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The two forces behind stock price changes

ENTERPRISE
By Peter Wambu | November 27th 2019

Countless schools of thought have been advanced as to why stock prices fluctuate as they do. 

Some people point at earnings, management, the industry or the economy. While these factors impact buyers and sellers of stocks, in reality they have minimal direct impact on prices.

What these and many other factors do is change the balance of supply and demand.

This is a fundamental truth that every investor or trader needs to grasp.

Stock prices are a direct result of supply and demand. All other factors like company, industry, sector and economic performance affect the desirability of owning or selling a stock. If a company surprises stock owners with low earnings, demand for the stock could wither. As it does, the equilibrium between demand and supply of the stock is altered.

Future buyers will require a discount in the stock’s price and many sellers will need to be motivated to accommodate that price, whatever the cause.

More sellers than buyers means that supply will exceed demand, so the price falls. At some point, a stock’s price will drop enough for buyers to find it attractive. There are many factors that can change this dynamic. As buyers move into the market for a stock, demand grows faster than supply and the price increases.

Often, supply and demand find equilibrium at a price that buyers accept and sellers accommodate. When supply and demand balance, so that they are roughly equal, prices move up and down in a narrow price range. 

We can find many examples of stocks staying in a flat range for days or months before an event disrupts the supply/demand balance. This period is referred to as consolidation.

Effects of demand and supply

If demand for a stock exceeds the supply, its price will rise. However, it will only rise to the point where buyers find the price attractive. After which, demand will typically wane.  As you know, declining demand will cause stock owners to sell.

As owners sell (for whatever reason), the price will fall as there is now more supply than demand. By dropping the price, sellers of a stock hope to encourage buyers.

This dynamic works just the same when demand increases but in reverse. As the price falls, it will reach a level where buyers find the stock attractive and demand will increase. When investors start buying, the stock’s price will rise as more and more sellers need to be enticed to sell their shares.

These mechanics of supply and demand are the most important truths that new investors need to learn about stock prices. It is the give and take between supply and demand that sets the price.

No matter how well a company has performed, the price of its stock will not go anywhere if there is no demand for it.

Similarly, the stock of a poorly performing business can skyrocket if market participants become enthusiastic about it for reasons that may not even be fundamental.

Who can impact the supply demand equilibrium

If stock prices are a direct result of demand and supply, then it follows that those who own many shares of a particular company or have lots of money are the ones who influence stock prices most.

Such entitiesinclude institutions like mutual funds, pension funds, endowment funds, banks, insurance firms and high net worth individuals. These entities trade in sufficient volume to impact stock prices. Their large transactions drive stock prices up or down depending on the number and speed with which they buy or sell.

This is the reason why when institutions want to offload or buy a stock, they have to do so slowly. If they flood the market at once with sell or buy orders, it will create a huge supply or demand respectively. This will drive the price down or up very fast to their disadvantage.

Stocks are subject to the laws of demand and supply as much as any other product. Identifying stocks with the proper technical indicators to motivate institutional buying or selling is critical in locating stocks that are ready to make large price moves. It is no wonder that stocks with huge numbers of outstanding shares require institutional support for their prices to move.

Retail traders dealing in small numbers of shares will not move such stocks.

How is this information useful?

Look for stocks with a rising demand? How do you know this? Look at trading volumes and volume based charts like OBV. If a share trades on a daily average volume of 200,000 and suddenly starts trading over that average, it is an indicator of demand or supply rising. Watch that stock! It could be headed down or up.

It could be time to buy or sell. Rope in other factors to see in which direction it is likely to go.

The writer is the author of the book, ‘The Ultimate Framework for Success in Shares’.  

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