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Friday, December 4, 2020

How Stock Prices Work (Before You Start Investing!)

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Before you start investing, you should learn exactly how stock prices work

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When I started stock market investing, I didn’t understand how the stock market worked. I didn’t understand dividends, and how to make money, but I’ve always wondered, why do stock prices go up and down? I thought it was because people are buying and selling stocks all the time right? So the price keeps changing and that makes sense, but who changes those prices? Is it people in the stock exchange, is it a committee of people like the stock brokers, or is it some automatic computer algorithm? And if it is automatic, how does it know what to change the stock price to? More importantly, who controls this program? These are very basic stock market investing questions that I’ve had since forever and believe it or not, even some professional investors are not be able to answer these basic beginner investing questions

Before the age of computers, there was something called floor trading, which still goes on today – traders would come together in an exchange like the NYSE, New York Stock Exchange located in New York city at 11 Wall Street hence the term Wall Street. Here, they would trade stocks or securities with one another with a very interesting method called the open outcry.

They would essentially just shout at each other – for example, “ I want to buy 100 shares of Disney at $50” and then someone would shout back “Sold 100 shares at $50”, they would then write it down, everything was handwritten and kept track of manually. At the end of the day, they would settle all their transactions and that’s how it worked for a long time. If you were a retail investor, you would call up your broker, and make your stock order with him or her and they would try to match you with someone on the floor who was either buying or selling what you had to offer.

Nowadays, everything is digital and free with apps like WeBull, M1 Finance, and Robinhood. So what determines the price of a stock then now that it’s all digital? Not the value of the shares which stems from fundamentals like earnings reports, dividends, and other financial factors – rather, the actual price itself that you see on a stock exchange, why it moves, and who’s controlling it?

The “price” is actually nothing more than the last price that the stock or security was traded at. There is no formula or math equation that looks at a company’s intrinsic value. At any moment, the price ONLY represents what people are willing to pay for a stock. So the price you see in the brokerages that keeps on being updated every second is what the last price of the stock that was just bought at or sold.

There are many factors that could influence a change in the stock’s price but the main reason we can say it changes is due to market supply and demand. For example, if the stock price starts to increase, that means a lot of people want to buy the stock – that’s what’s happening to Tesla right now. A stock price will fall, when everyone is trying to sell it because then, you’ll have less buyers, and when there’s no no around to buy it, people are going to be willing to sell it for a lot less until It meets the demand.

Each exchange does this process behind the scenes, and you don’t see it, but it’s important to understand how it works so you don’t end up buying stocks that are over priced. This is all automatic and it happens invisibly that through a digital database that contains the “electronic limit order book” or ELOB.

Imagine a column of buy offers on one side, and a column of sell offers on the other. On the buy offer side, the offers are organized from largest dollar value, to smallest dollar value. The sell side is the reverse, it starts with the smallest dollar value, and goes down to the highest dollar value. This is what’s known as the “bid” and the “ask”. Buy is bid, ask is sell.

That’s where limit and market orders come into play, and that’s what is discussed in the video.

*Links above include affiliate commission or referrals. I’m part of an affiliate network and I receive compensation from partnering websites. The video is accurate as of the posting date but may not be accurate in the future.

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