In-depth Analysis

An Examination of Price

In the market, we spend an inordinate amount of time discussing “price”, both future and current, and what that price tells us about an instrument, its prospects and what the market really thinks of it. 

However, we rarely if ever stop to consider how we arrive at a price.  

That was made clear to me in a conversation in one of my trading charts this week when I highlighted that more than 200 US large cap stocks (>$5.0billion market cap) had gapped down ahead of the open compared to just 3 gaping up. 

Several traders in the chat asked what the significance of that data was?

That surprised me because I thought it was self-evident but it obviously wasn’t to them.

That set me thinking that an examination of what we mean by price and how it’s derived might be overdue.

Price can be thought of as a point of equilibrium between supply and demand 

Supply and demand are the forces that drive all markets whether in goods and services or financial instruments and investments. 

A market is simply a mechanism through which price discovery and equilibrium between supply and demand are obtained.

In financial markets, we can easily substitute the terms buyers and sellers for supply and demand. An excess of buyers over sellers creates excess demand or price rises, whilst an excess of sellers over buyers creates excess supply and price fall.  

When prices move they are looking for the next point of equilibrium. That might sound complex but it’s not if you think about it like this. When buyers and sellers are equally matched then price remains unchanged because the market is in a state of equilibrium at this point.

However, if there are a majority of buyers or sellers then price moves to new levels in an effort to attract new buyers or sellers into the market, in doing so it discovers the new price point at which business can be conducted or failing that it continues to move on to new levels to try and balance the scales between buyers and sellers.

A price captures the point at which buyer and seller were matched, a point at which that market was in equilibrium. But that might be just a fleeting moment in time. We can visualise these points of equilibrium or exchange, over time, in a price chart such as the one of Tesla (TSLA) below. 

The rise and fall of the price clear shows the points at which there was an excess of demand for  the stock and those where supply or sellers had the upper hand. The point where one group rests control from the other represents the end of one trend and the beginning of another. 

In the final analysis, price or rather prce change is the ultimate expression of investor sentiment. Or if you prefer greed and fear. Because when traders are fearful of loss they sell and market prices fall, but when they are greedy and worried about missing out on profits, they buy and market prices rise. 

On that basis, trading comes down to spotting those swings in, and peaks of sentiment and acting accordingly and knowing that when you see a ratio of 200:3 in favour of stocks gapping down that’s a signal that sellers outweigh buyers by a huge margin. 

 

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