Another one...
http://openlib.org/home/ila/MEDIA/2005/equitymkt_faq.html
Recent fluctuations in the stock market raised many questions about the determination of stock prices, speculation and market manipulation. Unsubstantiated media reports generated hysteria and images of the BSE Sensex being manipulated. The reality is different. While there may be problems with manipulation of small stocks, it is nearly impossible to manipulate the market index.
q: How is a stock price determined?
a: When you own one share of a company, you are part owner of the company. As owner, you get a share of the profits that are paid out, which is the "dividend" earned by the share. The price of a share reflects the value of all future dividends that the company is expected to give.
q: Why do stock prices go up and down?
a: Changing expectations about the future dividends lead to changed prices.
As an example, suppose there is a company in the oil extraction business. As of yesterday, it's share price would reflect the dividends that it was expected to produce as of yesterday. Now suppose that today an announcement is made that the company has made a big discovery of crude oil. This new information positively changes the outlook for future dividends. Hence, the share price will go up.
Similarly, on 17 May 2004, the outlook for all Indian companies as a whole became much more gloomy when the stock market saw that the UPA was going to be unable to push economic reforms. Share prices fell in response.
Every day, new information unfolds, and share prices move in response to that information. Sometimes people say there is a "law of gravity" that when share prices go up, they have to go down. Numerous people glibly talked about a "long overdue correction". There is no law which says that good news has to be followed by bad news or vice versa. In fact, over the long decades, stock prices have risen dramatically - the BSE Sensex was at just 120 in April 1979. There is no law which says that it has to go back to 120.
q: How does this process, of feeding information into prices, take place?
a: Prices are formed out of the process of speculation on the stock market. A very large number of speculators are constantly watching the thousands of prices in the country. They are looking at all manner of information about the companies. If they feel that a price is "too low", they buy shares. If they feel that a price is "too high", they sell shares. This process of speculation, spread across a very large number of players, is called "speculative price discovery". It is a highly effective method for obtaining informative prices.
q: What about money flows into the market?
a: Many people make a mistake by claiming that for share prices to go up, "someone has to be buying". But for a trade to take place, there has to be one buyer and one seller. If someone is buying, then equally, someone is selling. A newspaper headline "Stock prices went up on heavy FII buying" can equally be written as "Stock prices went up on heavy individual selling".
q: But we always hear that FIIs dominate the stock market?
a: In 2004, FII transactions accounted for 5.8% of the market trading. The tail cannot wag the dog. The dominant force in the Indian equity market is the tens of thousands of individuals operating from all across the country.
q: Why do you claim that these speculators make a "sound" price?
a: Individual speculators have the correct incentives. If a share is "too cheap", some speculators will like to buy it. If a share is "too costly", some speculators will like to sell it. If an individual speculator makes a mistake, he pays the price for it. If he makes a correct decision, he reaps the fruits of it. There are no regulatory or corporate governance problems intruding into his decisions.
Unlike individuals, employees of finance companies, grandiosedly called "financial institutions" are often unable to act rationally. Wrongly drafted regulations routinely forbid rational decisions. And the self-interest of an employee may not lead to correct decisions. A great strength of Indian finance is the small size of sluggish institutional investors and the large size of rational individuals.
q: How many such individuals exist?
a: Nobody knows. But we know that there are 7 million accounts at NSDL. We don't know how many of these are active speculators, involved in price discovery.
q: What is market manipulation?
a: A manipulator starts with (say) Rs.100 crore and chooses a company X. He engages in sustained heavy buying on the market. He might also plant some fraudulent stories about company X in the business press. The price goes up. He hopes to sell out at the high price and walk away holding a cool profit.
q: What are the impediments faced?
a: When a price becomes "too high", rational speculators from all across the country start selling shares of X. Hence, the amount of money required to distort the price is quite large relative to the size of trading (or "liquidity") of the shares of X.
Manipulators do not distort prices for fun: they distort prices in order to make money out of it. The bigger hurdle faced by the speculator is that of getting out of a manipulative position with money. It is one thing to put down a large amount of money into buying shares of X. The difficult thing is selling out and translating this into profit. When a price is known to be too high, no rational speculator will want to buy those shares. The manipulator is often reduced to unethical practices of locating some ignorant public sector bank or FII on whom the shares are dumped at the high price. This carries it's own risks: it might not always be possible, and the manipulator can get caught.
Manipulation will take place when the rational manipulator compares the costs and benefits of manipulation and feels that he has a good chance of making a very high return. More liquidity on the market, and less big money in the hands of ignorant institutional investors, means that there will be less market manipulation.
Over the years, it has become increasingly clear that the biggest traded securities in India are simply too big for anyone to engage in market manipulation. Securities like Nifty, Infosys, Reliance, etc. are vast pools of speculative activity. It is too difficult for a manipulator to affect such prices. As market liquidity has gone up over the years, the problem areas have shifted down to smaller and smaller stocks, such as the recent concerns about companies with share prices below Rs 5, called "penny stocks".
q: What can SEBI and the exchanges do to increase the impediments faced by market manipulators?
a: These impediments are heightened when there is equity derivatives trading and short selling. When these are available, the rational speculator is able to exert pressure even if he does not own shares in X. A key aspect of this is derivatives trading, which empowers people who have knowledge. The equity derivatives are settled in cash: this means that a man who has knowledge but not shares can participate in that market, help restore sanity, and profit from it.
q: Why is it nearly impossible to manipulate stock market indexes?
a: Nifty is the 50 biggest stocks in India. The market capitalisation of Nfity is Rs.12,26,126 crore. Yesterday, Rs.10,184 crore of trading in Nifty derivatives took place. These are all very big numbers. The manipulator would need massive amounts of money to even influence the price. More importantly - it is not clear how he could profit from it.
q: What should the rational reader do?
a: You do not need to be a speculator to enjoy the superior returns of equity investment. You can participate in the growth of the equity market through index funds. Index funds are available on Nifty, Nifty junior and the BSE Sensex. All three have shown handsome profits in recent years, given the growth of these indexes. The BSE Sensex has gone up from 120 to 8600 in the period from 1979 to 2005.
If you do engage in stock speculation, be sure you really know a lot about the companies that you are trading in. And, if you are concerned about manipulation, you are safest when you are in a active stock where there are thousands of other traders.
