Pricing

Taking a break from our series on the best investment, here is a primer on how stock market pricing works.

You have a box spring you want to sell, so you advertise for $150 dollars. Your neighbor offers you $90. You accept because you just want it gone. (This is not biographical in any way.)

The market is similar. Below are four components of the pricing system, but the exact system is a little more complex.

Components

1. Bid-Ask

Here is one person who stands ready to buy a stock at a particular price: the bid price. Conversely, here is another person who stands ready to buy that same stock, but only at their particular price: the ask price. The price listed on market reports and on Google are an average of the bid and ask prices.

2. Spread

Interestingly, there is always a difference between the bid and ask price: the spread. The person selling will not sell below their ask price, and the person buying will not buy above their bid price. New buyers and new sellers have to accept the available bid or ask price if they want to trade.

3. Volume

Volume is the number of trades on a stock per day, sometimes reported as per week. Volume affects the spread. The higher the volume, the narrower the spread. This will make better sense in the scenarios below.

4. Orders

When a person wants to buy or sell, they put in a buy or sell order. That order has a lot of information on it. Simply though, it has: the name of the stock they want to trade, the operation (buy or sell) and the price at which they desire that trade, if applicable. In fact, it is usually the case that people selling will sell at the highest available price. The converse is true for buyers. Orders come in several flavors, but stop orders are crucial. This is where bid and ask prices originate. One person will sell, but not below $10. They put in a sell stop order, which states their intentions. The lowest price at which someone is willing to sell is: the ask price! Again, the converse is true for buy stop orders.

Scenarios

A. One trade

A person wants to buy a stock at any price. They will buy it from the person who is willing to sell it at the lowest price. That was the ask price, remember? After that transaction, there is a new ask price. This comes from someone who stood ready to sell all along, but not as low as the last guy. Every trade in either direction exposes the next layer of bid or ask prices.

B. Market sell-off

This stock is not doing well. The company represented by that stock (a factory) has just discovered radioactive substances under their building. In the market that morning, the panic sets in. Many people who own that stock put in sell orders (sell at any price). The first bid price available is $9.42. For every sell completed, a new bid price is uncovered, so the bid price keeps dropping precipitously. As it drops, the ask price also drops because traders who put in sell stop orders are now retracting them and putting in new, lower sell stop orders. Thus, both bid and ask prices drop.

C. Market buy-up

It turns out that the company Geiger counter was broken. There is no radioactive substance, just oil. Oil! The market that morning responds with a buy up. The first ask price is taken, then the next available ask price, then the next and so on, raising the listed ask price. The bid price rises similarly as buy stop orders are retracted and resubmitted.

D. Small cap to big cap

If a stock has one million shares outstanding and every shareholder owns one hundred shares, what is the highest number of traders that can act on new information? Answer: 20,000. Each trader (10,000) has a counterpart from the market (another 10,000). Every company is limited in trading by the number of shares available. The larger the company, the more they are worth, the more shares issued, the larger the potential volume. As more people own the stock, and as more information is broadcast (larger companies get more attention), the more traders will want to trade it. As more people react to smaller bits of information, the more trades will occur (the volume will rise) and the spread will narrow.

Ugly truth: no one person can understand the impact of every trader on the market price.

Beautiful truth: you do not need to understand any of that. You just need coaching.

Simon Joshua is a licensed investment advisor representative at Cornerstone Wealth Partners in Michigan. He has structured his practice around investor coaching and committed himself to leading communities in establishing a legacy of fulfillment.