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What You Should Know About The Stock Market

What You Should Know About The Stock Market

Everyone’s heard of the stock market — but few know why it works. Were you aware that each stock has two prices? That you can’t buy and sell for the same amount? That a “stock market” works better and is more open than a “stock store”?

If you’re like most of us, probably not. Here’s why stock markets rock:

Most explanations jump into the minor details — not here. Today we’ll see why the stock market works as it does.

iPhones Ahoy!

I’m told iPhones are popular with the 18-35 demographic. A market research firm asked me to find a good selling price, so I’ll pass the question onto you:

Me: You, the coveted 18-35 year old demographic, want an iPhone. What’s it worth?

You: Dude, just get the price. Duh.

Ok hotshot, riddle me this: what is the price, exactly?

So which price is the “real one”? Both.

You see, buyers and sellers each have prices in mind. When prices match, whablamo, there’s a transaction (no match, no whablamo).

The idea of two prices for every item is key to understanding any market, not just stocks. Everything has a bid and an ask, and each shopping model has a different way of handling them. This leads to different advantages for buyers and sellers.

Shopping Time

Suppose we want to buy an iPhone from Amazon. You see the selling price of \$200 (Amazon’s ask), and personally decide if it’s “worth it” (i.e. less than or equal to your bid):

store pricing model

In the store model, Amazon shows a public asking price (\$200). Each buyer has a secret bidding price, some more than others. Buyers willing to bid \$200 or more purchase the iPhone; the rest hold off (\$199 and below).

Amazon picks a price that attracts the most bidders yet still keeps a profit. In the store model:

Even though buyers are “in control”, they may have to search around to find a store that meets their bid (if any). That’s inefficient.

Onto eBay

Now suppose we want to sell our new, unopened gadget (you, the 18-35 demographic, are fickle like that; the survey said so). Sure, we could try to sell it on Amazon — now we’re our own store and need a price we think people will pay. We’re in the same boat as Amazon, and could set the price too low. That’s no fun.

Instead, we auction off the new iPhone on eBay to maximize profits:

ebay pricing model

In the eBay model, buyers have public bids and compete for the product. The seller keeps their minimum price secret and hopes to make a profit by having someone “overpay”. In the auction model:

eBay is great for sellers — you have the chance of making extra profit. For buyers, it’s not so great: you can lose auctions by \$1 (paying 201 when 202 was the highest bid), even though the seller would have been happy with 201. You could enter multiple auctions with \$201 but risk getting two iPhones.

Want Ads and Hagglers

There’s other trading approaches also:

In want ads, the asks are transparent while the bids (your value) are hidden. When haggling, both prices are hidden which can lead to a stressful situation.

It’s About Supply and Demand

Each model has similar concepts, namely:

The phrase liquidity refers to how effectively you can trade; how easily cash can flow. When buyers and sellers have to argue or haggle, trading freezes up. In particular, there’s a common problem in the market above:

When buyers and sellers need to search to find each other, and haggle when they get there, trading slows down.

Enter the Market

But hope is not lost! Surprisingly, the very symbol of capitalism is an “open source” model:

And here’s what it looks like:

market price model

Every iPhone seller lists their asking price (210, 205, 201, 200). Every iPhone buyer lists their buying price (190, 195, 199, 200). When prices match, a transaction happens: the buyer who wants to pay 200 gets matched with the seller who wants 200. They’re happy.

Eventually the matches cease and we come to a standstill.

Drop and Spread ‘em.

Trades don’t last forever: there’s a standoff and an awkward pause. The lowest sellers want \$201, and the highest bidder wants \$199; this \$2 gap is called the spread. The last price of a transaction was \$200.

Now what happens? Buyers and sellers can do:

When you place a limit order (“Buy an iPhone for 195″), your order gets added to the bid queue (similar for asks).

If you need to trade right now (“buy it now!” or “sell it now!”), then you use a market order. You’ll get the best price available:

Now this is interesting. Notice how market orders take items off the queue and change the last price. When people place market orders, the stock price fluctuates. Yes, it’s “just” supply and demand, but it’s pretty cool to know it’s happening real-time in the stock market.

If there’s a lot of buyers, they’ll “use up” the ask queue and the price will rise. If there’s a lot of sellers, they’ll “use up” the bid queue and the price will fall.

This explains why it’s hard to buy and sell for the same price. If you buy for 201, and no new bids come in, you’ll only be able to sell for 199.

In the real world, the list looks like this:

bid ask market depth SPY

You see the bids, asks, quantities, and names. Here the bid is 204.91 (max someone will pay) and the ask is 204.92 (min someone will sell). When a buyer or seller gets restless, they may decide to immediately buy/sell, which moves the price. This detailed data is called a Level II quote.

So Who Runs This Popsicle Stand?

The NYSE and NASDAQ are the two major American exchanges. There are differences, but at the core they provide:

How Do They Make Money?

Well, often they don’t. In the NYSE, 88% of the trades happen between the public without needing the specialist (remember those guys waving papers and screaming at each other? I wouldn’t want to get involved with them either).

But sometimes they are needed. The market makers literally “create a market” by providing liquidity: you can buy and sell stocks to them at the bid and ask prices. Popular stocks have a small spread due to the demand and volume.

But how do market makers make money?

market maker

Well, it’s a bit like a currency exchange at a bank, where’s there’s a different rate for buying and selling. Let’s say Sue has an iPhone to sell, and Bob wants to buy an iPhone. It might go like this:

See what happened? The market maker bought an iPhone for 199 and sold it for 201: it pocketed the spread of \$2. Dealers constantly change their prices based on the bids and asks; they can even lose money depending on the trades coming in. But usually it’s a pretty good gig.

You, the investor, can avoid paying “the spread” by placing limit orders to sell or buy at a certain price. But then you aren’t guaranteed to make a trade.

It’s All About Timing

Bill Gates has a lot of shares of Microsoft. People naively put this wealth as “shares times price”, but you know that doesn’t really work. If he tried to sell all his shares, he’d use up the bids.

Each block of shares would be sold for a lower and lower value — and potential buyers would panic and reduce their bids, thinking something was amiss. Sellers would fear the worst and lower their asks to compete. Pandemonium would ensue. So the actual liquidation value of his shares is really some fraction of the reported amount. But it’s still nothing to sneeze at.

Similarly, large institutions must spread their stock trades over time so they don’t disrupt the market (and evaporate their profits).

The market has built-in shock absorbers: as you sell more, the price you get is smaller and smaller, so you sell less. As you buy more, the price you pay gets higher and higher, so you buy less. So it makes sense to take things slow. Nifty.

There’s Much to Learn

I’ve simplified a lot of things and only scratched the glossed-over surface. Each market has its own rules to create a trading-friendly environment. Read more here:

But, my goal wasn’t to fill your head with details. I want to share insight:

Want a stock tip? Don’t listen to stock tips. (Stolen from a Charles Schwab ad). This article is about looking at a system as one way to solve a larger problem. Happy investing.

Other Posts In This Series

  1. The Rule of 72
  2. Understanding Accounting Basics (ALOE and Balance Sheets)
  3. Understanding Debt, Risk and Leverage
  4. What You Should Know About The Stock Market
  5. Understanding the Pareto Principle (The 80/20 Rule)
  6. Combining Simplicity and Complexity