Have you ever looked at the small numbers in red and green displayed at the bottom of a daily news segment and wondered how those prices are set in the first place? Have you ever wondered why it seems as if these prices change within the blink of an eye? Well, if so, you are in the right place. If not, how stock prices are set is still one of the most fundamental aspects of finance, and it is important for you to learn! Let’s dive into it.
Supply and Demand
First, let’s go over supply and demand. The supply of stocks refers to the number of stocks that can be sold at a point in time, and the demand of stocks refers to the number of investors, or speculators, who are interested in buying a stock at a point in time. Fundamentally, stock prices naturally adjust to balance the supply and demand ratio. A good analogy is that of an auction: in an auction, the price depends directly on the highest bid at a point in time. If one bidder bids $500, and then another bidder bids $550, the item being auctioned would sell for $550. Stocks work similarly to auctions, but unlike auctions, the sellers have to match the price they ask for the stock to be sold with the price the buyer is willing to pay. This is done through an order book.
The Order Book and Bid-Ask Spread
Think of an order book as a journal that organizes all of the wagers on stock into a legible format. There are many components of an order book, but today, we will go over three: buy orders, sell orders, and the bid-ask spread.
To start, let’s go over buy orders or bids. Buy orders are comparable to the bids discussed in the auction analogy. If somebody wants to buy a stock, they can put in an order to buy it at whatever price they deem, or at their bid. If person A wants to buy stock B, they can place an order that says, “I will buy this stock if I can purchase it at $500”. If they place this order, the purchase will only go through if person A can buy stock B at the set price.
Now, let’s go over sell orders, or asks. Sell orders are the direct opposite of buy orders. If person B already has five shares of stock B, and person B wants to sell 2 of their shares of stock B, person B has an option to put in an order to sell that stock at whatever price they deem worthy. For example, their sell order would say, “I will sell this stock if I can sell it at $500.” A sell order of this type works the same as a buy order in that it will only go through if they can sell it at $500.
The bid-ask spread is the difference between the highest bid and ask prices. A sale will go through if that difference is zero or if the bid price exceeds the asking price. In our example of stock B, person A wants to buy the stock at $500, and person B wants to sell the stock at $500. Therefore, the order will go through because the people have agreed on a price.
Market Price
Now, the market price, or the price you see on TV of stocks, is determined equivocally. There is no one way that the market price is determined. Sometimes, the market price is the same as the last traded price of a stock. So, if a stock is sold at $101, the market price will be $101. Other times, it may be the average of a bid and an ask. If a bid is $96 and an ask is $98, the market price would be the average of those two terms, which is effectively $97. There are also many other ways of determining the market price of a stock. If we zoom out of the granular and think about a giant stock trading on a significant stock exchange such as the NASDAQ, it is easy to see how these prices can change so much. For some stocks, new orders are made every second; therefore, the market price will change accordingly.
So, now you know how stock prices are set! You have just begun your journey to discover the mechanics of money.
Talking Finance . 