Prices of stock move on certain pieces of information relatively swiftly. Throughout the year there are earnings reports, investor meetings, high-level resignations and appointments, product introductions, and changes in analyst’s opinions. These tidbits of news quite often change the direction of a stock either positively or negatively in a short period of time.
However, what about those days when no information of import occurs and a stock price moves suddenly? For instance, there are days when stock prices move up almost a dollar for no reason at all. Is insider trading occurring? Or do other investors know about the direction a firm is heading before the rest of the market? What causes these sudden jumps and volatility trading situations?
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Let us return back to microeconomics 101 and analyze supply and demand. Microeconomics teaches us when there is more demand than supply, this causes prices to rise until a new equilibrium is met and satisfies the overall market. In addition, when there is more supply than demand, prices fall until equilibrium is reached. This same logical thinking occurs daily in the stock market.
For example, imagine an investor at an investment bank is interested in purchasing 50,000 shares of Company A with a limit of $22.50. The current price of Company A stock is trading at $22.00 and has consolidated during trading days the last week. First, we are going to analyze this transaction. This investment bank is purchasing a large number of shares, 50,000 to be exact, and is willing to keep purchasing shares up to $22.50. If the stock price goes over $22.50, no more shares will be purchased. Second, for every transaction there is also a seller on the other side. This investor needs enough sellers to purchase 50,000 shares with a limit of $22.50. This transaction is creating momentum on a stock due to large demand, which will push the stock price higher.
In the situation described above, more demand for a stock causes the price to rise due to lack of sellers in the market price. As the price rises, more sellers enter to offload shares because this is an optimal selling point.
Now let’s look at the opposite scenario where there is more supply than demand. This scenario will describe the Flash Crash of 2010. On May 6, 2010, more sellers entering the market than buyers on certain stocks. These orders were rushed to be executed at the market price, which means stock prices took a sudden dive to meet this unexpected demand. The large amount of sellers overwhelmed the market and in turn hurt other investors who did not use limit orders. If you were a regular investor who placed your bid to the market without a limit you might’ve not sold at your ideal price. This is why limit orders are critical for retail investors in an effort to avoid the realities of rapid price changes in the market.
Supply and demand is once key element as to why stock prices gyrate on random days even when there is no basis for doing so. It is important to recognize the role supply and demand plays and for investors to take this notion into account when prices of stocks rise or fall rapidly.
