Trading for Dummies- A simple Analogy

Trading in Capital markets is one of the most lucrative business opportunity available to common man. It offers very good ROI if done with a stable mindset coupled with proper subject knowledge. However, 8 out of 10 individuals fail to understand the very basic concepts of Share trading and end up in losses. The intention of this post is to explain Trading in layman terms.

Let’s start with the story of John, a fruit juice vendor. John earns his livelihood by selling fruit juice at a busy street of town. He has a small truck where he keeps stock of fruits and has installed a hand-operated juicer. Every morning he procures fruits from a wholesale shop and gets it to this truck. He manages to sell approximately 100 glasses of juice every day, priced at 20 Rs. per glass. Thus his total revenue comes to 2000 Rs. per day or 60000 Rs. per month. His total expense comes around 40000 Rs per month towards procuring fruits, paying rent for the truck and space etc. Thus John effectively earns 20000 Rs per month through this small business.

John envisions goShare Trading for dummiesod future prospects in this business and plans to expand it by renting a shop and purchasing an electronic Juice machine. Also, he would employ a person to help him during wee hours of day. The challenge is that he doesn’t have enough capital to materialize his plans. So he contacts few of his friends and relatives to invest in his business. He explains them the business model and his future plans to expand the business. Luckily he manages to convince two of his friends to raise capital.

John raises 1 Lakh each from his two friends and promises them a good ROI when his business grows. He invests this amount towards a new rented shop, furniture, juicer machine and appointing a helper. Also, he increases the price of juice to 25 Rs. per glass. This transformation indeed grabbed attention of customers and his sale got twice to 200 glasses per day. So his monthly revenue became 1.5 Lakh. After isolating the expenses towards fruits, rent and helpers salary his net profit comes to 60000 per month or 720000 per year. A decent sum, Isn’t it?

Now the question arises, how would the investors gain from this deal? When John took money from his friends he signed an agreement to give them 5% of his total profit amount each year. This calculates to 36000 Rs. Also, John would allow investors to withdraw money from his business at their will. The amount withdrawn would depend on the market value of business at that time. As John’s business grew further, more investors would be attracted towards it and he could open multiple shops in the town.

Now let’s boil down this anecdote in Share market terminology:-

  • John and his fruit juice shop is analogous to a company which wants to raise money from investors, or in other words the company which is registered in Stock exchange.
  • John’s friends represent the shareholders of his company who invests in it with the prospect of making money.
  • John estimated the net initial worth of his company as 10 Lakhs, and offered 1000 shares worth Rs 1000 each. His friends purchased 100 shares each, at the price of 1000 per share. Thus, their individual investment is 1 lakh. Once they purchased these shares, they would be legal Shareholders of John’s company.
  • John offers 5% of the net profit to their investors every year. In share market terminology this is called dividend and offered as a fixed amount per share held.
  • As John’s company grows, its market capitalization would increase which in turn would increase the price per share. Every investor would benefit from this increase in share price. Below is the formula for calculating Share Price.

          Share Price= Market Capitalization / Number of shares outstanding in Market

  • As John’s company grows, more and more investors would be attracted to buy its shares, which in turn would help John to expand his business.
    John carried out all these transactions privately without the involvement of any regulating authority.
  • In real world, such transactions are carried out in recognized stock exchanges regulated by a vigilance authority to avoid malpractices. NSE, BSE are the examples of such exchanges. Companies can list their shares in these exchanges and investors can buy it.

So stock market is as simple as that, isn’t it? We hope this analogy helps budding investors to understand the markets. Please feel free to leave a message if we can help you further.

2 Comments

  1. Great explanation Sir. I started trading 2 years back, but didn’t know these fundamentals. Please share similar analogy for future and options too

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