Have you ever wondered how stock exchanges function in India? Those who are baffled by the theoretical aspects of their operations, investments and derivatives, read on. We present here some basic facts about the stock market and how trading is done. V Raghunathan and Prabina Rajib demystify the stock market. . . 

How are shares traded on stock exchanges?

Investors wishing to trade securities in a stock exchange have to channel their trade through a stock broker who is a member of that stock exchange.

The stock broker may be a corporate or an individual though of late individual stock brokers are on their way out, as stock exchanges now tend to favor corporate memberships over individuals. In any case, there are specific guidelines for admitting a person or an organization as a member broker and various criteria such as net worth, education and experience of the aspirants (promoters/management team in case of corporate membership), track record etc are considered before granting membership. These criteria may change depending upon the nature of membership.

For example, determination of whether or not a member may undertake trading in derivatives or debt market instruments, may require a particular level of education and expertise. Each member is also required to maintain a suitable security deposit with the exchange and pay annual membership fees.

The brokers act as agents to trade in securities, i.e. buy and sell securities, on behalf of clients (individual investors, companies etc) for a commission and may also act on their own account and risk.

Until the emergence of electronic trading in the form of dematerialized shares in 1993, trading on Indian bourses was conducted in the age-old style of open outcry system whereby brokers physically assembled on the floor (also known as the ring) of the stock exchange and indulged in some high energy physical trading involving a combination of vigorous gesticulation and lung power, creating an ambience not unlike that of a fish market.

During trading hours (which was between 12 noon and 2.30 pm in most stock exchanges in India) brokers made bids to buy and offers to sell shares, indicating the name, volume and price of shares sought or offered, with a wide variety of signals using their hands, fingers and voices to communicate with other dealers.

The emergence of the electronic trading spelt the end of the era of open outcry. With the advent of electronic trading, investors from distant areas of the country were able to trade in securities through brokers and sub-brokers with on-line connectivity to the stock exchanges.

Both NSE (National Stock Exchange) and BSE   (Bombay Stock Exchange) offer fully computerized screen-based trading facilities to investors. The on-line trading system of BSE is known as BOLT (BSE's On-line Trading System), while that of NSE is known as NEAT (National Exchange for Automated Trading). Both BOLT and NEAT use satellite communication fro trading, using V-SAT.

Thanks to these trading systems, brokers merely enter their buy and sell orders on the computers installed in their premises instead of assembling in the trading ring. Retail investors can also communicate their buy or sell orders through the Internet. The ease of electronic trading has also resulted in a significant increase in trading hours, i.e. from 9.55 am to 3.30 pm on all weekdays or almost six hours daily.

In India, investors may trade in equity shares using two different methods -- cash account (or cash market) or margin trading.

What is trading in the cash market?

The term cash market is a misnomer since trading in the cash market does not really involve any cash transaction. They are all either delivery based or non-delivery based transactions. A delivery based transaction happens in the trade-to-trade segment. The actual delivery of share certificates (electronic delivery) and the payment for the purchase takes place before the next settlement date, when the outstanding accounts arising from trading on cash account for individual investors are settled.

Non-delivery based trading in the cash market is known as day trading. During trading hours, day traders buy and sell stocks in the hope of making profits from intra-day price variations. They take reverse positions to set off their original positions in stocks within the day. At times, these trades may be reversed within minutes. In other words, these traders do not keep their positions open until the settlement date.

Incidentally, an open position implies a bought or a sold position. Reversal of a position implies that the original open position is nullified by a reverse position so that if one has bought a position for 100 shares of a stock, by selling 100 shares of the same stock, this can be reversed and one is back to a neutral position vis-�-vis that stock.

Thus in delivery based trading in the cash market, shares are traded with the intention to deliver (or take possession of), while in the case of day trading positions are squared off within the day. In India, day trading now accounts for almost 80 per cent of cash market equity trading in terms of volume of trade.

The main feature of trading in the cash market is that the total value of the shares bought or the total number of shares sold, has to be delivered on or before the settlement of date.

Reprinted by permission of Tata McGraw Hill Publishing Company Limited.

Excerpted from:

Stock Exchanges, Investments and Derivatives

By V Raghunathan and Prabina Rajib

Price: Rs 295.

V Raghunathan  is currently managing director of GMR Industries [Get Quote] and CEO of GMR Varalakshmi Foundation. Prabina Rajib, with a PhD in Finance from IIT, Kharagpur, is currently working as Associate Professor (Finance) area at Vinod Gupta School of Management, IIT Kharagpur.