The stock market is a thing of mystery and fantasy for many people. Almost everyone is affected by the stock market, yet few understand the nuances of how stocks are priced or how the stock market works. To understand this component of the United States economy requires a quick lesson on economics and the law of supply and demand.
Anyone who has taken a high school economics class has a basic understanding of supply and demand. If we imagine a rudimentary market consisting of a few people and one commodity we can illustrate the supply and demand concept.
Supply is the amount of output available in the market. Based on the supply, the price is determined by the sellers. It is derived from the cost of goods, productions costs, etc. For example, wheat growers may be willing to sell one million bushels of wheat if the price is $1.75 per bushel and substantially more if the market price is $2.00 per bushels.
Demand is a person’s desire to own a commodity backed by purchasing power. For example, a consumer may be willing to purchase two bushels of wheat if the price is $1.75 per bushel. However, the same consumer may be willing to purchase only one bushel if the price is $2.00 per bushel.
This basic example of supply and demand is the same concept that drives the stock market. If stocks are thought of as commodities rather than as an ownership stake in a company, the concept of supply and demand can be transferred to stock shares.
Imagine a large mutual fund company with mutual fund managers that are capable of purchasing large quantities of shares. A mutual fund manager has the ability to drive the price of a stock because of their ability to purchase shares in high quantities. If the manager decides he wants to add one hundred thousand shares of Amazon.com stock to his mutual fund the price of the stock will go up as the purchase is executed. As the order for one hundred thousand shares of stock hits the trading floor, the specialist on the floor assigned to Amazon’s stock matches buyers, in this case the mutual fund manager, and sellers, in this case other investors. If the price starts at $20 per share the specialist will match all of the sellers willing to sell at $20 to the buyer. If there are twenty thousand shares for sale at $20 when all twenty thousand of those shares are purchased the market specialist will have to adjust the price up to get more sellers to appear. As he adjusts the price up, more people are willing to sell their shares. As the price climbs toward $21 another twenty thousand shares appear for sale. As these shares are purchased, the price is adjusted again and more shares appear. By the time one hundred thousands shares are purchased the price may be considerably higher than $20.
This is the mechanism by which stocks are priced in the market. It relies on the basic concepts of supply and demand. It is important for anyone investing in stocks to be knowledgeable about how stocks are priced and the mechanisms that cause price changes. It is one piece of a broad base of knowledge that any investor should strive to acquire as they trade stocks.