Why Prices Move
30 Nov, 2012
Look at any price chart. What makes it tick? How does price go up and down?
Price is made up of three elements: the bid, the ask, and the last. The ask price is the lowest price we are able to buy at. The bid price is the highest price we are able to sell at. The bid is always lower than the ask. The last price is the market’s current price.
Whatever the latest transaction in the market was, selling (bid) or buying (ask), determines what the last price is. Lets say that the ask price is the last price because people have been buying all day long. All of a sudden, Jerry wants to sell his position so he places a sell order at the best bid. The last price changes from ask to bid as the latest transaction is now a sell order.
Think about this shift as a traffic light. When a car goes north (Bulls) past the light, the light turns green. The light stays green until a car goes south (Bears), at which point the light turns red. If cars keep going back and forth, the light will constantly flicker from red to green. But if there is a sustained flow of traffic in one direction, the light will remain the same color.
Every trade falls either under buy or sell. When people keep buying, price moves up. Selling makes price fall. The problem with this logic is that every trade is technically made up of both a buy and a sell order. If I want to buy Google stock, someone has to sell it to me. The key is understanding how the order placed effects the latest market price.
When we decide to buy a stock, we place an order at the ask price. This changes the market’s current price to the best ask price. Our order is the latest traded price and therefore the market is now in ask mode. The last price remains ask until someone decides to sell, shifting the current market price to bid. Because bid is always lower than ask, the market price has to fall. So because the last order placed was a sell order at the best bid, this is considered bid volume, EVEN though buying and selling technically took place within that one order. The bid and ask volume is what determines the direction of price.
Looking back at traffic light example, it’s not the fact that the cars are moving north or south that matters, its the flow of traffic that matters. We have to assume that there will always be cars coming from either direction. The trick is to figure our which direction has a heavier flow of traffic, because that lane will dominate the market. If there are more Bulls driving north than Bears driving south, price will rise. In terms of market crashes, it’s because everyone is selling at the same time, so the traffic is overwhelmingly in one direction. The crash ends when there is no one left to pass through the traffic light; everyone who wanted to sell has already sold. With everyone now chilling south of the light, some of the braver drivers will venture back north, and so the buying resumes.
So next time some wannabe market guru tries to explain to you why the price went down in the market that day; listing various macro and microeconomic reasons, look at him straight in the eyes with a smug look on your face and say, “my friend, there were simply more sellers than buyers today.”