Most people know of a co-worker, a friend or even a family member who is actively involved in the stock market – maybe that person “made a killing” or “lost their shirt”. The greatest feature of the stock market is also its greatest hazard: namely that anyone with capital can participate. One of the biggest advantages that great traders have over beginners is that great traders understand that a market is actually an arena of opinions and beliefs.

In this article, we want to expand upon the idea of markets as competitive arenas. Specifically we want to show you that when thinking about trading, it is very important to understand that price is just a reflection of beliefs about a particular stock.

Pick a price, any price

In one of our previous articles, we described the market as a “price discovery mechanism” – that is, through the actions of buyers and sellers of a good (in this case a stock), the market price of that good can be established. In the highly complex world that we now find ourselves in, money – or more accurately purchasing power, is critical to keeping the world going. Having a mechanism to ensure we know how much ‘things’ are worth is absolutely essential to allow people to exchange the right amount of money for those things.

When you see a price quoted for a stock, it is actually slightly misleading in the sense that it leads you to believe that a stock has only one price, when in fact the price for a stock could be one of three prices.  In stock trading language, the price a buyer wants to buy at is known as the “bid price”; the price a seller wants to sell at is known as the “ask price” and the price they ultimately settle on is known as the “last price”.  It is the “last price” that is often quoted as the “market price”.

“Let us not negotiate out of fear, but let us not fear to negotiate….”

Even though that quote by John F. Kennedy had a very different context, it is surprisingly applicable to life in the market. Prices in the world of trading are similar to prices that people pay for items in the store. Let’s suppose that you, the buyer, go into an electronics store to buy a camera.  The store in this example is the seller.  Generally most buyers that go into a retail store believe that the price on the sticker is fixed i.e. the selling price is the price they have to pay, and once they pay it, it becomes the ‘market’ price.  When the item is popular, it generally doesn’t go on sale (like most Apple products), and if it is unpopular it is highly discounted.  What most people don’t realize, however, is that what they want to buy the item at is one possible price, and what the retailer is selling it at is also another possible price. The final price, the one you actually pay at the register, is a reflection on what both the buyer and the seller ultimately agree upon.  To think like a great trader, you almost always are inclined to negotiate, even at retail, because great traders realize that there is always a price they can pay that may or may not be better than the price on the sticker.

 Going the distance

The difference between what a buyer is willing to pay for something and what a seller is willing to sell at is referred to as the spread. Most beginner traders or investors look at the last price as an indicator of what something is worth, and while not incorrect, what great traders pay attention to is the distance between the prices of buyers and sellers – the spread. After all, once you buy something with expressed intention of selling it, you want to be able to be sure that you are going to get a good price for it.   Spreads between prices are very valuable in establishing how efficient the market is for a particular stock.

Markets that function well are those that can efficiently determine what something is worth.  The more participants there are in a given stock, the better the chance that the “market price” is close to what the stock is actually worth (or at least that’s what the theory says should happen). A market for a given stock with lots of participants is said to be highly liquid – meaning that one can easily purchase or sell that stock should they want/have to.  For example, cash is considered a very liquid asset because you can readily spend it (technically it’s very easily transferred). A collection of antique dishware, though valuable, is not so readily convertible into cash.

When it all goes pear shaped

If the market for a stock becomes illiquid, that means that there are not a lot of buyers or sellers and if one or both of those parties no longer participate the market becomes frozen and/or crashes.  Remember that markets determine what things are worth, and if you can’t determine what something is worth, you can’t determine what you are worth (in monetary terms).

This is the exact issue that arose during the recent financial crash. Many banks had assets (mortgages) that the market disappeared for, thereby making virtually impossible to calculate what those assets, and therefore anyone who held those assets, were worth. If nobody knows how much the holder of those assets is worth, then it is very hard to justify being an investor because you just don’t know what you’re buying into.  Recall that as uncertainty (or disagreement between buyers and sellers) increases, the spread between buyers and sellers will become much wider.

It is a scary prospect if you are on the wrong end of one of those moments where the market for a given stock goes sharply in one direction or another. The fewer the participants trading a particular stock the more likely that stock’s price will fluctuate more wildly.

Coming up next

In the next article in this series, we will talk about how great traders approach market fluctuations.  For now though, it is important to understand that prices are reflections of opinions and beliefs.  Each participant, buyer or seller, has an opinion about what a stock should be worth at some point in the future and it is that belief that (generally) drives their purchase or sale of a stock. Sometimes those opinions are correct and sometimes they are not, and great traders are the ones who can consistently figure out the difference.