How Stock Prices Are Set
Supply and Demand Is Key to Understanding Stock Prices
You might read and hear a lot of explanations about stock prices, their movement, and why they rise and fall seemingly at random. You will hear about the influence of earnings on stock prices, the economy, or credit markets. While all these factors do indeed figure into price changes, the reality is that they have a little direct impact on prices. Those and other factors do, however, change the balance of supply and demand, which is integral.
Supply and Demand
Stock prices are a function of supply and demand, although other influences—such as earnings and the economy—might affect the desirability of owning or selling a particular stock. If a company reports surprisingly low earnings, demand for its stock might fade, and as the price drops, the balance between buyers and sellers is changed. Buyers will begin demanding discounts off the existing price, and many motivated sellers will accommodate them to get rid of the stocks. When there are more sellers than there are buyers, this creates more supply than demand, so the price begins to fall.
The Role of Prices
At some point, a stock's price might drop to a level where buyers find it attractive, or some other factor will change the dynamic. As more buyers move into the market, demand grows faster than supply, and the price correspondingly goes up. Sometimes supply and demand find a balance—a price that buyers accept and that sellers accommodate. Prices will bounce up and down when supply and demand are roughly equal, but they will do it in a narrow price range. It's possible for a stock to stay in this range for days or even months before another outside factor disrupts the supply and demand balance and causes either a noticeable increase or decrease in price.
If demand for a stock exceeds the supply, its price will rise, but it will only increase to a point where buyers suspect that demand is waning. At that point, holders of the stock will likely begin selling. Some might have ridden the price up and believe a reversal is coming, so they sell their shares and take their profits while they are still ahead.
When stock prices begin to fall—which can happen for several reasons—and more owners start selling their shares, there will be more supply than there is demand. To entice buyers, sellers must drop prices to accommodate for the saturated market. The same dynamic works on the other side, but in reverse. As the price falls, it will reach a level that buyers find attractive. As buyers acquire shares, the stock’s price will rise because sellers must be enticed to let go of their shares.
The Bottom Line
The dynamic between supply and demand is the most important truth investors should learn about stock prices before they jump in. Although investors might want to assign a value to a stock, it's ultimately the market and the give and takes between supply and demand that sets the price.