Stock prices are determined by the pressure that buyers and sellers exercise on each other by trying to consume the available quantities of shares at each price level being traded. If there are only 100 shares available at a price of $10 and the next batch is 150 shares priced at $10.5, as soon as any trader executes a market order to buy 200 shares, the share’s price will move to $10.5 leaving the remaining 50 shares to be bought.
Let’s get into deeper detail on how this process works and the basics you need to know about shares in order to understand everything. Here’s what we’ll talk about:
What is a stock?
A stock is a small piece of ownership in a company. We have to be really careful with the word “ownership”, just because you’re a shareholder in a company that doesn’t mean you can walk away with a desk or a laptop that belongs to the company, a company is a legal entity and it can own things.
The ownership refers to the shares themselves, which depending on the type of stock we talk about can give you the right to vote in important decisions, receive dividends (by the way, here's a cool explanation about dividends) in different ways such as a preferred fixed payments or just a profit split based on the amount of shares you own.
Remember, owning a company’s stock doesn’t mean owning the company itself, it literally means owning just the shares which will give you certain benefits.
Investors want to buy stocks for several reasons, for example:
- They believe the price of the stock itself will rise.
- They want to gain control over company’s votes in order to steer it in the direction they want (for example, by controlling a large voting power such as 70% of the shares, an investor can appoint whoever he wants as CEO of the company, or chose to liquidate the whole business, sell it for parts and bank some profits out of this).
- They want to earn dividends (profits generated by the company) in proportion to how many shares they own.
Why companies issue stocks?
Companies issue stocks with the precise intention of raising more capital. Imagine, right now there is a company trying to launch a monster product worldwide, they don’t have enough capital for the expansion and after some good thoughts, they make decision to open themselves for investors.
Investors buy shares and through this process everyone gets what they want:
- Investors get a new asset which can generate them profits in several ways.
- The company gets more capital, becomes more valuable and is able to double down on their business plans.
Where are stocks traded?
Traditionally stocks are traded in Stock Exchanges such as NYSE (the New York Stock Exchange) or many more all over the world, in each country there can be several stock exchanges.
Bear in mind that not all stocks are traded publicly, that’s why you probably heard the distinction between a privately owned company and a publicly traded one.
If you go right now and open your own company, you could issue stock and change the valuation of your company to attract some private investors but in this case, your company is still privately owned, not everyone can go buy and sell your shares.
In the case of publicly traded companies such as Apple, Google, Microsoft, anyone can buy and sell their shares as long as they are connected through a broker to the exchange where those shares are being traded.
How does exchange trading work?
An Exchange can be a physical location, electronic platform or even both where market participants coincide to execute their buy and sell orders.
Exchanges are usually not directly accessible by retail investors, that’s why we have the middleman called broker.
If you want to buy or sell 100 Apple Shares, you log in to your broker and execute the transaction which get’s routed straight into an exchange and matched against the available orders.
A very important point to remember is that we must never make the mistake to think that trading CFDs happens over an exchange, CFDs are OTC derivatives and they’re trading directly between parties off-exchange.
What is the order book?
The order book, as the name says it, is literally a record of all the buy and sell orders pending to be executed or being executed at the moment and here lies the key to understanding how prices are being determined. Here’s how they can look:
By the way, before you continue reading check this out: usually it’s more complicated to look at order books for stock exchanges as brokers charge data fees in order to provide this service, but in the cryptocurrency world they’re wide open, click here to visit Binance’s advanced platform and just stare for a bit at the right side of your screen (in a desktop PC) and you’ll see the magic of the order book flowing right in front of you (we’re not advising you to sign up there or to trade crypto, this is just for you to know how it looks in real time while it functions).
So, going back to our explanation:
How are stock prices determined?
If the current price of a share is $10 and you place a SELL LIMIT order at $15, your order will be on the exchange’s order book pending to be executed.
Another market participant can see that the share’s price is $10 and chose to place a BUY LIMIT order at $9.
Both orders are pending and when this process is being repeated by thousands of market participants then the order book looks fully packed of pending orders waiting for certain price conditions to be met.
Now, there are other market participants who don’t want to wait for a particular price, they just want to buy or sell RIGHT NOW!
They execute MARKET ORDERS, which means that as soon as they click the button, the buy or sell orders will be executed immediately upon availability.
So, this is literally how prices move! Market participants eat through the available shares at each price level.
Example of how stock prices are determined
Suppose that we have:
- 10 Available shares to be SOLD at $53
- 10 Available shares to be SOLD at $52
- 10 Available shares to be SOLD at $51
- 10 Available shares to be BOUGHT at $50
- 10 Available shares to be BOUGHT at $49
If you log in to your trading platform (assuming you’re trading real shares and not CFDs) and you execute a market order to BUY 20 Shares, you’ll instantly move the price of the share to the next level available above $52 which is $53 as you consumed all the available quantities below (20 shares).
Also something interesting is that usually this renders the cheaper buy orders below useless as they get further away from reaching their target and usually those market participants will have to either wait forever for prices to reach their desired target or to readjust their pending orders.
Now you understood 100% how stock prices are determined and it’s very simple:
Market participants are constantly battling one another and consuming available share blocks at specific price levels thus causing prices to change.
Thanks to this constant actions in the financial markets, we talk about the battle between bulls and bears, as buyers and sellers are constantly fighting one another to take their money.
Some important points to remember:
- When you trade CFDs, you are not making an impact on market prices as your trades are off-exchange between you and your broker, you’re just betting on price differences and every buy or sell orders does not consume anything in an exchange’s order book.
- Viewing the order book for a stock exchange usually is not that easy as not every broker provides this option and usually it’s considered an extra cost that needs to be passed to the users, they usually refer to it as the data connection fee.
And last but not least:
We understood the process of price determination, but ultimately what will move stock prices is whatever is going on through the head of the people clicking the buy and sell buttons.
If tomorrow everyone wakes up believing that Apple’s shares will skyrocket to $5000 per share, then everyone will proceed to immediately cancel any sell limit orders they have at cheaper prices and this will trigger a chain reaction that will make the price of that particular share appear suddenly at a huge price level, simply by removing pending sell orders.
Good luck and happy trading!