How Do Stock Prices Work?
For many investors this should be an easy question to answer, right?
It is a basic bit of knowledge for stock market investors, yet you would be gob-smacked at how many private investors really do not understand the mechanics behind share price movements.
Back to basics
Let's revisit the basic principles:
Stocks, or shares of a company, represent ownership equity in the firm, which give shareholders voting rights as well as a residual claim on corporate earnings in the form of capital gains and dividends.
Stock markets are where retail, professional and institutional investors come together to buy and sell shares in a public arena. Nowadays these exchanges exist as electronic marketplaces.
Share prices are set by supply and demand in the market as buyers and sellers place orders. Order flow and bid-ask spreads are often maintained by specialists known as 'market makers' to ensure an orderly and fair market.
What is a stock?
While there are two main types of stocks, common and preferred, the term "equities" is synonymous with common shares, as their combined market value and trading volumes are many magnitudes larger than that of preferred shares.
The main difference between the two is that common shares usually carry voting rights that allow the shareholder to have a say in annual general meetings, where matters such as election to the board of directors or appointment of auditors are voted upon. Where as preferred shares generally do not have voting rights. Preferred shares are named because they have preference over the common shares in a company to receive dividends as well as assets in the event of a liquidation.
Common stock can be further classified in terms of their voting rights. While the basic idea of common shares is that they should have equal voting rights - one vote per share held - some companies have dual or multiple classes of stock with different voting rights attached to each class. In such a dual-class structure, Class A shares, for example, may have 10 votes per share, while the Class B "subordinate voting" shares may only have one vote per share. Dual or multiple class share structures are designed to enable the founders of a company to control its fortunes, strategic direction and ability to innovate.
Stock exchanges are secondary markets, where existing owners of shares can transact with potential buyers. It is critical to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis, Companies may engage in stock buy-backs or issue new shares, but these are not day-to-day operations and often occur outside of the framework of an exchange.
So when you buy a share or stock on the stock market, you are not buying it from the company, you are buying it from an existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company, you sell them to some other investor.
Hence, the stock exchange market is made up of buyers and sellers only - a very important point to note!
The advent of modern stock markets ushered in an age of regulation and professionalisation that now ensures buyers and sellers can trust that their transactions will go through at fair prices and within a reasonable period of time. Today, there are many stock exchanges in the U.S. and throughout the world, many of which are linked together electronically.
This means markets are more efficient and therefore more 'liquid'. We will talk more about why liquidity matters in a later blog.
In most developed countries, stock exchanges are self-regulatory organisations, non-governmental organisations that have the power to create and enforce regulations and standards set by financial regulators.. The priority for stock exchanges is to protect investors through the establishment of rules that promote ethics and equality.
Setting a stock's price
The prices of shares on a stock market can be set in a number of ways, but most the most common way is through an auction process where buyers and sellers place bids and offers to buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which somebody wishes to sell.
When the bid and ask coincide a trade is made at the price where the bid and ask collide.
The overall market is made up of millions of investors and traders, who may have differing ideas about the value of a specific stock and therefore the price at which they are willing to buy or sell. The thousands of transactions that occur as these investors and traders convert their intentions to actions by buying and/or selling a stock cause minute-by-minute fluctuations in the stock's market price over the course of a trading day.
For the average investor to get access to these stock exchanges, they would need a stockbroker. The stockbroker acts as the middleman between the buyer and the seller. Getting a stockbroker is most commonly accomplished by creating an account with a well-established retail broker.
Stock market: It's all about supply and demand
The stock market also offers a fascinating example of the laws of supply and demand, at work in real-time.
For every stock transaction, there must be a buyer and a seller. Because of the immutable laws of supply and demand, if there are more buyers for a specific stock than there are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.
The bid-ask or bid-offer spread - the difference between the bid price for a stock and its ask or offer price - represents the difference between the highest price that a buyer is willing to pay or bid for a stock and the lowest price at which a seller is offering the stock. A trade occurs either when a buyer accepts the ask price or a seller takes the bid price.
If buyers outnumber sellers, they may be willing to raise their bids in order to acquire the stock; sellers will therefore ask higher prices for it, moving the market price up.
If sellers outnumber buyers, they may be willing to accept lower offers for the stock, while buyers will also lower their bids, effectively forcing the market price down.
Buyers vs. Sellers
Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as market makers.
A two-sided market consists of the bid and the offer. The more narrow the bid-offer spread and the larger size of the bids and offers (the amount of shares on each side), the greater the liquidity of the stock.
If there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth. Stock markets of high quality generally tend to have small bid-ask spreads, high liquidity, and good depth. Likewise, individual stocks of high quality, large companies tend to have the same characteristics.
Matching buyers and sellers of stocks on an exchange was initially done manually, but it is now increasingly carried out through computerised trading systems. The manual method of trading was based on a system known as "open outcry," in which traders used verbal and hand signal communications to buy and sell large blocks of stocks in the "trading pit" or the floor of an exchange.
However, the open outcry system has been superseded by electronic trading systems at most exchanges. These systems can match buyers and sellers far more efficiently and rapidly than humans can, resulting in significant benefits such as lower trading costs and faster trade execution.
The price of any stock at any moment is determined by finding the price at which the maximum number of shares will be transacted. After that price is determined, the transactions are completed and that price is shown as the price of the stock at that moment. This process is continued repeatedly during trading hours, as well as during the after-market trades.
This process is highly reflexive, a fact not appreciated by many. It is reflexive because the price listed at a moment or during a sequence can be a (very) important factor in determining offers to buy or sell. There is an entire field of stock analysis, called technical analysis that studies just such movements.
To get a clearer picture of this important phenomenon, imagine that stock prices were always determined only by objective external factors, subject to analysis, e.g. earnings. Then all actors would place their orders independently of market trading, selling when they think the price is high relative to their perceptions of the growth of the underlying stock and/or their liquidity needs and buying if they think prices are low and they have the money.
Showing prices of transactions at all times changes the picture as there can be some actors who act on price movement alone e.g. they might be more inclined to buy stocks which have been going up, or have followed certain patterns etc.
Such players also contribute to the overall market by providing additional liquidity which makes trades more efficient by lowering spreads between asking and bidding prices. Note that improved efficiency of trading does not imply improved efficiency of price discovery as it can be argued that the influx of technical trading players makes prices more prone to such patterns in a reflexive process.
For instance, if they tend to keep buying only stocks that go up, then stocks will tend to go up just for the sake of doing so until they suddenly stop because technical buyers reached their technical limits. Similar scenarios apply to other widely accepted technical trends e.g. head-and-shoulders etc.
Companies with highly valued stocks are masters of managing this process by making sure their fundamentals keep improving and that they react to bad patterns and breaks in technical behaviour of their stocks.
One can argue that companies with great track records of continually rising earnings do not need to care about behaviour of their stock prices, as they often state themselves. Google has been a great example of such behaviour. On the other hand, there are also companies that have been enjoying benefits of very high stock prices for years, with minimal actual earnings, such as Amazon.
Their fans will point out to all the potential, but you can ask their competitors what they think of markets giving Amazon continued access to all this capital to squash competition and run their operations. The point is that reflexive market behaviours can be a key factor in determining who wins and loses.