How are Stock Prices Determined?
What's the difference between a $4 stock and a $400 stock? Learning how stock prices are determined is a serious advantage.
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Do you ever get the feeling that stock prices are determined randomly?
Like there’s a machine on Wall Street somewhere that just sporadically spews out numbers each day.
You may be surprised to see that the most valuable company on the planet, Apple, has a share price of $125, while Chipotle shares sell for over $1,400. It’s even more shocking to hear that Chipotle’s share price isn’t driven above Apple’s price by a surge in avocado sales. 🥑
Instead, it’s determined by economic principles and emotional trading.
Stock prices are determined by principles of economics; the market is a big game of supply and demand. Learning how stock prices are set can make you a better investor. It can help you understand when valuations are artificial and when you should pull the trigger on a buy order. 💰
In this article, we’ll discuss how stock prices are determined, how fundamentals impact that price, how to read patterns, and much more.
So, ready? Let’s get straight to it.
- How Stock Prices Work
- How Markets Impact Stock Prices
- Economy and Legislature
- Stock Prices in a Recession
- Fundamentals and Stock Prices
- Day Traders and Volatility
- Price Trends and Patterns
- Mass Psychology and Stock Prices
- Institutions and Stock Prices
- Conclusion
- Stock Prices: FAQs
- Get Started with a Broker
How Stock Prices Work 🏗
On the surface, understanding stock prices is simple. The prices are entirely determined by how much buyers and sellers are willing to trade assets for. If buyers on the market determine that a stock is worth $300, and sellers agree this is fair, then the stock’s price will be $300. Easy, right?
The bad news is that the markets are typically a little more complicated than that. The stock market is being used by humans, so that means there are emotions in the mix.
Anxiety and FOMO can push a stock’s price out of its normal value. Besides emotions, there is only a limited amount of shares available for any company. A limited supply is going to lead to increased prices.
The supply of stock, also known as the shares outstanding, is the total amount of shares held by investors that have been issued by a company. For the most part, this is a set number, but sometimes investors participate in illegal behavior, circumventing the regular rules of the stock market, and resulting in failures to deliver. The shares outstanding are listed on many stock screeners.
The shares outstanding are constantly being bought and sold, so the price is always changing. The stock price that you see jumping up and down by a company’s ticker symbol is the last traded price (LTP) of the asset—the last order on the market that was sold. As share prices increase and decrease, so does the overall value of a company.
The stock price is directly linked to the total valuation of a company, something that is called market capitalization. The market capitalization is determined by multiplying the shares outstanding by the current share price.
This means that the valuation of a company is in flux. It adjusts as the underlying share price changes.
With this information, we are beginning to understand why a share of Chipotle is over $1,400. It’s because they have fewer outstanding shares to get to their market cap of $40.87 billion. A valuation that would probably be higher if the extra avocado was free.
Comparing Market Cap ⚖️
| Company | Share Price | Shares Outstanding | Market Capitalization |
|---|---|---|---|
| AAPL (Apple) | $125 | 16.79 Billion | 2.11 Trillion |
| CMG (Chipotle) | $1,452 | 28 Million | 40.87 Billion |
Understanding how price relates to valuation is important in determining the size of a company, but how do you know if a stock price will increase? You need to know the demand.
How Markets Determine Stock Prices 🌎
Stock prices are constantly changing on the market. The stock market will go up if there are a high amount of buyers in relation to sellers. It will go down if there are more sellers than buyers.
One key indicator of how many buyers and sellers are active comes from looking at the trade volume of a company. If trade volume is high, and a company’s share price is increasing, this means there are more buyers on the market. But different markets will have different levels of normal activity.
Because different markets have varying levels of popularity, companies that are similar in value and fundamentals may trade for wildly different prices just based on the competition in the marketplace. A large stock exchange like the NYSE is going to have more competition than a small one like the Johannesburg Stock Exchange.
There are several different ways a stock can be sold. Each of them has its own pros and cons, but generally, most people will buy stocks on the secondary market.
Private Offerings 🕵️♂️
Private offerings are the private sales of shares in a non-public company to individual investors. These kinds of offerings will occur before a company goes public. Private offerings can be lucrative because it allows investors to buy a company when prices are low, and then they have the potential to explode in value once they go public.
The SEC doesn’t manage much when it comes to private offerings, but there are still some protections in place. Generally, private offerings will only be available to accredited investors—people who can take the hit if a large investment turns out to be a raw deal.
Primary Markets 🎯
The primary market is the place where stocks are originally created and sold. When a company does an initial public offering (IPO), its shares become available for the first time and can be purchased through some top stock brokerages. IPOs happen all the time; some of them can be lucrative if the price is right and you believe in the company.
The important thing about an IPO is that it allows a private company to become public. Public companies have more governmental oversight and there are more protections in place for investors. Going public is key to allowing private investors to make a return on their money.
Secondary Markets 🗃
The secondary market is where investors sell stocks to one another—this is also referred to as the stock market. Shareholders who acquired their positions on the secondary market are entitled to less legal compensation if a company goes bankrupt.
Most trading takes place here and it’s the most accessible way to start investing. Stock prices change rapidly here because there are many investors reacting to all kinds of stimuli—this makes the secondary market one of the most liquid places to sell assets, and that leads to constant changes.
Economy and Legislature 💡
Stock prices are going to be influenced by the economy at large. When there are sharp downturns in the overall economy, you will see investors panic and potentially sell their shares. With an increase in sellers, we will see a dip in the share price.
But it’s important to remember that the share price is not entirely determined by the current economy. During the months following the initial sell-off of the COVID pandemic, we saw share prices quickly recover while the economy was in relatively poor condition. That’s because the stock market is forward-looking.
If the investors expect the economy to bounce back in the long term, they may consider temporary downturns in the economy the perfect time to invest in growth stocks. And so far, it appears that was the case with COVID.
The legislature can also impact the share price of companies. For example, if the government decides that green energy is the way to go and enacts a lot of policies to incentivize companies to create renewable energy, that may make share prices in green companies increase
Or if the government is distributing stimulus checks to its citizens, we might see a temporary jump in the market as savvy investors dump their money into stocks. Some investors aren’t even doing this to see a return on investment, but simply because they are bored during the pandemic (#relatable).
Stock Prices in a Recession 📉
During recessions, investors often have poor outlooks of the market. This can lead to companies trending downwards for no particular reason other than mass-pessimism. The government might take steps to prop up the market, such as the fed printing money to buy corporate junk bonds.
The decisions of the legislature can be amplified during recessions, which is why we saw such steep declines after the bank bailout bill of 2008 was rejected by congress. When the government intervenes to provide aid to an economy, it generates optimism and raises the market.
However, some stocks actually have a good time or are stable during recessions. These are mostly safe-haven stocks like utility providers and immortal blue-chip companies, but some stocks actually explode when recession hits.
One prominent example of this are gold stocks—people flock to safe investments like gold when the stock market is going down, so naturally, companies that hold gold can have a good time. For example, SPDR Gold Shares (GLD) weathered the 2020 crisis very well while the Barrick Gold Corporation (GOLD) stock exploded.
How a Stock’s Fundamentals Determine its Price 🎛
A stock’s fundamentals can help drive share prices. A company can increase public confidence by having solid business models, good earnings reports, and a reliable, intelligent management team. All of these things drive the share price independently, sudden changes can often introduce volatility.
Investors can be scared off by the wrong kind of leadership or bad deals with the company. For example, if a company takes on a lot of debt and reduces its free cash flow, it can mean that a company is less likely to survive downturns in business. Bad levels of debt can lead to a lower share price.
Likewise, if a company isn’t putting enough of its equity back into the business to grow, it means investors are losing out on returns. Companies that return more money to shareholders are more valuable on the market.
Fundamentals can change from time to time, and that’s why investors are interested in major events and reports so that they can ensure the health of the business. When news is turbulent, share prices become inconsistent.
How Day Traders Use Volatility ☀️
Some day traders take advantage of volatile events like earnings calls or big annual meetings to profit off of these short-term swings. These swings often occur when investors aren’t sure how to react to changes. A few of the most common times traders will follow companies are during earning calls, annual meetings, and major events.
Earnings Calls ☎️
Earning calls are an important time for investors to take advantage of fluctuations in price. Typically, there will be a lot of traders trying to scalp a highly anticipated earnings call—this is when supply and demand are in full effect.
If bad news comes out about earnings, we can see sellers dump their positions and buyers lose interest. That’s why it can be good for managers to joke about their bad reports—optimism helps stock prices.
Annual Meetings 📅
Things like annual meetings and conferences can have the same kind of effect that earnings calls have. There will be highly anticipated events like product reveals or changes in leadership. This can have a huge impact on speculation.
Acquisitions 🤝
Acquisitions can impact stock price because corporations have to pay a premium to acquire other companies. This is because acquisitions typically need to be approved by shareholders. Shareholders won’t be happy if they are losing their investment under the current market price.
This also means that the company that initiated the acquisitions can fall in value because they are paying so much for the deal. The two companies will often move in opposite directions in price.
Inflation 💸
Something that all investors should be concerned about is inflation. It’s basically the bogeyman 👿. As inflation increases, the purchasing power of each dollar will decline, and this means that investors will have to pay more for their shares.
Inflation—to a small degree—can help an economy and even prevent a depression. For the individuals responsible for controlling inflation (the Federal Reserve in the US, for example), this is more of an art than a science.
If nothing else, that means all the stocks you have will see their price increase due to inflation over time. As long as your assets are growing faster than the rate of inflation (which is usually 2%-3% per year), you’re making money—and if a stock’s growth is slower than infation, you’re losing money.
Price Trends and Patterns 📈
Day traders use big events to determine whether a stock can be bought and sold for a good price, but there are also trends and patterns that help determine good entry points in the short term. This is great for those who day traders because it allows them to profit on the upswings and downswings of a company.
Technical analysis requires a multivariable approach. Traders are less interested in the overall health of a company, and more in the short-term movements. This is why traders use screeners to weed through many different stocks and look for familiar patterns such as stocks trading at an all-time high, or breakout sessions.
Following RKT Mortgage’s overall trend downwards since the spike earlier in March, you can use different patterns and modals to place winning trades. These trends are focused on short-term movements alone and don’t account for outside factors.
Patterns like the rising wedge help traders decide when a good time to enter is. Following simple trends can help generate a profit and react to different situations on the market.
Mass Psychology and Stock Prices 🧠
The stock market is driven by fear and greed, at least that’s what some people say. When people get excited about a stock they can drive a company well beyond what the asset should be worth under normal circumstances *cough* GME *cough*. When this happens the risk for large losses is substantial.
Even average returns are less and less likely the more volatile a stock is. That’s because you are less likely to be able to base financial decisions on more reliable metrics like the fundamentals of a company.
Panic selling during a pandemic illustrated how markets will fall when people are scared. Keeping a cool head and taking advantage of other investors’ fear is an excellent way to buy when a stock is undervalued.
How Institutions Determine Stock Prices 🏛
Large institutions that have more money than Scrooge McDuck can swing the value stocks massively. If you have followed Elon Musk on Twitter you might have seen some of this in action. If he tweets that his company is overvalued, the share price will react.
There is also evidence to suggest that major hedge funds are able to entirely inflate and deflate the value of stocks by themselves to improve reporting. This just goes to show that even if you know what you are doing with a particular company, your buying price can be manipulated by seemingly random conditions.
The worst part is that there isn’t much you can do to avoid this activity. Hedge funds are active in the market all of the time, so there is no way to avoid them.
Famous investors like Bill Ackman have become infamous for publicizing a stock that they had a large position in, and then selling that company after it had become popular. Sometimes referred to as pump-and-dump schemes, it is important for investors to avoid overly advertised stocks.
The Bottom Line
The price of a stock can be seemingly random at times, but understanding what drives price movement is essential to determine whether you will make money on the market, or lose it. Keeping an eye out for good deals means understanding the numbers beyond the price.
As stock prices are influenced by numerous factors, it pays to keep an eye on anything you think other traders will act on. This includes a company’s fundamentals, technical data, hot news, as well as large-scale events like the state of the economy and changes in legislature.
Stock Prices: FAQs
-
How Do Stock Prices Change?
Stock prices change whenever a sale of a share happens. Generally, the stock market follows the law of supply and demand. When there are more buyers than sellers on the stock market, the price will rise. When there are more sellers, the price will fall.
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How are Stock Prices Set Each Day?
Stock prices are set each day whenever the sale of a stock occurs. This is referred to as the last trade price (LTP). The stock price for the day starts at whatever price the first share of the day sold for.
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What Happens if a Stock’s Price Drops to Zero?
If a stock’s price drops below $1 on the NYSE or the NASDAQ, then the company that those shares are associated with will be delisted. Typically, the stock exchange will give the company a set amount of time for the price to rise above $1 before it is entirely removed.
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Does Shorting a Stock Drive the Price Down?
Shorting a stock can drive the share price down. This is because the price of a stock is determined by supply and demand. Short sellers increase the supply of a stock, lowering the price.
Get Started with a Broker
If you made it this far, pat yourself on the back! 🙌 You’re clearly taking investor education seriously. It’s important to take your broker seriously as well.
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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.
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