes to pay Rs.500 for the share (Bidding)

But Nimal, not a jerk, knows that this share earns Rs.2000 now (Earnings Per Share)

Trading occurs on Siril’s undervalued Shares

Nimal

asks Rs.2000/= for the share

(Asking)

Sunil agreed and he buys the share for Rs.2000/=

(trading happens)

Trading occurs on Siril’s undervalued Shares

A Bit of a

Bubble

Forms

Oh, What was other share holders

were thinking???

“ Hey, what does Nimal just did? How did he made

money that much quick?We wanna sell too!!!”

Siril’s other neighbors : “We’d like to buy too!!!”

A Bit of a Bubble Forms

Shares are trading...Now share price = Rs.5000/=

It is more than the earnings of Siril’s plantation

(now, shares are over valued)

A Bit of a Bubble Forms

One loyal share holder -> Gayan

Buyers asks for Rs.6000 but he refuse to sell

Why?

He has a fixed income

A Bit of a Bubble Forms

Oh no, Beetles

They destroyed whole one year’s production

Share holders are in troublebecause they used their savings to invest in

A Bit of a Bubble Forms

Bubble bursts

2 share holders, want money, sell their shares to Gayan for Rs.2000/=

(share price declined)

Now Gayan owns 3 shares of Siril’s company

Other share holders also want to sellBut, Gayan don’t need any.

Oh, They are in trouble

Bubble bursts

Jayantha comes in to the sence

He offers Rs.1500 per share

2 share holders sell their shares to Jayantha Rs.1500 each

(share price goes down more and more)

Bubble bursts

Demand is still there

Siril wants to start again

But he don’t have any money...

Bubble bursts

Siril

Issues a

Bond

Due to the tragedy happened,Siril do not want to issue more shares

He don’t wanna get a load either...

........................................

New Idea......

Siril Issues a Bond

Why not sell some of his items?

He selects some crates to sell without actually selling them

(because he needs them back when the production resumed)

Siril Issues a Bond

Call for Nimal from Siril....“Nimal, my good friend, I have an offer for you. I'll sell you my crates, which are worth Rs.5000 total, for a mere Rs.3000 and then buy them back next week for the full Rs.5000.“

Nimal thinks for a while and agrees

Deal is done

Siril Issues a Bond

"But Nimal," Siril adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."

"I don't know - can we call it a

promissory note?" Nimal asks enthusiastically.

"Sure can, but I was thinking more of calling it

a bond or a certificate," says Siril.

Siril Issues a Bond

Insecticide applied -> beetles eliminated

And he pays Nimal as promised and re-own the crates

All are back to normal

Siril Issues a Bond

What

we

learnt?

This story may not explain everything about investing in stocks,

but it does highlight one very important point: ‘the price of Siril's stock followed investors' opinion of the stock's value rather than just the performance of Siril's company.

What we learnt?

Because the stock market is an auction,

There is no set price for a certain stock,

There is a concept that derails most people's trains of thought:

the price paid for a stock is what it's

"worth" until a lower or higher price is offered.

What we learnt?

This fluctuation of worth is good and bad for investors

– because it allows for profit (when you buy an undervalued stock)

– but also makes losses possible (when you pay too much for a stock).

What we learnt?

Learn more about Stock trading

and Colombo Stock Exchange...

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