Anyone that’s paid the slightest attention to the stock market knows price isn’t directly tied to a company’s business. Stock prices, commodity prices like oil and gold, and even bond prices aren’t directly tied to the economy either. Yes, fundamental factors such as a company’s business performance and economic conditions do matter, but there’s something else in between that controls the seemingly random ups and downs in prices.

That mysterious gear that directly controls stock price is the supply and demand of the stock itself as an investment choice, not the value of the company.

This is the most important truth for any investor in any market.  Take a moment to let that sink in. From this point forward, this is how you view all investing and trading. The same applies to investing in commodities, bonds, futures, forex, or real estate.

Thinking of stocks like real estate, the quality and location of a home, just like the quality and business positioning of a company, are considerations for the price. In the end, home prices are based on the supply and demand of homes. If no one wants to buy your home or no one can afford your home, there’s no demand.  You can’t sell the home no matter how magnificent the furnishings are or how great the location. To sell the home, you must keep lowering your offering price to a price a buyer is willing to bid for.

This is the core of how the stock market, real estate market, job market, and even Craigslist work. It doesn’t matter what the buyer or seller think the price of something should be. The price is whatever both buyer and seller agree on to make a transaction. As a seller, if you don’t sell your inventory, whether it be toys on Ebay or stocks in your portfolio, you can’t get cash you can use. The inventory temporarily has no value as it just sits there collecting dust.

Let’s look at how this works for stocks. But remember, the same applies to other assets you can put your money in such as options, futures, forex, commodities, bonds, and real estate. In fact, these compete with stocks for your money. Something to think about.

What Affects Stock Prices (by Affecting Supply and Demand of Stocks)?

Whether you’re investing to build wealth or trading for income, this saying applies:

“Only price pays”

If you need cash, it doesn’t matter if you own a million dollar home you can’t sell. This is why investors and traders alike should apply the basics of technical analysis, aka supply and demand analysis, aka price and volume analysis.

Asset allocation. Top reason factor moving stock prices, commodity prices, bond prices, and other markets up and down. Think of what you do with your investments and financial planning. If you need money, you may cash out some of your investments. If you sold a house or got a bonus, you may add to your investments. These personal decisions have nothing to do with the companies you invest in!  Sure, you’re just 1 person, but everyone does something similar. Multiply you by a million and that’s a big effect on the markets.

Portfolio Management. No one has unlimited amounts of money to invest or trade. So you, or the portfolio managers of your mutual funds, must decide on how to allocate the money set aside for investments. Even if a company is great, you don’t have unlimited funds to keep buying that one company. Even if technology stocks are doing great, diversification tells you to keep some money in dividend stocks or bonds for safety. So a certain stock prices may not do as well as the company’s business suggests because investors, as a whole, don’t have enough money to spend on this particular stock.

Sector Rotation. This is part of portfolio management. Let’s say technology stocks may be doing well, but bank stocks may have even better potential. This is what you’ll hear as “sector rotation.” When portfolio and fund managers sell stocks in one sector (industry), good or bad, to buy stocks in the better industry at the moment. Why do they have to sell? Because they have a limited amount of funds. In order to buy something, they must sell something else first. Shift money from one place to another.

Government Policy and Economic Conditions. These so called “macro” or conditions on a big scale influence everyone’s opportunities and decisions. Housing credits provided by the government can shift investment money from the stock market to buying homes. Lower interest rates makes bonds and CD (certificate of deposits) poor investments, so people may choose to pay down debt or invest in stocks, gold, or other assets.

Psychology. When people feel confident about the economy and, more importantly, have a job and feel confident about their financial situation, they’re more likely to invest. The economy or a business may be doing just fine, but if investors prefer to keep their money as cash in the bank instead of buying shares of stock, the stock will have a hard time going up and may even fall. Cash also competes with stocks, gold, oil, and other assets.

Investors and Traders in the Market. All of these factors I’ve mentioned shows how other people’s actions will affect the market price. Each person, group, company, and government has it’s own agenda, it’s own risk tolerance. We all have a limit of how much we’re willing to or can afford to lose. These “cry uncle” points is where many people have decided to throw in the towel and sell. With many people selling at similar prices, the market is flooded with a large supply like at a firesale. Though it may be temporary, this flood of supply makes shares plentiful and thus cheap. Other sellers may join in and match the lower prices just to make their prices competitive. Thus, other people’s financial situation and investments they own can affect the overall market. It is important to know the types of investors and traders in your particular stock, stock industry, or other assets such as forex or gold.

Business Performance & Health. Lastly, this is what most investors focus on, but as you see it’s only one aspect of the supply and demand story. Not the most important, either. Over time, these so called fundamentals of business health and performance matter because the company can be bought out by another company below a certain price. Or, the company can use the cash it has to buy all of it’s shares back from you and other investors. Most companies do have some real value: cash, buildings, factories, intellectual property, and so on. In bad economies or bad seasons for a particular industry, the business may not do as well. Make less sales, accumulate less cash. Strong companies may use bad conditions to buy smaller struggling companies to expand their empire. These things also factor into how attractive or unattractive a stock is to an investor.

When Prices Go Up: More Demand for Stocks Than Supply Available

At some price, buyers will find a stock cheap enough to buy all the shares the sellers are selling. With whatever cash the buyers still have, they want to buy more. The buyers pay a bit more so the sellers are willing to let go of more of the shares they own. In this way, the buyer’s demand keeps pushing prices higher. This continues until a balance is reached where the buyer has bought all they want at a higher price and the seller isn’t willing to lower their price to entice the buyers to buy more.

When Prices Go Down: Less Demand for Stocks Than Supply Available

On the flip side, at some point buyers don’t think it’s worth buying more for high prices. They’ve accumulated a lot of inventory, whether if it’s stocks, gold, or other assets. If anyone who owns some inventory thinks there’s not much that’ll happen to make the stock more valuable, such as a cancer curing medication, they’ll want to sell the stock to take profits and get cash. As more owners sell (for whatever reason), the price continues to fall. The sellers are now providing more supply than demand. To entice a buyer, the holder of the stock keeps lowering the price.

What is market liquidity?  Why is it an important consideration when trading the markets?

The definition of a Liquid market is a market in which selling and buying can be accomplished with minimal effect in price.

Let’s look at a real world representation of market liquidity and see what conclusion you come to.  The screen shots shown below in two boxes are commonly referred to as a DOM (Depth of Market) or Trade Ladder.  Both markets are futures, but the idea is the same for other markets.

• The center column shows the price of the market.  
• The left of this center column is bid size and this measures how many bids are at each particular price.
• The column to the right of the center column is the ask size and this measures how many asks are at each particular price. 

Please compare the number of bids (buy orders) and asks (sell orders) in each box.

• Which market has more bid and asks? 
• Which market has a smaller differential between the bid and ask Price?
• If you were going to enter an order to buy (go long) 25 contracts, which market do you feel would be more able to absorb that order when using the definition for a liquid market mentioned above? 

The box on the left represents the market that best characterizes the correct answers to these questions. The market shown in the left box has a quantity of 219 bids and 474 asks at the current market (see orange underline). In contrast the market shown on the right box has 3 bids and 1 ask with not many bid and asks supporting those (see orange underline).  Now look at each center column (Price) which will display the minimum price size or tick, the market on the left is 1 tick difference whereas the market on the right has an 8 tick difference.

Here are a few additional questions to consider:

• As an investor, trader, speculator, etc. does it make sense to participate in a market where the ability to enter and exit leaves as little impact on the market as possible? 
• Which of the markets pictured above would generally be subject to larger price swings a liquid or non-liquid market? 

The real world of trading has costs that are associated with them.  You have trading costs like commissions, exchange fees, etc.  You must factor in the spread of the market price when determining your break even. It should be rather obvious then that a liquid market will allow you the chance at entering and exiting the market with minimum impact on market pricing.  A non-liquid market (picture box on right) certainly shows that any significant volume needing to be traded would be met with some larger price swings and wider price spreads.

The type of trading you plan on doing is also a very important consideration.  If you are going to buy and hold a position over a long period of time then deep liquidity is not very important.  A day trader does need deep liquidity and needs that liquidity during the times they are planning on trading.