Stock prices fluctuate frequently, increasing and decreasing in value (sometimes by shocking amounts) in a single trading day. Novice investors may wonder why this is the case.
To help you understand, here is a basic overview of some of the forces that cause this volatility. Read on to learn about the way the stock market works and how stock prices are set.
- The stock market is essentially an auction in which buyers and sellers negotiate prices for shares of ownership in publicly traded companies.
- Traders on the stock market can be individuals, governments, corporations, institutions, or asset management companies.
- Like any other market, supply and demand is the primary factor driving the price of stocks.
- Other factors, such as major financial news, natural disasters, investor reaction to company financials, or pricing speculation can cause large price fluctuations.
The Stock Market Is an Auction
First, realize that the stock market is, in essence, an auction, with one party wanting to sell its ownership in a particular company, and another party wanting to buy ownership. When the two parties agree upon a price, the trade is matched, and that becomes the new market quotation for the stock.
The buyers and sellers can be individuals, corporations, institutions, governments, or asset management companies that are managing money for private clients, mutual funds, index funds, or pension plans. In many cases, you won't have any idea who is on the other side of the trade.
The number of shares traded is called the "trading volume," and it can indicate how "hot" a particular stock is or how much interest there is in it from other investors. It can also give traders an idea of how easy it will be to get into or out of a position in a certain stock.
Supply and Demand
Stock prices are affected by supply and demand. Because the stock market functions as an auction, when there are more buyers than there are sellers, the price has to adapt, or no trades will be made. This situation tends to drive the price upwards, increasing the market quotation at which investors can sell their shares and enticing investors to sell when they had previously not been interested in selling. On the other hand, when sellers outnumber buyers, and there is less demand, whoever is willing to take the lowest bid sets the price, resulting in a race to the bottom.
When large amounts of stock are dumped on the market at once, it can be a problem. For example, during the financial crisis of 2007 to 2009, firms such as Lehman Brothers were forced to dump everything they could to try and raise cash as they struggled with bankruptcy, as many of their assets were illiquid. This activity flooded the market with securities that were worth far more to a long-term buyer than the price at which Lehman was willing to sell.
What Influences Buyer and Sellers
On a typical day, the value of shares of stock doesn't move much. You'll usually see prices go up and down by a percentage point or two, with occasional larger swings. But sometimes, events can occur that cause shares to rise or fall sharply.
Increased trading could be caused by an earnings report that shows good or bad financial news. It may be a major financial news event, such as an interest rate hike, or it could even be a natural disaster, such as a hurricane, that is likely to have far-reaching consequences. Any of these events could trigger a reaction in the market, causing investors to rush to sell or to buy. These reactions could be based on emotion, or could they could be the result of a calculated decision, but either way, they can affect the price of the stock.
Investing style can vary widely and affect the sale of stock. For example, suppose a particular company issues a poor earnings report. Some holders of that company's stock may panic, selling their shares and driving the price down as supply exceeds demand. On the other hand, some investors may see the bad news as temporary and thus spot an opportunity to scoop up shares at a discount until the value of the stock rises again.
Speculators—those who buy and sell not based on a company's intrinsic value, but on some other metric—can drive stock prices to extremes. Contrast them with investors, who care only to purchase stock at a discount from its worth, with the confidence it will grow in value over time.
Generally, investors who use the value investing method choose to buy or sell shares based on their evaluation of the company's balance sheet, and their overall impression of whether a company is fairly priced.