Understanding Stock Prices: Supply, Demand, & Exchange Calculation

[Curious6]

I have searched on the Net, but I was wondering if anybody could explain this to me in more detail. What exactly determines the price of a stock (share) in a stock exchange? I know it is determined by supply and demand, but what does this mean in more concise terms. For example, how is the price calculated based on the quantity supplied and quantity demanded? How is the quantity demanded and quantity supplied known? I'm 19 so I haven't yet been to a stock exchange, but I was wondering if somebody could explain it. Thanks for the help!

BTW, I know strictly speaking this shouldn't be in this forum, but I couldn't find another appropriate forum to place it.

 

[juvenal]

Very simple: one person wants to buy a stock at a certain price and another person wants to sell at the same price. Then you have a transaction. There are middlemen like traders and stockbrockers who facilitate the transaction and take a cut out of the transaction.

Have you never used ebay or traded baseball cards or comic books or anything like that before? The underlying ideas are very similar.

 

[russ_watters]

Supply and demand really is all there is to it, but I don't think you understand what supply and demand means when applied to each individual purchase/sale. Try not to think in terms of quantities - what determines the stock price is how badly someone wants to buy and how badly someone else wants to sell. Everyone who wants to buy anything has a maximum price they are willing to pay and everyone who is selling something has a minimum price at which they are willing to sell.

The quantities only really come into play when you look at the overall picture for a certain stock. Having 1000 people who want to buy and 500 who want to sell at a given price will typically push the price up because there are more supply than demand at that price. If the price rises, some people willing to buy at the lower price will no longer be willing to buy at the higher price and some additional people will be willing to sell. The stock reaches an equilibrium somewhere in between and the transactions take place.

The way it looks on the ground is that the stock market is a big room in New York(NYSE, but it is only one of dozens) where people buy and sell pieces of companies (today, most of it is done electronically, though). A "share" of stock is literally a "share" of the ownership of a company. So when someone offers to buy some shares, someone else has to offer to sell. Supply and demand kicks in and they reach an agreement on the share price based on the current perception of the value of the company that they are trading. Like juvenal said, it works almost exactly the same as buying and selling baseball cards.

 

[Curious6]

Yeah, but doesn't that mean that there is not a single 'market price'? I mean, different sellers would sell their stocks at different prices, so how can you say a share of a particular company is worth 'x' dollars? Is it an average?

 

[russ_watters]

Yeah, but doesn't that mean that there is not a single 'market price'? I mean, different sellers would sell their stocks at different prices, so how can you say a share of a particular company is worth 'x' dollars? Is it an average?

If there weren't a single "market price", you could act as a middle-man and buy shares from one person and sell to another instantly, turning a profit. Since all trades are public, the guy you're selling to at the higher price would quickly realize that he could buy directly from the guy who is selling it to you, at the lower price. Having all the trades public is how you get one single price.

edit, caveat: for you and me, it works that way, but for reeeeeeeeally rich people, corporations, and stock funds, the size of a single transaction can affect the market price. That's why mergers have pre-negotiated stock prices.

 

[Astronuc]

Well the initial value of a stock is determined in an initial public offering where the price is set. That represents the initial capitalization of a company, and the price per share depends on the total capital (cash) raised and the volume of 'shares outstanding'.

Beyond that, the market then sets a price based on a balance between what buyers and sellers want. That produces the volatility in share prices.

A reasonable benchmark for share prices can be the P/E or price/earnings ratio (earnings per share) and 'return on investment' (ROI) of the company, as well as the dividends paid by the company.

 

[Curious6]

OK, thanks for the info. I have another question that refers to the pricing of stocks. Say, if somebody would like to buy 100 shares at 20 USD and another person would like to sell 100 shares at 22 USD, then how is the price determined?

 

[Astronuc]

There is more than just a buyer and a seller. The traders on the floor match bids for selling and buying. 100 shares is peanuts.

A stock trading company would probably cover 100 shares themselves.

On the floor, one is trading thousands of shares, or more like 10,000's or 100,000's shares.

Volume today on NYSE - 2,077,190,000 shares

Volume today on Nasdaq - 1,544,656,000 shares

 

[Bystander]

OK, thanks for the info. I have another question that refers to the pricing of stocks. Say, if somebody would like to buy 100 shares at 20 USD and another person would like to sell 100 shares at 22 USD, then how is the price determined?

"Limit buy" meets "limit sell" is a no transaction situation; market buy meets limit sell, some sharpie has unloaded a dog on a sucker; limit buy meets market sell, some sharpie has just stolen someone's family heirlooms. Buy and sell orders go into a queue determined by time received, limits, and size; for your example, 20 buy vs. 22 sell, the orders are going to be in line behind 20 1/2 vs. 21 1/2 which are behind 20.98 vs. 21.02 (forgot things are decimal now) and will sit there all day unless one of three things happens. Market goes up and seller doesn't react quickly enough, he sells at 22 when the market's buying at 24; market goes down, and buyer is buying at 20 when the market can't sell anywhere else for more than 14; or the buyer and seller back off on the greed factor --- offer more, ask for less on their "limit" orders.

 

[hitssquad]

I have searched on the Net, but I was wondering if anybody could explain this to me in more detail. What exactly determines the price of a stock (share) in a stock exchange?

This book has everything you need to know in plain language:
amazon.com/exec/obidos/tg/detail/-/0375503889

 

[Curious6]

OK, thanks for the help guys. This has clarified the functioning of stock exchanges. Hitssquad, that book looks interesting, I'll take a look at it. Anyways, now that we are at it, is the price of a barrel of oil also determined in a stock exchange, or is that price set by an entirely different mechanism?

 

[Astronuc]

Oil and other commodities are handled at the various commodities/mercantile exchanges, but the process is pretty much the same.

Google on "Commodities Exchange" and check the NYMEX website -

http://www.nymex.com/how_exchang_works.aspx

 

[Curious6]

OK, once again, thanks for the help. I have another small question related to this, and it is about the bid and offer prices. When we hear on the news that the price of shares is say, $x, do they refer to the bid price of the share or the ask/offer price?

 

[Astronuc]

If the stock market is closed, then the price is what is was at closing. During the day, it is the price at which both seller and buyer agree, i.e. it is both asking and selling price (that makes the transaction possible).

 

[Curious6]

But aren't actions traded indirectly via a specialist, i.e. an action is first bought at a lower price and then sold by the specialist at a higher price, creating the bid/ask spread? That was my understanding of the issue, so I was wondering if the quoted price was either the price the specialist had bought the share at or sold the share at.

 

[russ_watters]

But aren't actions traded indirectly via a specialist, i.e. an action is first bought at a lower price and then sold by the specialist at a higher price, creating the bid/ask spread? That was my understanding of the issue, so I was wondering if the quoted price was either the price the specialist had bought the share at or sold the share at.

No. As I said above, if that were the case, people could get better prices by skipping the middle-man and the middle-man would quickly become obsolete. No, there is no middle-man. All prices you see are actual sale prices and there is only one (at a time).

Brokers make money on a per-trade basis or a percentage basis. They do not make money by acting as middle-men. What may often happen that looks like a middle-man is that a brokerage firm might handle a trade entirely from their own holdings (as Astronuc said). But they don't buy for a lower price than they sell.

 

[Curious6]

OK, interesting. So there is no middle-man. If the highest bid price is $20 and the lowest ask price is $20 1/8 then how is a deal reached? Some Websites explain it as the buyer paying $20 1/8 and the seller receiving $20, with the remaining $1/8 representing the profit of the specialist. Is this the way it works? Or do they bargain further until reaching an agreement? What I'm really interested in is in the actual execution of the trade (different Websites have different explanations, which has caused the confusion).

 

[russ_watters]

OK, interesting. So there is no middle-man. If the highest bid price is $20 and the lowest ask price is $20 1/8 then how is a deal reached?

If neither is willing to change, then no deal is reached.

Some Websites explain it as the buyer paying $20 1/8 and the seller receiving $20, with the remaining $1/8 representing the profit of the specialist.

Where do you see that? I've never heard of such a thing.

I have a [small] portfolio and I generally check my stock prices at USAToday.com, but there are lots of places where you can check. If I see something I want to buy (or sell), I place a trade online with my bank, and unless the stock price has fluctuated in the 20min or so that it takes for all this to happen (or if I place a limit order), I get exactly the price I saw on the ticker.

http://stocks.usatoday.com/custom/usatoday-com/html-quote.asp?symb=%20lci is what one stock I own did on Friday. It spent about 4 hours in the middle of the day at $4.71, +- about a penny. If I had placed a trade (buy or sell) at any time in those 4 hours, the price would have been exactly that.

There is a comission though - perhaps you are reading sites where they add the price of the comission to the price of the stock. That's useful for calculating how much you actually gain or lose in a transaction. For example, if I buy 10 shares of LCI at $4.71, but pay $24 in comissions, that's $71.1. If I wanted to turn a profit, I'd have to sell for more than $95.1 - the stock would have to double. So it is often not worth it to buy or sell so few stocks at a time.

 

[Curious6]

What I was talking about is the bid/ask spread, and you can find an explanation of it on many different sites. Here is one of them:

http://daytrading.about.com/cs/educationtraining/a/bidask.htm

It also speaks about market makers buying and selling shares at different prices, i.e. acting as middle-men. How can this be explained then?

 

[russ_watters]

Hmm - I didn't know about that. I'm not a day-trader, so it doesn't affect me much, but it seems that that's an additional "hidden" comission that brokers take for bringing buyers and sellers together. I guess the "market" price would be right in the middle of those. Virtually all of my trades are limit orders, so I've never noticed it.

 

[Bystander]

Commissions and fees give brokerages room to make the 20 offer vs. 20.10 ask trades "go." For regular customers, for large transactions, to clear trades, witching hours, triple witches, and a host of other reasons. Aunt Sally wants to sell the family treasure, 7 shares of ABC at a limit of 30, all or none, and you want to adjust your ABC holding of 97 to an even lot of 100, at a limit of 29 --- several things can happen: the brokerage may buy Sally out at her price, sell to you at your price, figure on skinning some fool making a "market" buy, or throwing the four into some other odd lot "market" sell, or nothing might happen.

You call your broker and want ABC at a buck under market, if you're a valued customer, he'll make it happen; if you're a piddler, don't hold your breath, and if you're a nuisance (odd lots three times a day), he'll laugh at you over the phone. Sales depend on the market cap of the stock --- MSFT trades millions of shares a day, compared to Keithley Instr. at hundreds or ks a day. MSFT --- lots of even and odd lot bids and asks to match; Keithley --- small cap, good way to get skinned with "market" orders, buy or sell.