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When discussing with my son basic economics (how the price is driven by demand, among others), I came to wonder which exact mechanism triggers a price change in a stock exchange.

In everyday life, prices are fixed (in practical terms) by the provider (a shop for instance). The consumers either buy it or not, which can drive the provider to lower the price (or not). In any case, there is a trigger (the decision of the owner to set a price) that probes the market.

What is the equivalent in a stock market? Specifically, what exact mechanism modifies the price to get a reaction of the ones who would like to buy or sell stock? I understand that globally the demand drives the price, but once the price is, say, 10 EUR - what triggers a change?

  • Is it a random mechanism ("we, the stock exchange organization, will fluctuate the price around 10 EUR to see whether more will buy or sell")?
  • Or an offer is done by some of the ones who would like to sell or buy ("I will ask around to buy for 9 EUR and see if someone sells", or "I will set the price of my share to 11 EUR instead of 10 and see if someone buys from me"?)
  • Or something else?
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    $\begingroup$ Maybe read abotut a "bid-ask spread" which is the amount by which the ask price exceeds the bid price for an asset in the market. The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. $\endgroup$ – Jesper Hybel Sep 29 at 10:11
  • $\begingroup$ Simplified logic. Limit orders are placed to buy (Bid) or sell (Ask) at specified price. These go into the order book. Market orders to buy "lift" the Ask orders, from lower to higher price, until volume is filled. Market orders to sell "hit" the Bid orders, from higher to lower price, until volume is filled. Active buyers lift offers. Active sellers hit bids. Greed and fear can be seen at price levels when the order book clears and prices move up or down rapidly at the best bid and ask. Day traders and market makers watch order flow. Now usually fast computer algorithms monitor order flow. $\endgroup$ – SystemTheory Sep 29 at 16:11
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    $\begingroup$ The mechanism is a sale of the share. The stock price is nothing more than the last price someone paid for a share. It changes again the next time a share is sold. Unlike normal prices you're used to, which are advertised prices - a promise to sell something to you at a fixed price, a stock price is just looking in the rear view mirror to see what the last person paid. It's not what you would pay - you pay whatever the best offer price is. $\endgroup$ – J... Sep 29 at 23:54
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I won’t discuss the fundamental reasons why stock prices change (discussed in another answer), but the mechanics (roughly) work like this. (Real world is more complex, since there are multiple exchanges, and high frequency trading.)

An exchange matches orders from buyers and sellers. The sensible way of making an order is to put a limit price on it. So you either make a bid up to a maximum price, or sell at a minimum.

  • If your order cannot be matched to an existing order, it is added to the queue of orders. There is a list of bids (buy orders) and offers (sell orders), which are ordered by price. E.g., if the highest bid is to buy at \$90, a bid at \$100 is better and is added to the front of the queue. (If the order price matches an existing price, the orders are processed first-in, first-out.) No transaction has happened, so there is no recorded stock price change. (Exchanges report the best bid/offer, which might change.)
  • If your order can be matched (either you pay as much as someone is willing to sell at, or sell at a price people are willing to pay), you buy/sell at the prices specified by the existing orders. E.g., if there were orders to buy 100 shares each at \$100 and \$90, and you are willing to sell 200 at \$90, you first sell at 100, then 90. The pricing history will note the transactions, and the price drops.

Other orders are “market orders,” where you buy/sell at the best offer/bid. In the era of high frequency trading - where the prices move extremely fast - this is surprisingly risky. A market order can be considered to be a bid with a limit of infinity (!) or a sell at 0 (which explains the risk, if orders can jump extremely rapidly). In a market where most orders are market orders, they will account for most of the transactions - limits are set not to trigger a transaction, rather they wait for a market order.

One thing that is often not appreciated is that professional traders will continuously monitor their open orders. They will remove them and add them back at new prices in response to news. This means that the prices can jump without any buying or selling: people can adjust prices without there being any transactions. This effect means that it is safest to think about prices as being set based on traders’ views, and not some mechanical supply and demand effect based on buying and selling flow numbers.

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    $\begingroup$ "This effect means that it is safest to think about prices as being set based on traders’ views, and not some mechanical supply and demand effect." But trader's views define what the demand is. If based on my preferences I demand 10 quantity at price 1 and when I demand 5 quantity at price 2 then that is my demand regardless of whether any trade takes place or anyone is willing to sell me that quantity at that price (same goes for supply). So if the price is based on trader's views then they are based on supply and demand effects. $\endgroup$ – csilvia Sep 29 at 12:23
  • $\begingroup$ I clarified, but the point is the same: those bids and offers are not fixed for all time. They move based on information. The common error is to assume we can just look at buy/sell order quantities. $\endgroup$ – Brian Romanchuk Sep 29 at 14:35
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    $\begingroup$ "...If your order can be matched either you pay as much as someone is willing to sell at, or sell at a price people are willing to pay..."---this means a limit order that crosses the spread. In practice, limit orders are rarely placed on the other side, which defeats the point of limit orders. "Some orders are market orders...this is surprisingly risky"---this suggests market orders are rare, because they are "risky". This is somewhat misleading. Most trades occur due to market orders. LO's and MO's trade off between execution risk and price risk. $\endgroup$ – Michael Sep 30 at 23:12
  • $\begingroup$ It’s a simplified discussion. Given the speed of HFT trading, I wouldn’t recommend market orders, since you have fairly open-ended potential to get stuffed. $\endgroup$ – Brian Romanchuk Oct 1 at 1:54
  • $\begingroup$ Question at hand is what's the mechanism that causes price change. If price means "transaction price" (instead of quoted price), the fact is that vast majority of transactions occurs by market orders, regardless whether someone "...would/wouldn’t recommend market orders...". If one inspects the limit order book at tick frequency, it would show that the type of transaction you describe occurs rarely. $\endgroup$ – Michael Oct 1 at 5:34
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In stock market price is determined directly by supply and demand interacting in a way that is somewhat similar to haggling in traditional physical markets. Buyers will offer their bids for a stock (i.e. they will state for which price they are willing to buy a stock). At the same time sellers will have their ask price (i.e. they will state the price for which they are willing to sell).

Normally the bid will be lower then ask price and either buyer has to increase their bid or seller decrease their ask for trade to occur or some combination of thereof. In past this was done physically by people literally ‘haggling’ on the floor but nowadays it is mostly done by price setting algorithms.

The bids and asks themselves depend on what the buyers and sellers think the company's value is. Value of a company depends mainly on its future profitability. For example, a very simple model for determining company's value is the Gordon Growth model where stock price $P$ would be given as:

$$P = \frac{D_0(1+g)}{r-g}$$

where $D_0$ is the dividend in base year, $g$ is the growth rate of dividend payments and $r$ is the rate of return. The formula above is in its essence a discounted value of future income streams (which in turn ultimately depend on firm's profitability as firm that is constantly experiencing loss wont have any resources for dividends) from the stock. This is not the only way how to value stocks it is just an example of how one might determine how much a stock price is worth. I also choose the model as an example because its simple not because its necessary more useful than other asset pricing models.

Because the future profitability and value of the company is always uncertain and very difficult to predict stock prices will move in a stochastic fashion and be random to some degree. However, that is not because buyers and sellers would randomly pick price and see what happens - they will try the best to make their valuations based on their own perceived best predictions of company's future profitability. For example, in the context of the Gordon pricing formula above two traders might disagree what $g$ or $r$ will be and their predictions of what they will be might fluctuate across time. But the prices are not random in a sense that sellers just randomly picks price on interval $[0,\infty)$ and see what sells.

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  • $\begingroup$ Indeed, a seller can't randomly pick a price on the interval $[0, \infty)$. There is no uniform probability distribution on $[0, \infty)$. $\endgroup$ – Charles Hudgins Sep 30 at 0:25
  • $\begingroup$ @CharlesHudgins There are non-uniform distributions. $\endgroup$ – user253751 Oct 2 at 15:23
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    $\begingroup$ That's true, but a non-uniform distribution already expresses some prior knowledge about the distribution of prices. Making a choice, even if done probabilistically, on the basis of prior knowledge is not what I think the layman would understand by the term "random." $\endgroup$ – Charles Hudgins Oct 2 at 15:48
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    $\begingroup$ For instance, a delta distribution would reflect perfect knowledge about which price to pick. I don't think we would say that someone who chooses on the basis of such a distribution chooses randomly. $\endgroup$ – Charles Hudgins Oct 2 at 16:05
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In secondary stock market trading a surplus of shares occurs when current owners are eager to sell in some volume and current buyers are reluctant to buy at current prices in that much volume. A shortage of shares occurs when current owners are eager to hold for more gain and current buyers are eager to purchase at current or rising prices in some volume. A combination of factors drives the surplus or shortage at any time because there are traders working on different time frames, different fundamental models, and some traders also employ technical analysis on one or more time frames.

Nasdaq(TM) BookViewer(TM) product provides a real time representation of the depth of book (product splash page):

https://data.nasdaq.com/BookViewer.aspx

User Guide (six pages):

https://data.nasdaq.com/pdf/Bookviewer3_UserGuide.pdf

If trade strategies are executed using automated systems (robots) then some of the order information may be processed too rapidly for a human being to follow in real time. Setting aside the problems of automated trading the mechanics of a Last Match or Last Sale are best understood in the context of aggregating the order book into a structured view model. These models look similar to the BookViewer image shown in the User Guide.

User Guide quotes:

Last Match (Price) — Reflects the execution price from the most recently matched orders on for the particular security on the Nasdaq stock market. Please note that trades matched on other venues are not included in the calculation.

Buy Orders and Sell Orders - BookViewer automatically displays up to the first 30 individual open visible buy and sell orders, that are available for instant matching. Buy orders are on the left, and sell orders are on the right. Orders are presorted according to execution priority (price and time) so orders higher on the list will be executed before orders lower on the list. Hidden orders are not displayed.

Shares — Reflects the number of shares per order, available for matching. The displayed amount may be less than the original number of shares entered if the order was partially executed or partially canceled.

Price (Buy/Ask) —Reflects the limit price for each order.

A keyword search for "aggressive limit order" shows a reference that makes the following statement:

The way of achieving full execution of an order is to use an aggressive limit order, meaning an order that has a higher price than the best prices at the other side of the market and walks up the limit order book. For a buy (sell) order, this means it has a price higher (lower) than the best ask (bid).

So in simplified general terms a transaction at the Last Match or Last Sale occurs when a market order is filled at the best prices available in the order book at the time when the trade executes; or occurs when an aggressive limit order is placed to hit bids or lift offers from the order book.

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