The Economics of Stock Trading

Economics is really all about supply and demand, and this is certainly the case with stocks that are traded. This is where the rubber meets the road so to speak, where all matters become decided as far as price goes.

Stocks fluctuate in value over time, and often fluctuate quite a bit, and the fact that the stocks represent shares in companies can lead people to believe that this is really just about business performance. After all, when you own a piece of a business, isn’t the business performance what you own?

The Economics of Stock TradingThat is the case actually with privately held stock, stocks that do not have a market, and one’s ownership in the company completely comes down to one’s share of the profits, through the payment of dividends. These stocks don’t have an effective price normally, their valuation comes purely from what the company is worth and their future business expectations.

A lot of people think that publicly traded stocks work the same way as well. This is not the case at all though. The price of a stock is purely determined what people are willing to pay for it.

Of course, how a company is doing is going to play some sort of role in the pricing, especially in the long term. The longer the term, the more business performance matters. It only matters though because of how this tends to affect the supply and demand equation of its stock, not because there is any direct relation between business performance and price.

Stocks vary considerably as far as their price to earnings ratio, and while some of this is due to future earnings expectations, the market will set whatever price on a stock that people are willing to pay, based upon whatever it decides is important.

The Role of the Stock Market Overall

Why do so many stocks move together?  This is due to the concept of opportunity cost, the amount of money in the stock market as opposed to having it elsewhere.

At any given point in time, there is a certain percentage of money invested in the stock market, as opposed to alternatives such as the bond market, gold, the money market, and so on.

If, for whatever reason, there is a movement away from the stock market and into another asset class, this affects the overall pool of investment. People will typically liquidate their stock positions in concert with this, and if for instance people are moving 10% of their stock holdings into bonds, on average, this is going to increase the supply for a given stock by that much, on average, and this will result in a decline.

Now the underlying business may not have seen any real change, and people might wonder why the price went down so significantly anyway, and it is due to the conditions of the market, and not necessarily business conditions.

On the other side of the coin, when money flows into the stock market from other asset classes, or if the investment pool simply grows over time, with more people putting more money into stocks, this increases the money in the stock market and will result in stocks going up on average.

The fact that people invest more in the stock market over time is the sole reason why stocks on the whole have historically increased over time.

These market forces shape the performance of stocks considerably. Stocks aren’t all affected at the same rate of course, and those stocks which are superior will still outperform lesser valued ones to some degree, but the size of the total pool does exert significant force upon the price of all stocks in a market.

Managing risk is a key element of successful stock trading, and this market risk must be accounted for. This is the biggest reason why very long-term holdings of stocks is seen as less risky, because over time the market has always grown in the long run, and therefore holding stocks this long takes out the noise of the usual ups and downs of inflows and outflows in the market, as well as things like business cycles.

Market Volatility Can Be Your Friend as Well

A lot of stock traders and investors see volatility as a bad thing, equating it with risk, and seeing risk as a bad thing. This forgets that where there is volatility, there is opportunity, and the worst case scenario for a market is stagnation, where no one makes money.

There is a strong bias in stock markets toward the long side of trades, and what is feared is that the price of a stock may decline due to volatility such that a trader may sell it by mistake, being unwilling to ride out this volatility, or having to sell to raise funds for something else and selling at a loss.

People never complain when the volatility goes their way, and they celebrate that, but volatility is a two-way street, and you really can’t have positive volatility without the risk of it going the other way.

Volatility is a measure of the potential for both risk and return, and one certainly doesn’t want to become involved with stocks that are too risky for their tastes, so volatility is something to be accounted for, even though volatility in itself isn’t a negative thing. It’s actually a good thing provided one is willing and able to take on the risk involved with a certain amount of it.

Any time you leverage a trade by trading on margin, you purposefully increase the volatility of the trade. If you put up 50% of a stock trade and borrow the rest, you are doubling the volatility.

This means both your wins and losses will basically be doubled, net of trading costs, and people seek this out because they are assuming that their trading strategies are sound, and therefore favorable overall, and want to increase their expected profit. Whether their strategies are indeed sound or not is another matter.

People don’t generally trade stocks with the expectation of losing though, so leveraging trades makes perfect sense, provided that the trade is still within their comfort zone.

Market Forces Driving Individual Stocks

Now that we’ve dealt with market risk and the way it affects stock prices, now we’re down to business risk, right?  So now the performance of a business or it’s expected future performance are going to drive the rest of a stock’s price, right?

The impact of all of this actually comes down to the actual supply and demand of the stock, and business results certainly do play a role in this, but only to the extent that it affects the supply and demand of the stock, no more and no less.

It is true that dividends do get priced into a stock’s value, and for instance if a company expected to turn a profit and pay out a dividend, the stock price would never go down to practically nothing, or at least stay there for very long. It still could though if that’s all people were willing to pay for it at a given point in time.

Computerized trading can massively drive down the price of stocks temporarily, even though the company’s stock by any measure of value would be worth much more. There have been cases of this, where the supply of a stock becomes so overwhelming that it simply exhausts the demand for it and approaches being almost worthless for a time.

This would never persist though as this does correct itself quickly, but even the possibility of this should give us some real insight into what really drives the trading price of stocks.

This is why, in the shorter time frames at least, and to some degree in all time frames, looking at price performance alone can provide some very good insights into future price performance. There are many traders who solely trade this way and may not even know the name of some of the companies they are buying stock with, just the symbols and the charts, but sometimes that’s all you need.

Business data, the fundamental side of things, as well as aggregate economic data, does drive stock prices to be sure, but it’s important to realize that the nature of this influence is variable and ultimately depends on investor behavior, how many people want to buy a stock at a certain price versus how many want to sell at a certain price.

The Long and the Short of It

There’s two main components to what drives the stock market, the opportunity cost of being in the stock market versus having your money elsewhere, and with the money that is in the stock market, the opportunity cost of having your money in a certain stock over having it in other stocks.

The market opportunity cost drives things like stock indexes, where the individual opportunity costs determine which ones are going to perform better than others and the degree that they do so.

If you are going long, with an expectation of prices rising, it’s best to do so when the market itself is rising or is expected to do so, and the reverse is true with going short.

Investors who are looking to invest for the longer term aren’t going to want to consider going short, and mutual funds generally aren’t allowed to take short positions, so there is a huge bias toward long trades. Money can be moved in and out of the market to look to manage changing market conditions but that’s the only tool they have.

Shorting does involve more risk though, and this is because stock markets generally trend upward, so if you’re looking to bet against that you need to be surer of yourself than usual, and the downside is also therefore greater overall.

Using both techniques does allow us to take better advantage of the basics of stock trading, changes in supply and demand driving prices both higher and lower, being able to profit from the changing economics of the market regardless of how they are changing.

Market rules do require that short sales are done on an uptick, and this can sometimes be a little disadvantage, but unless something is truly tanking, one can often get these orders filled at least in the neighborhood of your desired price point.

In the end, it all really comes down to how the market is perceiving something, whether that be associated with a particular stock or the stock market in general. Paying attention to fundamentals is important as well but it’s market behavior that always ultimately decides stock prices.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.