Why do stock prices move (Part I – Short Term)

At a glance

  • Stock exchanges like the BSE and NSE facilitate stock trading by providing the platform to match buyers with sellers
  • The key price-setting mechanisms buyers and sellers follow are “at limit” (setting a pre-defined price) and “at market” (taking whatever is the prevailing price)
  • When more buyers look to buy “at market” the price trends upwards and when more sellers do the same the price declines
  • An investor’s ability to deal with short-term price movements has a huge impact on her success or failure

Imagine you walk into a street market in a large city…

You’re thinking of buying a t-shirt. This is the biggest market around and is famous for selling cheap t-shirts in all colours and sizes. As you walk in, you observe there seem to be many people buying red t-shirts and lots of buzz around the stalls selling them. Even though not many people know what’s up with the red t-shirts, more people now want those bright red t-shirts, offering even higher prices. What would you do? …

Would you join in the throng of those wanting a red t-shirt, or would you walk casually over to the stalls selling the blues and the greens and calmly ask about a discount?

Stock Trading Mechanics

If you tune into any financial news channel at around 8.45am on a working day, you’ll hear the anchors and several experts talk of expectations for the day around market movements. At 9am the pre-open session starts and runs for 15min, think of this as the mechanism to allow for arriving at one opening price which often is different from the previous closing price, based on any changes in perception overnight.

7 bse

Source: bseindia.com

At 9.15am the start of the continuous trading session is signaled by the symbolic gong of the bell declaring markets “open”. On a side note, for the next 10-15 minutes the anchors frantically try and talk of every price change they see happening, like a radio commentator, even though the changing prices are there for all to see.

So what’s happening during a regular stock trading session? Market participants (trading desks of large banks, corporate, retail investors) engage in buying and selling stocks of their interest. Buyers can look to buy at “market” i.e. whatever is the prevailing price or at a “limit” i.e. the maximum they’re willing to pay. At the same time sellers are doing the same, some looking to sell at market and others at a specific minimum price. Orders are matched electronically on a first-come first-serve basis.

Market participants and impact on prices

Scenario 1: Say a stock is trading at ₹20 and a buyer wants 100 shares at market. The system has two sellers at that instant, one offering 50 shares at a limit price of ₹20.50 and the other with 100 shares at a limit price of ₹20.60. The system matches the 1st seller with the buyer at the new price of ₹20.50. Since that only fills part of the buyer’s order, the remaining 50 shares are matched at the higher price of ₹20.60. The new price of the stock is now ₹20.60, up 3%.

Scenario 2: On the other hand, if the buyer had set a limit of ₹20 on her buy order and the sellers had the same limit prices as above, no trade would happen. Now, if another seller looks to sell at market, the trade will immediately go through at ₹20 and the price of the stock would remain at ₹20. But instead of selling at market, if the new seller had set a limit price of ₹19.50, the trade would go through at that price and the stock price would change to last executed trade i.e. ₹19.50, down 2.5%

Now consider thousands of investors looking to buy or sell a stock, each looking to get the best price. Price moves in the direction that the overall majority believes it should move, on the day. Thus, on a given day, if there are many more buyers than sellers, the buy orders set at lower limit prices will go “unfilled”, leading them to increase their limits until more supply comes into the market and driving the price up. This movement often causes some participants to think that they’re missing out on a great opportunity and look to buy more at the higher prices, fewer people become willing to sell for the same reason and the prices go further up.

More than the ability to identify “winning” stocks, how an investor reacts to the movement of stock prices has a significant bearing on their success or lack of, as an investor.

Coming up next, what moves stock prices in the long term?…

References (links to external websites):

Bombay Stock Exchange (BSE)

National Stock Exchange (NSE)

 

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