Economics Asked on June 3, 2021
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?
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.
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.
Correct answer by Brian Romanchuk on June 3, 2021
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.
Answered by 1muflon1 on June 3, 2021
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.
Answered by SystemTheory on June 3, 2021
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