How Stock Prices Are Set

Supply and Demand Drive Stock Pricess

The methods of calculating the daily price of a stock and the long-term price target are two different processes.

It is important for stock investors to know how the market (and other investors) arrive at these numbers.

Investors calculate long-term stock price targets based on fundamental analysis of the company’s strengths and weaknesses.

This process considers the financial and market strength of the company and examines its competitive advantages (if any).

Daily stock prices, however, are a different matter.

Supply and Demand

In the stock market, prices are driven by supply and demand.

Supply equals the willing sellers and demand equals the willing buyers.

Where their mutual interests intersect, is the current price.

That intersection is a moving target so at one moment there is more supply than demand and at some other moment the balance has shifted to more demand than supply.

This is especially true of heavily-traded stocks, but it applies to all.

Simple Illustration

Here’s a simple illustration of how it works.

ABC stock opens trading at $25 per share. At that price, there are holders who are willing to sell and buyers who are willing to buy.

Under these circumstances, the price will stay close to $25 per share until the balance between supply and demand changes.

But what happens if more buyers (demand) want ABC stock than sellers are willing to sell at $25 per share?

The buyers must bid up the price to a level where sellers are willing to part with their shares.

Price Will Rise

In other words, the price of ABC will rise.

If there is a sustained demand (more buyers joining the action), the price will continue to rise.

At the price rises, it will reach a point when owners become nervous and/or want to take a profit.

When the supply of shares for sale approaches and then exceeds the demand, prices begin to fall.

Sellers must now make the shares more attractive to buyers by lowering the price.

As the price falls, more holders sell to lock in a profit or cut a loss. This adds to the downward momentum.

At some point, the price will drop far enough that prospective buyers will once again be attracted to the stock.

When the demand for shares approaches and then exceeds the supply, prices begin to rise and the whole cycle starts over again.

This back and forth dynamic between supply and demand may play out over days, hours, minutes and even seconds depending on how actively a stock is traded.

This simple illustration demonstrates the underlying forces at work in the stock market, but the stock markets are dynamic environments where many factors come in to play in arriving at prices.

The give and take between supply and demand remains the basis for how stock prices are set in the market.

Articles in This Series

How Stock Prices Are Set
Supply and Demand Drive Stock Prices
Bull and Bear Stock Markets Two Sides of Same Coin
Following the Stock Market Herd Often Wrong Decision
How Low Can Stock Prices Go?
Understanding What Affects Stock Prices
How the Fed Affects Stock Prices

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